The second generic type of market failure is when parties other than the buyer and seller are significantly affected by the exchange between the buyer and seller. However, these other parties do not participate in the negotiation of the sale. Consequently, the quantities sold and prices charged do not reflect the impacts on these parties.
Economists call the effects of market activity on the third parties externalities because they fall outside the considerations of buyer and seller. Although the concern with significant externalities is usually due to harm to the third party, externalities can be beneficial to third parties as well. Harmful externalities are called negative externalities; beneficial externalities are called positive externalities.
Some examples of negative externalities are pollution of air or water that is experienced by persons other than those directly related to the seller or buyer, injury or death to another person resulting from the market exchange, inconvenience and annoyances caused by loud noise or congestion, and spoiling of natural habitats. Some examples of positive externalities are spillover effects of research and development used for one product to other products or other firms, training of a worker by one firm and thereby creating a more valuable worker for a future employer, stimulation of additional economic activity outside the market, and outside benefactors of problem-solving services like pest control.
Negative externalities clearly create an inequity because the third parties are harmed without any compensation. However, significant negative externalities also create inefficiency. Recall that inefficiency means there is a way to make someone better off and no one worse off. Take the case of a negative externality like air pollution caused when an automobile owner purchases gasoline to use in his car. Hypothetically, if a representative for outside parties were present at the negotiation for the sale, she might be willing to pay an amount to the buyer and an amount to the seller in exchange for foregoing the sale by compensating the buyer with the consumer surplus they would have received and the producer with the economic profit they would have received, with the sum of those payments being worth the avoidance of the externality impact of the air pollution.
Even in the case of a positive externality, there is inefficiency. However, in this case, the third parties would actually benefit from more market exchanges than the sellers and buyers would be willing to transact. In principle, if third parties could participate in the market, they would be willing to pay the buyer or seller up to the value of the positive externality if it would induce more market activity.
Regulation of externalities usually takes two forms: legal and economic. Legal measures are sanctions that forbid market activity, restrict the volume of activity, or restrict those who are allowed to participate as buyers and sellers. As examples of these, if an appliance is prone to start fires that might burn an entire apartment complex and injure others besides the buyer, the sale of the appliance might be banned outright. If sales of water drawn from a river would threaten a wildlife habit, sales may be limited to a maximum amount. A firearms manufacturer might be allowed to sell firearms but would be restricted to sell only to people of at least a certain age who do not have a criminal record. Because legal measures require monitoring and enforcement by the government, there are transaction costs. When a legal measure is excessive, it may actually create a reverse form of inefficiency from denying surplus value to buyers and sellers that exceeds the benefit to other parties.