7.4.3—Positive and negative externalities

A negative externality imposes an uncompensated cost on a third party; a positive externality gives an uncompensated benefit. They can arise in consumption or production.

The key test is whether the affected person is outside the buyer-seller decision and whether the spillover is omitted from the market price. Negative externalities usually cause overproduction or overconsumption; positive ones cause underproduction or underconsumption.

Noise from a nightclub is a negative consumption or production spillover depending on the source. A firm’s research that other firms learn from creates a positive production spillover.

Externality signs are about the direction of the spillover, not whether the activity itself is “good” or “bad” in every context.