Definition
Externalities
An externality is a cost or benefit of an economic activity that falls on third parties not involved in the transaction, such as pollution (negative) or vaccination (positive).
When a factory pollutes a river, the health costs borne by downstream residents are a negative externality the factory doesn't pay for. Education and vaccination create positive externalities benefiting society beyond the individual.
Because markets ignore externalities, governments intervene: India uses pollution taxes, emission norms, and subsidies for clean energy and vaccines to align private incentives with social welfare. A Pigouvian tax on a harmful activity is a classic corrective tool.
Related terms
- Pigouvian TaxA Pigouvian tax is a levy on activities that generate negative externalities, set to make polluters or harmful consumers bear the social cost, as India's high GST rate on sin goods like tobacco aims to do.
- Carbon PricingCarbon pricing puts a cost on greenhouse-gas emissions, via a carbon tax or a cap-and-trade market, to make polluters pay and incentivise cleaner choices.
- Public GoodsPublic goods are non-rival and non-excludable: one person's use doesn't reduce another's, and no one can be easily excluded, so markets underprovide them and governments step in.
- Tragedy of the CommonsThe tragedy of the commons describes how a shared, unowned resource gets overexploited because each user captures the full private gain from using more, while the cost of depletion is spread across everyone.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.