Production Externality

Production externalities are side effects that society has to deal with from the process of production. Usually, production externalities are negative externalities, meaning they’re a cost to society rather than a benefit.

Ever seen that video of people lighting their tap water on fire? That’s from fracking natural gas and oil nearby, which leaked some gas into the groundwater, which ends up coming out of sink taps. That’s an example of a production externality, which is also a negative externality. Production externalities are unintended, but those whom they impact...don't really give a hoot.

When production externalities are negative externalities, they cost society: people’s health, the environment, and even the economy are all things that could be negatively affected. Economists say we can solve this problem by internalizing negative externalities, i.e. making the one dishing out the cost pay for it. Carbon tax and cap-and-trade are both systems designed to internalize negative production externalities.

What about a positive production externality? Maybe you used to live in the middle of nowhere, until recently. Now, there’s a really nice grocery store nearby, and a haircut shop and a movie theater. From all that civilization, housing prices in the area rose. The production produced the positive production externality for locals: a rise in housing prices. Bingo.

See: Negative Externality.