Why do externalities arise?

Externalities arise because the actions of individuals or firms affect others who are not directly involved in a transaction, leading to costs or benefits that are not reflected in market prices. These effects can be positive (benefits) or negative (costs), such as pollution impacting nearby residents or a well-maintained garden enhancing neighborhood property values. The lack of appropriate compensation or regulation for these external effects often results in market failures, as the true social costs or benefits are not accounted for in decision-making. Consequently, externalities can lead to overproduction or underproduction of goods and services.