What are externalities in economic terms?

Externalities are defined as costs or benefits that affect third parties who are not directly involved in a transaction. This concept illustrates how the actions of individuals or businesses can have unintended effects on others in society. For instance, when a factory pollutes the air, the affected residents experience negative externalities in the form of health issues or reduced quality of life, even though they are not part of the factory's operations or transaction.

Understanding externalities is crucial because it highlights the potential for market failures, where the actions taken by individuals do not reflect the true societal costs or benefits. This can lead to overproduction of goods that generate negative externalities, like pollution, or underproduction of beneficial goods that generate positive externalities, such as education. By recognizing externalities, government intervention or regulation may be warranted to correct these imbalances and ensure that the market outcomes are more aligned with the overall welfare of society.