Externalities occur when an individual firm’s decision brings either costs or benefits to third party stakeholders.
(Dwayne Benjamin, Toronto PPG 1002H)
Externalities are an important cause of market failures because they create Pareto inefficient outcomes. The practical problems associated with externalities generally arise because of poorly defined property rights and can largely be eliminated if property rights are well defined. Once property rights are clearly assigned, different parties are able to bargain and negotiate with each other, which leads to a Pareto efficient allocation. Externalities can arise through the production of a good or through the consumption of a good.
Consumption externalities occur when one consumer’s welfare is directly affected by another agent’s production or consumption decisions. Consumption externalities can be either positive or negative. Second hand cigarette smoke is an obvious example of a negative externality. An example of a positive externality could be your neighbour’s decision to keep a well-groomed lawn. This decision, though perhaps not made with your well-being in mind, permits you to enjoy a more pleasant looking neighbourhood and may also positively impact the value of your home should you decide to sell it.
Production externalities occur when the production costs of a firm are affected by the choices made by another firm or consumer. The classic example is that of an apple orchard located next to a beekeeper. In this situation, there are mutual positive production externalities because each firm’s production positively affects the production of the other firm.