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What are externalities and provide an example of a negative externality of consumption

An externality is the cost or benefit a third party receives from an economic transaction outside of the market mechanism. In other words, the spillover effect of the production or consumption of a good or service. Externalities can be positive (external benefits) or negative (external costs)Negative externalities are caused by demerit goods. These are associated with information failure. Since consumers are not aware of the long term implications of consuming the good, and they are usually over-provided in the free market e.g. cigarettes and alcohol are demerit goods. The negative externalities to a third party of consuming cigarettes is second hand smoke or passive smoking which can lead to health complications in the future.Positive externalities are caused by merit goods. These are associated with information failure too, because consumers do not realise the long run benefits to consuming the good. They are under-provided in a free market society. Examples of merit goods include education and healthcare. The positive externality to third parties of education is a higher skilled workforce which leads to higher paying jobs and so more spending in the economy.

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