Externality
An action imposes a cost or hands a benefit to someone who had no say in it and is neither paying nor being paid for it.
Often misread asJumping from 'there is an externality' to 'a tax or a regulator is needed', skipping the question of whether the parties could simply bargain their way to the efficient outcome.
How to see it
Your choice lands on someone who was not in the decision
An externality is a cost or a benefit that falls on someone who had no say in the action and receives no payment for it. Each person optimises against their own payoff, which leaves the effect on others out of the sum entirely, so the total can be bad even though no individual decision was a mistake. They can be positive as well as negative.
The checkWith clearly defined rights and low bargaining costs the parties may internalise it between themselves; the case for intervention rests on those costs being high, not on the externality existing.
Try itTwo flatmates and one shared kitchen. Write down the payoff of cleaning it from your own point of view, then from the pair's. Note that in the bad outcome neither flatmate has done anything irrational.
Games that show it
Know these first
Leads on to
Easily confused with
Sources
- Pigou, A. C. (1920). Macmillan.
- Coase, R. (1960). Journal of Law and Economics 3, 1-44.
- Mas-Colell, A., Whinston, M. & Green, J. (1995). Oxford University Press.