What is an Externality?

Definition: At times, an economic decision made by one party has an unintended effect on another unrelated party. This effect is known as an externality. Most externalities are negative, although there are many positive externalities as well.

What does Externality mean?

A company may set up a chemical factory near a river and discharge its liquid waste into it. This untreated effluent could poison the water and pose a serious health hazard to the people who live downstream.

The polluted water is a negative externality. The company benefits as it saves on investing in equipment to treat its waste. But the cost to society is far greater than the savings that the company makes.

How can negative externalities be tackled? In most instances, it is up to the government to step in with appropriate regulations. Firms that pollute the environment should be fined heavily. Government regulations should make it compulsory to install equipment that cleans up the waste that is emitted during the company’s production process.

An externality could also be positive. Google Maps offers satellite imagery, street maps, and real-time traffic updates. It helps the company make money through advertising. But it is also of great benefit to taxi operators and anyone else who is driving to an unfamiliar location.

Example of Externality

Arthur C. Pigou, a British economist, wrote about externalities in his book, “The Economics of Welfare.” He said that it was necessary for the government to intervene with taxes and subsidies when externalities arose. These are called Pigovian taxes and subsidies.

A firm that pollutes the environment should be subjected to a Pigovian tax. But which are the externalities that should attract a government subsidy? When a person is educated, it is of benefit to the individual, but the entire society also gains.

It is for this reason that the government could consider subsidizing education. Individuals would be encouraged to enroll in college if the fees were affordable. A Pigovian subsidy would help to achieve this end.


An externality could have a negative or a positive effect. The consequences of an externality are felt by people who are unrelated to the activity that causes it.