An externality is a cost or benefit imposed on a third party who is not part of the transaction. Here, students disrupting a lecture are engaged in a consumption activity (attending/consuming the class) that inflicts an uncompensated cost on other students and the teacher — a harmful spillover. A cost-imposing s …

Step 1 — What is an externality?

An externality is a benefit or cost that an economic activity confers on a bystander who is neither the producer nor the intended consumer, and for which no market payment is made.

Step 2 — Production vs consumption; positive vs negative

• Production externality arises from a firm's production activity (e.g., factory pollution).
• Consumption externality arises from a household's consumption activity (e.g., loud music, smoking near others).
• Positive confers an uncompensated benefit; negative imposes an uncompensated cost.

Step 3 — Apply to the facts …