Definition
An externality is a cost or benefit of a transaction that falls on parties outside that transaction — third parties who neither bought nor sold, and therefore have no voice in the price. The buyer and seller negotiate based on their private costs and benefits; if the transaction also harms a neighbor or benefits a stranger, those effects are "external" to the market and do not influence the price or quantity traded.
Externalities are the primary explanation for market failure in otherwise-competitive markets. When negative externalities (pollution, noise, congestion) are not priced, producers over-produce relative to the social optimum — they bear the private costs but offload the external costs onto others. When positive externalities (education, vaccination, R&D spillovers) are not subsidized, producers under-produce — they capture only their private benefit while the social benefit exceeds it.
Why it matters
Negative vs. positive externalities
The Coase theorem and bargaining solutions
Property rights as an alternative
Ronald Coase argued that government intervention is not always necessary to resolve externalities. If property rights are clearly defined — say, a homeowner has a legal right to clean air — the affected parties can bargain directly to reach an efficient outcome. The factory can pay the homeowner to accept pollution if the factory's gains from pollution exceed the homeowner's losses. The efficient outcome emerges through private negotiation.
Why Coase fails in practice
The Coase theorem holds only when transaction costs are low and the number of affected parties is small. For diffuse externalities like air or water pollution, where millions of people are harmed by thousands of sources, private bargaining is impossibly costly. No homeowner can negotiate individually with every carbon emitter. Coasian solutions work for localized disputes (noise between neighbors, a factory and a single downstream user) but not for global or widespread externalities.