Cambridge International as and a level Economics Ebook

Externalities
Defining externality
If the market system is to work well and lead to economic 
effi
ciency, it is important that those people who make 
economic decisions are the same as those who are 
aff ected by these decisions. A transaction between a 
supplier and a consumer for a product needs only to 
aff ect the particular supplier and particular consumer 
involved. As long as this is the case, then both sides will 
act only so long as both feel that they will benefi t from 
any action – all is well in the market. However, a problem 
could clearly arise if someone else not party to the 
economic decision is aff ected by that decision. Th
is is the 
concept known as 
externality
.
Externality:
 
where the actions of producers or 
consumers give rise to side eff ects on third parties who 
are not involved in the action; sometimes referred to as 
spillover eff ects.
KEY TERM
An externality is said to arise if a third party (someone 
not directly involved) is aff ected by the decisions and 
actions of others. Th
e side eff ects can be negative or 
positive. A 
negative externality 
occurs when the side 
eff ects have a negative or detrimental impact that 
involves unexpected costs to third parties. A 
positive 
externality, 
which is less common,
 
is where the side 
eff ects provide benefi ts to third parties. In both cases, 
those who are aff ected are outsiders to the action that 
causes the externality to occur.
Negative externality: 
where the side eff ects have a 
negative impact and impose costs to third parties.
Positive externality:
 
where the side eff ects have a positive 
impact and provide benefits to third parties.
KEY TERMS