An externality is a positive or negative spill-over affect on a third party after an economic transaction has taken place between two involved parties.
Externalities occur when there are external costs or benefits which spill-over from an economic activity into the general public. When an economic activity is agreed upon by a firm (producers) and individuals (consumers) they incur the private costs and enjoy the private benefits. Almost every economic activity will however have an external affect on other people (third parties).
Therefore, to measure the actual cost and benefit of an economic activity on all of society, we must include the external affects. We call this the social cost and the social benefit.
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Key terms:
Social cost – private costs + external costs
Social benefit – private benefits + external benefits
Third party – someone who is external to an agreement made between a producer and a consumer.