Externalities are common in virtually every area of economic activity. They are defined as third party (or spill-over) effects arising from the production and/or consumption of goods and services for which no appropriate compensation is paid.
Externalities can cause market failure if the price mechanism does not take into account the full social costs and social benefits of production and consumption.
The study of externalities by economists has become extensive in recent years - not least because of concerns about the link between the economy and the environment.
PRIVATE AND SOCIAL COSTS
Externalities create a divergence between the private and social costs of production.
Social cost includes all the costs of production of the output of a particular good or service. We include the third party (external) costs arising, for example, from pollution of the atmosphere.
SOCIAL COST = PRIVATE COST + EXTERNALITY
For example: - a chemical factory emits wastage as a by-product into nearby rivers and into the atmosphere. This creates negative externalities which impose higher social costs on other firms and consumers. e.g. clean up costs and health costs.