A factory dumps waste into a river. Downstream, fishermen lose their catch and a town loses its water supply. The factory pays for labor and materials, but not for the damage it causes. That damage is an externality, a cost or benefit that falls on third parties who had no say in the transaction.

Externalities can be negative or positive. Pollution is the classic negative example. Education is a classic positive one: an educated workforce benefits not just the student but also employers, neighbors, and taxpayers. Vaccination is another. When enough people get vaccinated, even those who do not are protected, a phenomenon called herd immunity.

Markets tend to produce too much of goods with negative externalities and too little of goods with positive ones. That is the economic case for regulation, taxes, and subsidies. Carbon taxes make polluters pay for emissions. Public funding for education and research spreads the benefits. Getting the level right is hard, and political fights over externality policy are fierce for good reason.

Examples

• Pollution from factories and vehicles
• Secondhand smoke
• Education and vaccination
• Noise from airports and highways
• Research and development spillovers