Externality theory

Externality theory involves the unintended side effects of economic activities that impact others not directly involved. These effects can be positive, like pollution creating health benefits elsewhere, or negative, such as a factory polluting a river used by local residents. Because these external effects are not reflected in market prices, they can cause market failures—where resources are not allocated efficiently. Addressing externalities often requires government intervention, like taxes, regulations, or incentives, to align private actions with societal well-being and promote a more efficient and fair outcome.