Concept of Externalities

In economics, externality is the term used to describe the cost or benefit incurred by the third party who did not choose to receive that cost or benefit. It is the consequence of economic activities endured by an unrelated third party due to lack of control over the factors that creates the cost or benefit.

An externality can be positive or negative.

Positive externality

Positive externality or benefit is an involuntary gain in welfare of one party due to activities of another party. The party causing benefit does not receive any financial compensation.
Given below are few examples of positive externalities which will clarify the concept of positive externality.

Example 1: A farmer who farms fruit does not only produce fruits for selling but also helps bee farmers around the area. The bees can collect ample amount of nectar to prepare honey and increases benefit of bee farmers for which bee farmers won’t be charged any money.
At the same time, bees help in pollination at fruit farm. Fruit farmers do not need to pay any kind of compensation to the bee farmers for this benefit.


Example 2: You go to college and university, and pay for education for personal benefit. However, your knowledge is helpful not only to you but also to other members in the society.
Also, when you join any company, the employers of that place would not need to spend time and money to train you, causing the company notable benefit.

Negative externality

Contrary to positive externality, negative externality or cost is an involuntary loss in welfare of one party due to activities of another party.  The party which causes loss does not need to pay compensation to the one suffering from it.
Few examples of negative externality are given below that will help you further understand about negative externality.

Example 1: Chemical manufacturing industries degrade the natural state of water resources by mixing sewages into them. The consequence of water pollution is faced not only by the industry causing it but by all the people living in and around that environment.
People may even suffer from air borne diseases. But the expenses that incur to people for treating their health won’t be paid by the industries.


Example 2: People who use automobile for transportation contribute to air pollution as well as congestion. Other people who do not own an automobile are also affected by these problems.