Third party costs in economics, also known as negative externalities or transaction spillovers, are costs arising from an economic activity that are incurred by a third party who did not agree to the actions that caused the costs. Generally third party costs are not fully reflected in the prices of goods or services.
A good example of a negative externality is pollution. A sugar factory in a community will produce sugar, while producing by-products such as harmful gases, which are released into the air, and caustic sludge, which is pumped into local ponds, affecting the water supply and leaching chemicals into the water table. The individuals living in the community will suffer from negative externalities as they will have higher health costs, poorer quality of life, decreased real estate value and other costs that are not borne by the sugar factory. The production of sugar therefore has a negative third-party cost to the people in the community. Other common examples of negative externalities are drunk driving, littering and anti-social behavior.
Negative externalities can result in market failure. Since the costs of the externalities are not accounted for in the calculations of the persons involved in the economic activities, the supply and demand will be inefficient in a free market system. If the externality is a cost, the market will supply too much. The good or service will be underpriced, resulting in a deadweight loss of economic welfare.
The problem of negative externalities can be addressed by regulation, bans, taxes and the creation of property rights, where appropriate. One solution is the Coase Theorem, proposed by economist Ronald H Coase: "Under perfect competition, once government has assigned clearly defined property rights in contested resources and as long as transactions costs are negligible, private parties that generate or are affected by externalities will negotiate voluntary agreements that lead to the socially optimal resource allocation and output mix regardless of how the property rights are assigned." The most efficient solution is thought to be self-regulation, where all the costs of an economic activity are factored in by those involved in the production process.
Third party costs, or negative externalities, result when individuals or firms do not have to pay all the costs resulting from an activity. This can result in market failure. The problem of negative externalities can be addressed by fully accounting for all the costs incurred during an economic activity.
