When I go about doing what I do, frequently I affect you as an incidental side effect. In many such cases, I don't have to pay you to compensate for any inadvertent harm done; symmetrically, you frequently don't have to pay me for any inadvertent benefits I've bestowed upon you. The term — externalities — refers to these cases, and they are pervasive and important because, especially in the modern, interconnected world, when I go about pursuing my own goals, I wind up affecting you in any number of different ways.
Externalities can be small or large, negative and positive. When I lived in Santa Barbara, many people with no goal other than working on their tans generated (small, true) positive externalities for passersby, who benefitted from the enhanced scenery. These onlookers didn't have to pay for this improvement to the landscape but, on the same beach, rollerbladers, traveling at high speed and distracted by this particular positive externality, occasionally produced a negative one in the form of a risk of collision for pedestrians trying to enjoy the footpath.
Externalities loom large in the present era, when actions in one place can potentially affect others half a world away. When I manufacture widgets for you to buy, to make them I might, as a side effect of the process, produce waste that makes the people around my factory — and maybe around the world — worse off. As long as I don't have to compensate anyone for polluting their water and air, it's unlikely I'll make much of an effort to stop doing it.
At a smaller, more personal scale, we all impose externalities on one another as we go through our daily lives. I drive to work, increasing the amount of traffic you face. You feel the strange compulsion that infects people in theaters these days to check your text messages on your cell phone during the film, and the bright glow peeking over your shoulder reduces my enjoyment of the movie.
The concept of externalities is useful because it directs our attention to unintended side effects. If you weren't focused on externalities, you might think that the way to reduce traffic congestion was to build more roads. That might work, but another way, and a potentially more efficient way, is to implement policies that force drivers to pay the cost of their negative externalities by charging a price to use roads, particularly at peak times. Congestion charges, such as those implemented in London and Singapore, are designed to do exactly this. If I have to pay to go into town during rush hour, I might stay home unless my need is pressing.
Keeping externalities firmly in mind also reminds us to be vigilant about the fact that in complex, integrated systems, simple interventions designed to bring about a particular desirable effect will potentially have many more consequences, both positive and negative. Consider, as an example, the history of DDT. When first used, it had its intended effect, which was to reduce the spread of malaria through the control of mosquito populations. However, its use also had two unintended consequences. First, it poisoned a number of animals (including humans) and, second, it selected for resistance among mosquitoes. Subsequently, policies to reduce the use of DDT probably were effective in their goals of preventing these two negative consequences. However, while there is some debate about the details, these policies might themselves have had an important side effect, increasing rates of malaria, carried by the mosquitoes no longer suppressed by DDT.
The key point is that the notion of externalities forces us to think about unintended (positive and negative) effects of actions, an issue that looms larger as the world gets smaller. It highlights the need to balance not only the intended costs and benefits of a given candidate policy, but also the unintended effects of the policy. Further, it helps focus attention on one type of solution to the problems of unintended harms, which is to think about using prices to provide incentives for people and firms to produce more positive externalities and fewer negative ones.
Considering externalities in our daily lives directs our attention to ways in which we harm, albeit inadvertently, the other people around us, and can be used to guide our own decision making, including waiting until after the credits have rolled to check our messages.