DEFINITION: In economics, an “externality” is an economic consequence of some economic activity, which affects an economic actor that was not involved in the activity.
Theoretically, an externality may be either beneficial (positive) or harmful (negative) to the economic actor in question. However, as a practical matter, harmful externalities are of most interest to economists.
Therefore, an externality may be thought of as an “indirect” or “external” cost to an economic activity.
ETYMOLOGY: The English adjective “external” derives from the Latin near-synonymous adjectives, exter, meaning “outward,” “foreign,” or “strange,” and externus, meaning “outside” or “external.”
The noun “externality,” which is derived from the adjective “external,” is first attested during the seventeenth century. However, its current meaning within the context of economics is relatively recent, dating from the late nineteenth century.
USAGE: The classic example of a harmful (or “negative”) externality is air pollution.
If one economic actor—say, a factory—emits pollutants into the atmosphere from its smokestack, then it may create a harm, which constitutes a cost that must eventually be borne by another economic actor.
In this example, the other economic actors which must bear the cost of the externality may be either the citizens who must breathe the polluted air or possibly a government entity charged with compensating for the pollution in some manner.
As already mentioned, the concept of externality may be traced to the nineteenth century. The eminent British economist Alfred Marshall mentioned the concept in passing in his writings.
However, it was a British economist of the following generation, A.C. Pigou, who first made externality a subject for focused theoretical analysis during the 1920s.
Pigou also clearly distinguished between “positive” and “negative” externalities.
During the second half of the twentieth century, up until today, the notion of externality has continued to increase in prominence in academic economics.