What are externalities? Explain positive and negative externalities.


Externalities refer to the cost or benefit of an activity by an economic agent for which it does not pay a price.

Example: For example, a factory producing goods emits poisonous smoke in the environment and dumps wastes into the water bodies causing air pollution and water pollution. In this case, the externality implies the negative effect on the health of the human beings and aquatic animals. 

Positive Externalities: Activities resulting in benefits to others are called positive externalities.
Example: Construction of a flyover or a highway reduces transport cost and journey time of its users. Expenditure on construction is included in GDP but not the positive externalities which increase welfare. This implies that welfare is much more than indicated by GDP.

Negative Externalities: Whenever the consumption of a commodity has observable negative implications on people who do not consume the good, this is known as a negative externality.
Example: The classic example of a negative externality is pollution (for example, due to vehicular usage)

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