Final answer:
An externality is a cost or benefit from an economic activity affecting third parties, called a spillover. Negative externalities can cause markets to fail to account for broader social costs. Positive externalities can result in underproduction but could be remedied if producers were compensated for the benefits they create.
Step-by-step explanation:
An externality is a cost or benefit that arises from an economic activity and affects third parties who are not directly involved in the transaction. An externality is also referred to as a spillover effect. Negative externalities can impose broader social costs, prompting parties to potentially reduce harmful activities if they are required to account for these external costs. Conversely, positive externalities lead to benefits that are not paid for, and if producers could be compensated for these, they may be incentivized to increase production. Examples of negative externalities include pollution, where the costs are shared by society rather than just the producer and consumer, leading to what economists term market failure. This occurs because private markets do not achieve efficient output as they do not include all social costs or benefits in their prices and production decisions.