Externalities: Why Do Others Bear the Effects of Our Choices?

An externality occurs when part of an action's cost or benefit falls on people outside the decision, without that effect entering the actor's own calculation. If someone plays music late at night in a flat, the enjoyment is theirs, while the neighbour's lost sleep does not appear in the price of the speakers.

This is not the same as every consequence that affects another person. A friend hearing the music and changing plans is merely an effect. An externality specifically involves someone who did not participate in the decision, while the cost or benefit they receive is not absorbed by the original exchange or responsibility arrangement. Pollution is a negative externality; the spread of knowledge can create a positive one.

An externality also differs from a side effect. A side effect asks what happened beyond the main aim; an externality asks who bears it. The concept matters because it pushes judgement beyond “Did I benefit?” and towards the true boundary of the action. To internalise an externality is to use negotiation, rules or prices to bring an omitted consequence back into the decision, rather than pretending it never existed.

https://www.imf.org/en/publications/fandd/issues/series/back-to-basics/externalities