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An externality occurs in economics when the actions of one consumer or firm affect the well being or production of another consumer or firm with whom there is no direct business relationship. Examples of these kinds of technological externalities might include:

In contrast:

Externalities are important in economics because they may lead to inefficiency (see Pareto efficiency). Because the producers of externalities do not have an incentive to take into account the effect of their actions on others, the outcome will be inefficient. There will be too much activity that causes negative externalities such as pollution, and not enough activity that creates positive externalities, relative to an optimal outcome.

Many of the most important externalities in the economy are concerned with pollution and the environment. See the article environmental economics for more discussion of externalities and how they may be addressed in the context of environmental issues.

Table of contents
1 Supply and Demand
2 Negative Externality
3 Externalities and property rights

Supply and Demand

Externalities can be illistrated on a standard supply and demand diagram if the externality can be monetized. An extra supply or demand curve is added. One of the curves is the private cost that consumers pay for a given quanity of the good (marginal or average private cost) and the other curve is the cost that society pays for the good (the marginal or average social cost). Similarly there might be two curves for the demand or benefit of the good.

Negative Externality

This graphics shows a negative externality. The private cost is less than the public cost. If the consumers only take into account their own private cost they will end up at price Pp and quantity Qp, instead of the more efficient price Pe and quantity Qe. The result is inefficient since at the quantity Qp the benefit (a.k.a. the demand) is less than the societal cost, so society would be better off if the goods between Qe and Qp had not been produced.

Externalities and property rights

Ronald Coase argued that where property rights are clearly defined, individuals will organise trades so as to bring about an efficient outcome and eliminate externalities. This result is often known as the Coase Theorem.