Externalities

There is no universally accepted definition for the term externality, but that put forward by Harvey Rosen adequately conveys the principle. He writes that an externality occurs when “the activity of one entity (a person or a firm) directly affects the welfare of another in a way that is outside the market mechanism.” Externalities may be negative (as when industrial pollution injures people's health or positive (as when the presence of a security guard whose function is to prevent theft from a store serves to protect you as well). In both cases, someone's welfare must be directly affected incidental to another's activity. Thus, externalities differ from altruism or spite. Additionally, the effect must be “outside the market mechanism,” that is, not mediated by prices. The ...