Define the term ‘externalities’

An externality is a positive or a negative effect experienced by a third-party to an economic transaction. In production for example, an externality would occur when there is a difference in the marginal private cost and the marginal social cost of producing a certain good or service. The marginal private cost is the cost of production to an individual firm whilst the marginal social cost takes into account both the private cost and the impact on the rest of society such as an environmental cost. A negative externality in production would occur when the marginal social cost is greater than the marginal private cost of production.