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In economicsan externality is the cost or benefit that is imposed by one or several parties on a third party who did not agree to incur that cost or benefit. The concept of externality was first developed by economist Arthur Pigou in the s. The prototypical example of a negative externality is environmental pollution. Pigou argued that a tax later called a "Pigouvian tax" on negative externalities could be used to reduce their incidence to an efficient level.

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Externalities often occur when the production or consumption of a product or service's private price equilibrium cannot reflect the true costs or benefits of that product or service for society as a whole. Thus, since resources can be better allocated, externalities are an example of market failure. Externalities can be either positive or negative.

Governments and institutions often take actions to internalize externalities, thus market-priced transactions can incorporate all the benefits and costs associated with transactions between economic agents. This is usually done similar to a quote where there is no tax imposed and then once the externality reaches a certain point there is a very high tax imposed.

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However, since regulators do not always have all the information on the externality it can be difficult to impose the right tax. Once the externality is internalized through imposing a tax the competitive equilibrium is now Pareto optimal.

For example, manufacturing activities that cause air pollution impose health and clean-up costs on the whole society, whereas the neighbors of individuals who choose to fire-proof their homes may benefit from a reduced risk of a fire spreading to their own houses. If external costs Agfee, such as pollutionthe producer may choose to produce more of the product than would be produced if the producer were required to pay all associated environmental costs.

Because responsibility or consequence for self-directed action lies partly outside the self, an element of externalization is involved. If there are external benefits, such as in public safetyless of the good may be produced than would be the case if the producer were to receive payment for the external benefits to others.

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For the purpose of these statements, overall cost and benefit to society is defined as the sum of the imputed monetary value of benefits and costs to all parties involved. Two British economists are credited with having initiated the formal study of externalities, or "spillover effects": Henry Sidgwick — is credited with first articulating, and Arthur C.

Pigou — is credited with formalizing the concept of externalities. The word externality is used because the effect produced on others, whether in the form of profits or costs, is external to the market.]