Externality
Plain definition
An externality is a cost or benefit of an economic activity that falls on third parties who did not choose to be part of the transaction.
In economics
Externalities cause market failure because prices reflect only private costs and benefits, not social ones. Governments can correct them with taxes (Pigouvian taxes), subsidies, quantity limits, or by defining property rights as in the Coase theorem.
Example
A factory emitting smoke imposes a cost on nearby residents (negative externality); a homeowner's flower garden gives neighbors a free pleasant view (positive externality).
Common confusion
An externality is not the same as an indirect effect through prices; if a new factory raises local wages, that is a market (pecuniary) effect, not a true externality.