An externality is a cost or benefit conferred upon second or third parties as a result of acts of individual production and consumption. But the cost or benefit of an externality cannot be measured in money terms because it is not included in market activities.

In other words, externalities refer to the benefits or harm a firm or an individual causes to another for which they are not paid or penalized. They do not have any market in which they can be bought and sold. There are two types of externalities viz.,

1. Positive externalities 

2. Negative externalities.

For example, let us imagine that there is chemical fertilizer industry. It produces the chemical fertilizers required for agriculture. The output of the industry is taken for counting GDP of an economy. This is positive externality.

While carrying out the production, the chemical fertilizer industry may also be polluting the nearby river. This may cause harm to the people who use the water of the river. Hence their health will be affected. Pollution also may kill fish and other organisms of the river. As a result, the fishermen of the river may lose their livelihood. Such harmful effects that the industry is inflicting on others, for which it will not bear any cost are called negative externalities.