It is quite common to walk around Oxford, OH on a Friday night and hear thumping music coming from house after house as students enjoy a party after a long week of work.
But what about students who are caught up studying, trying to drown out the blaring EDM music they can hear outside their window as they cram for their upcoming Monday exam?
These students are experiencing a negative externality!
What is an externality?
Let’s first start with understanding externalities in general.
Externalities are the costs or benefits of a market activity that affect a third party other than the buyers and sellers in the market. The externality can be the result of either production or consumer activities.
With this considered, it's important to understand that externalities are a type of market failure. Why? Because they're an unintended consequence of market activity!
Externalities are a type of market failure, which occur when there's an inefficient allocation of resources in a market.
Why are we dealing with a negative externality here?
Although the market of students who like to party are satisfied with this benefit, there are higher, unconsidered costs for those students who can’t stand the loud music and singing they hear across the street. Those studious students are the third party being impacted from the market activity.
Negative externalities are commonly referred to as spillover costs. This is when the costs "spillover" to someone other than the direct consumer or producer. In this case, the enjoyment of the EDM music is "spilling over" to students cramming for a Monday morning exam.
You may hear about private marginal & marginal social costs / benefits associated with externalities. It's easiest to understand these when graphed visually.