What is an externality in economic terms?

An externality in economic terms refers to a cost or benefit that affects a party who did not choose to incur that cost or benefit. This means that the actions of one individual or company can have unintended consequences—positive or negative—on others who are not involved in the transaction. For example, pollution from a factory imposes a negative externality on nearby residents who suffer from health issues as a result, even though they are not directly involved in the factory's operations. Conversely, a company that invests in community parks might create a positive externality that benefits the surrounding population without them having to pay for that benefit.

This definition emphasizes the broader social implications of economic activities, which can lead to market failures when external costs or benefits are not accounted for in the decision-making processes of those involved in the transactions. Understanding externalities is crucial for policymakers to create regulations that address these unintended effects and enhance overall welfare.