Externalities – Definition

  • Externalities occur when producing or consuming a good causes an impact on third parties not directly related to the transaction.
  • Externalities can either be positive or negative. They can also occur from production or consumption

Positive Externality in Production.

A farmer grows apple trees. An external benefit is that he provides nectar for a nearby bee keeper who gains increased honey as a result of the farmers orchard.

Negative Externality in Production

Making furniture by cutting down rainforests in the Amazon leads to negative externalities to other people. Firstly it harms the indigenous people of the Amazon rainforest. It also leads to higher global warming as there are less trees to absorb carbon dioxide.

Positive Externality in Consumption.

If you take a three year training course in IT. You gain skills but also other people in the economy can benefit from your knowledge.

Negative Externality in Consumption

If you smoke in a crowded room, other people have to breathe in your smoke. This is unpleasant for them and can leave them exposed to health problems associated with smoking.


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