In economics, an externality or spillover of an economic transaction is an impact on a party that is not directly involved in the transaction. In such a case, prices do not reflect the full costs or benefits in production or consumption of a product or service. An advantageous impact is called an external benefit or positive externality, while a detrimental impact is called an external cost or negative externality. Producers and consumers in a market may either not bear all of the costs or not reap all of the benefits of the economic activity. For example, manufacturing that causes air pollution imposes costs on the whole society, while fire-proofing a home improves the fire safety of neighbors.

In a competitive market, the existence of externalities would cause either too much or too little of the good to be produced or consumed in terms of overall costs and benefits to society. If there exist external costs such as pollution, the good will be overproduced by a competitive market, as the producer does not take into account the external costs when producing the good. If there are external benefits, such as in areas of education or public safety, too little of the good would be produced by private markets as producers and buyers do not take into account the external benefits to others. Here, overall cost and benefit to society is defined as the sum of the economic benefits and costs for all parties involved.