What defines an externality in economic terms?

An externality in economic terms refers to a situation where the actions of individuals or businesses have effects on third parties who are not directly involved in the economic transaction or activity. This means that the decision-making of one party can result in positive or negative outcomes for others, without those third parties having any control or say over the actions that cause these effects.

For instance, when a factory pollutes the air, it may reduce the quality of life for nearby residents who are not part of the production process. This would be considered a negative externality, as the factory's production imposes costs on those residents. Conversely, if a homeowner maintains a beautiful garden that enhances the neighborhood's appearance, the enjoyment and increased property values benefiting neighbors represent a positive externality. Thus, the definition captures the essence of how externalities arise from economic activities that affect unrelated third parties, highlighting their role in market inefficiencies and the need for potential interventions.