In economics, an externality is an indirect cost or benefit to an uninvolved third party that arises as an effect of another partys activity. Externalities can be either positive or negative. Positive externalities are benefits from an economic activity experienced by an unrelated third party, while negative externalities are costs of an economic activity experienced by an unrelated third party.

Externalities often occur when the production or consumption of a product or services private price equilibrium cannot reflect the true costs or benefits of that product or service for society as a whole. This causes the externality competitive equilibrium to not adhere to the condition of Pareto optimality, which means that resources can be better allocated. Thus, since resources can be better allocated, externalities are an example of market failure.

Governments and institutions often take actions to internalize externalities, thus market-priced transactions can incorporate all the benefits and costs associated with transactions between economic agents. The most common way this is done is by imposing taxes on the producers of this externality.

The primary cause of externalities is poorly defined property rights. The ambiguous ownership of certain things may create a situation when some market agents start to consume or produce more while the part of the cost or benefit is inherited or received by an unrelated party. Environmental items, including air, water, and wildlife, are the most common examples of things with poorly defined property rights.

Overall, externalities are a fundamental economic policy problem when individuals, households, and firms do not internalize the indirect costs of or the benefits from their economic transactions. The resulting wedges between private returns or costs and the returns or costs to society as a whole can lead to market inefficiencies and market failures.