Overview
An externality arises when one party's production or consumption affects third parties without passing through market prices. Marshall (1890) discussed the "external economies" that arise when an industry clusters in one place, and Pigou (1920) framed the idea as a gap between private and social cost, making it a core concept of public economics.
Positive and negative externalities
- Negative externalities push costs onto others, as with air and water pollution from factories, noise and traffic congestion. Because producers do not bear these costs, markets produce more than the socially optimal amount.
- Positive externalities spill benefits onto others, as with education, research and development or a beautiful garden. Because providers are not paid for these benefits, markets supply less than the optimum.
In a diagram of a negative externality, the social marginal cost curve lies above the private marginal cost curve, and the gap produces overproduction and a deadweight welfare loss. For firms, the key point in investment and management decisions is that this gap can turn into real costs in the future, such as taxes, levies or emission charges.
Remedies: internalization
Bringing an externality into prices is called internalization.
- Pigouvian taxes and subsidies: a tax equal to the external harm, or a subsidy equal to the external benefit, aligns private and social cost. Carbon taxes are the best-known example.
- Direct regulation: limits such as emission standards or bans restrict quantities directly; their pros and cons are discussed in theories of government regulation.
- The Coase theorem: Coase (1960) argued that if property rights are clear and transaction costs low, bargaining between the parties reaches an efficient result whoever holds the rights.
- Emissions trading: a cap is set on total emissions and permits are traded. The European Union launched greenhouse-gas emissions trading in 2005 and Korea in 2015.
Limitations and debate
In practice the size of an externality is hard to measure, so setting the right tax is difficult. The Coase theorem is hard to apply to problems such as air pollution with many victims and high transaction costs, and regulation risks government failure. The overuse of resources that belong to no one, the tragedy of the commons, is closely related.
Using it in economics study and understanding ESG
Externalities feature in the market-failure chapter of introductory economics, in civil-service and public-enterprise economics tests and in job interviews in the environment and energy sectors. They are also a basic concept for understanding corporate ESG (environmental, social and governance) disclosure, carbon costs and trends in emission-permit prices. A good answer shows overproduction and welfare loss in a diagram and compares Pigouvian taxes, regulation, Coasean bargaining and emissions trading. For the wider context of global environmental change, see also the Anthropocene.
Sources reviewed: 2026-10-16
References
- Marshall, A. (1890). Principles of Economics. London: Macmillan.
- Pigou, A. C. (1920). The Economics of Welfare. London: Macmillan.
- Coase, R. H. (1960). The problem of social cost. Journal of Law and Economics, 3, 1–44.
- Hardin, G. (1968). The tragedy of the commons. Science, 162(3859), 1243–1248.