externality

Classic definition of
externality is that “any indirect effect that either a production or a
consumption activity has on a utility function, a consumption set, or a
production set”. [Laffont] By
“indirect”, it is meant that the effect is created by an economic agent other
than the one who is affected; and the effect is not transmitted through prices
(non-pecuniary) (http://en.wikipedia.org/wiki/Externality). For example, if the
public transportation in Ann Arbor has an effect on the residents in Ypsilanti
and the government or transportation authority of Ypsilanti does not need to
pay Ann Arbor government or transportation, then the AA public transportation
is an externality to Ypsilanti.
There are three
kinds of externality: positive externality, negative externality and positional
externality (the third one will not be discussed in this essay). In the example
of AA transportation, people in Ypsilanti can enjoy the transportation service
provided by AA without their transportation authority paying AA. The benefit
caused by an action is called positive externality. In contrast, if an action
causes cost or bad effect, then the cost is called negative externality. For
example, a factory pollutes the air without paying price.

image source: Qi Shen

by Qi Shen