External Costs and Benefits

Economists define "externalities" and "external costs and benefits" as follows: Definitions:

• When some people bear costs that they are not paid or compensated for, these costs are said to be external costs.
• When some people get benefits that they do not pay for, these benefits are said to be external benefits.
• In general, if there are either external benefits or external costs, we say that there are externalities.

The idea is that the decision-maker, who does not pay for the costs nor get paid for the benefits, doesn't take them into consideration in deciding how resources shall be allocated. He has no motive to produce benefits that he doesn't get, nor to cut back on costs that he doesn't pay. The benefits and costs are "external" to his maximization of his own net benefits.

In general, if there are "external" costs or benefits or both, we say that there are "externalities," and we can expect markets to be inefficient when there are "externalities."