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An externality is a term used in economics to describe a cost or benefit incurred or received by a third party who has no control over the factors that created the cost or benefit.

One example of an externality is pollution.  A factory emitting toxins affects the surrounding environment by dirtying the air, water, and land.  This creates health problems for those who breathe the air, drink the water, and use the land. Up until the latter part of the 1900s, the costs for industrial pollution cleanup and the related health issues were borne by the local governments and the sickened people who paid for their own medical costs, not the factories that produced the pollution. 

Greater use of government regulations and tort litigation has shifted the cost of negative externalities to the entities creating the externalities.  This tends to cause the prices for the products in the affected industries to rise, as manufacturers pass on the expense. In fact, some economists argue that market failure occurs if the price of a product does not reflect all the costs associated with producing it – both direct and social costs.

Externalities also exist in a positive way.  For example, grassroots and government emphasis on education improvements generates a smarter workforce.  Companies who hire these graduates reap the benefit of intelligent, creative workers who innovate and require less training.  The company earns more money because of the innovation and saves money because of reduced training costs.  

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