An external benefit or positive externality is a benefit that a transaction or activity provides to a party that is not part of the transaction or activity. In other words, it is a benefit provided to a party that cannot control whether or not the transaction or activity occurs.
The complementary notion is that of external cost or negative externality.
The social benefit of an activity is usually defined as the sum of the private benefit (i.e., the total benefit to those participating in the activity) and the external benefit.
Problems with external benefits
Inefficiency and market failure
External benefits could in principle lead to market failure. For some activities, the private cost may exceed the private benefit, but, due to significant external benefits, the social benefit may exceed the social cost. Private actors may therefore decide not to engage in such activities, even though they are socially desirable. Thus, activities with significant external benefits run the risk of being underproduced.
Note that the existence of external benefits does not in and of itself lead to market failure, because for many activities, there is enough net private benefit for private actors to undertake those activities.
Private actors whose activities generate significant external benefits may not receive adequate compensation from society for these additional benefits. This is closely related to the free rider problem.
The concept of missing markets and transaction costs
An external benefit that is not adequately dealt with by the market is often thought of as a missing market -- hence the saying externalities are missing markets. In other words, allowing the external parties affected to enter market negotiations with those parties carrying out the transaction could often resolve the problem of external benefits.
The Coase theorem, proved by Ronald H. Coase, states that if people can compensate each other for external costs/benefits, and if transaction costs are zero, then bargaining will lead to an efficient outcome regardless of the initial allocation of property rights. Note that the Coase theorem highlights that the main reason for market failure is not the external costs themselves, but the transaction costs involved in negotiation. These transaction costs may be due to lack of trust, inability to enforce contracts, or a large number of parties involved.
Fairness and legal rights
While the Coase theorem states that in the absence of transaction costs, the outcome will be efficient regardless of the initial allocation of property rights, it does not say that the outcome will be fair. However, a stronger version of the theorem states that for every possible efficient outcome, there is an allocation of property rights under which, in the absence of transaction costs, bargaining will lead to that efficient outcome.
A Pigouvian subsidy is a subsidy provided to a transaction or activity so as to capture the external benefits of that activity. In the presence of a Pigouvian subsify, a private actor will undertake an economic activity based on whether the social benefit exceeds the social cost rather than based on whether the private benefit exceeds the private cost.
The analogous notion for external costs is that of a Pigouvian tax.