Final answer:
An externality is a market exchange impact on a third party, with positive externalities offering benefits and negative externalities imposing costs on non-involved parties.
Step-by-step explanation:
An externality is an impact from a market exchange that affects a third party who is not involved in the exchange, also known as a spillover. There are two types of externalities: positive externality and negative externality. A positive externality occurs when the exchange generates benefits to a third party, such as a person enjoying free music from a nearby concert. On the other hand, a negative externality occurs when the exchange imposes costs on a third party, like pollution affecting the health of nearby residents. When parties responsible for negative externalities had to bear the broader social costs, they might be incentivized to reduce the negative outputs, while those creating positive externalities may underproduce since they are not compensated for the additional demand.