People who are not directly involved in the transactions are frequently impacted by the consumption, manufacturing, and investment decisions made by individuals, households, and businesses.
These incidental impacts can occasionally be slight. However, when they are significant, or what economists refer to as externalities, they can cause issues.
The majority of externalities fall under the heading of "technical externalities," meaning that although their indirect effects have an impact on other people's opportunities for consumption and production, the price of the product does not account for them. As a result, there are variations in the costs or returns to the private sector and those to society as a whole.
The traditional example of a negative externality is pollution, when the polluter makes decisions based solely on the direct cost of production and the potential for profit, disregarding the indirect costs to those afflicted by the pollution. The indirect costs include lost chances for production, such as when tourism is negatively impacted by pollution, greater health care expenditures, and a diminished quality of life, as in the instance of a home owner who lives close to a smokestack. The social or total costs of production are higher than the private costs because the indirect costs are not incurred by the producer and are thus not passed on to the final consumer of the items produced by the polluter.
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