Every economic transaction has at least two people involved: the buyer and the seller.

But, what happens when an economic activity or transaction has a side effect on a third party?

You guess right! Externality. An externality can be defined as the positive or negative spillover that an economic transaction has on a third party who is not otherwise involved in the transaction.

More appropriately, an externality is a cost or benefit borne by individuals who are not part of an economic transaction. 

As an example, consider the case of Daniel, a second-hand smoker. His activities not only posed serious health and respiratory problem to him but to neighbors who may be exposed to his activities. 

Smoking produces negative externalities

Thus, we say, Daniel's smoking imposes an externality on his neighbors since they are external to the transaction (of smoking).

However, not all externality is negative. Some are positive. Hence, economists distinguish between positive and negative externality.

Positive externality

A positive externality occurs when an economic activity provides benefits to individuals external to the activity.

In other words, positive externality occurs when a third party experiences the positive side effect of an economic transaction.

Positive externalities are also called external benefits.

Your neighbor who decides to plays music loud in the neighborhood will certainly provide you with some cost and benefits.

If you are a music lover, then, you will receive some benefits from your neighbor's music.

Thus, your neighbor's music provides you with a positive externality, for which you enjoy an external benefit.

As another example, consider the individual who gets vaccinated against covid-19. Those around him will benefit since they cannot any longer contract the virus from him.

In this case, a transaction occurs between the doctor and the individual. However, this transaction has a positive spillover on everyone around him who is external to the transaction.

The problem with positive externality is that people who create these advantages can not charge the external beneficiaries for it

Hence, the beneficiaries free-ride in that they benefit from an economic transaction without paying.

Going back to our earlier example of you enjoying music. Your neighbor might endure certain private costs like buying the music DVD and other equipment. 

But, he can not charge you for listening to the music even though you benefit from it.

Because the creator of positive externality does not get compensated from the benefit, they have little incentive to create more of these goods.

The result is that the creator of these goods with external benefit will create less of the goods than society needs.

Negative externality

Negative externality, on the other hand, is an adverse side effect experienced by individuals who do not choose to be subject to an economic transaction.

More appropriately, negative externality can be defined as the cost incurred by third parties who are external to an economic transaction.

Negative externalities are also called external costs. The case of secondhand smoking, earlier given, provides a good example of a negative externality.

As another example, consider a sewage company located near your house. This company will certainly impose a cost on you as you will have to grapple with the smell of sewage even though you are not a subject of the economic transaction.

Thus, the sewage company imposes a negative externality on you.

The problem with negative externality is that individuals who create these disadvantages do not always pay for the external cost imposed on the third parties.

Returning to our earlier example of second-hand smoking. Daniel, like almost all smokers, would not compensate his neighbors for all the external costs they incurred from his activity.

Because daniel does not have to pay for the external cost imposed by his activity, he has little incentive to stop smoking.

The result is that the creators of these negative externalities will produce more than society require.

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Of course, the government won't fold its hand and allow more of these demerit goods to be created.

Government can correct this negative externality by internalizing this externality.

Such policies as persuasion, tax can be used by the government to correct externalities.

By doing this, the government hopes to recover funds to fixed the damage caused by negative externalities and prevent demerit goods from being over-produced.

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