Managerial Economics

Externalities

The second generic type of market failure is when parties other than the buyer and seller are significantly affected by the exchange between the buyer and seller. However, these other parties do not participate in the negotiation of the sale. Consequently, the quantities sold and prices charged do not reflect the impacts on these parties.

Economists call the effects of market activity on the third parties externalities because they fall outside the considerations of buyer and seller. Although the concern with significant externalities is usually due to harm to the third party, externalities can be beneficial to third parties as well. Harmful externalities are called negative externalities; beneficial externalities are called positive ...