Managerial Economics and Strategy, 2/e

16.4 Externalities

An externality occurs when a person’s well-being or a firm’s production capability is directly affected by the actions of other consumers or firms rather than indirectly through changes in prices. The effect is external in the sense that it occurs outside a market and hence has no associated price. A firm whose production process lets off fumes that harm its neighbors is creating an externality for which no market exists. In contrast, the firm is not causing an externality when it harms a rival by selling extra output that lowers the market price.

Externalities may either help or harm others. An externality that harms someone is a negative externality. You are harmed if your neighbors keep you awake by playing loud music late ...