Definition of "Spillover Costs"

by Mary Strain

"Spillover cost," also known as "negative externality," is a term used to describe some loss or damage that a market transaction causes a third party. The third party ends up paying for the transaction in some way, even though it was neither the buyer nor the seller and had no part in the original decision.


Pollution is a frequently used example of spillover costs. Say that a large manufacturer produces and sells widgets, but its factories belch unhealthy fumes that nearby residents have to breathe. The nearby residents neither produced nor bought the widgets, but they're paying for them nevertheless in reduced air quality and increased health problems. These negative third-party consequences of widget production are the "spillover costs." Spillover costs can also apply to the actions of individuals, such as when a smoker exposes nonsmokers to secondhand smoke at a restaurant. Nearby diners suffer annoyance and potential health risks from the smoker's actions, though they themselves are nonsmokers.

Market Inefficiency

When there are spillover costs, the market is operating inefficiently, because neither the producer nor the consumer of a certain product is paying its full cost. The production or consumption cost of a certain item is now being shouldered not just by the principals, but also by third parties. Since manufacturers and consumers aren't paying the full amount for a certain product, that product tends to be overproduced, resulting in market imbalance, a higher level of production or consumption than society really wants.


Spillover costs that affect society at large and reach a critical mass may be corrected by the government. The unpaid cost of a particular product may be added back in the form of taxes or other charges that the manufacturer or consumer must pay. The government may pass laws to directly address the negative spillover effect, such as prohibiting smoking in public places or requiring a company to switch to nonpolluting manufacturing processes. Some have noted that spillover costs often result from poorly defined property rights, and that if property rights were clearly defined, interested parties would negotiate a privately paid settlement.

Spillover Benefits

Spillover can be either positive or negative. "Spillover benefits" are the opposite of spillover costs. They are free benefits that third parties or society receive from the actions of others. For example, when the government uses tax money to create a public park, everyone in the neighborhood may benefit from its use, even those who pay no taxes. Such users reap a spillover benefit, since they paid nothing toward the creation of the park.

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