What are externalities?

• A. Costs or benefits incurred by consumers
• B. Legal requirements imposed on businesses
• C. Costs or benefits affecting third parties outside a transaction
• D. Financial incentives provided by the government

Answer: (C)

Externalities refer to costs or benefits that affect third parties who are not directly involved in a transaction. This means that the actions of one party can impose additional costs or provide benefits to another party without them being part of the original exchange. For example, pollution from a factory may harm the health of nearby residents, which constitutes a negative externality. Conversely, a residential garden that beautifies a neighborhood may provide a positive externality by increasing property values for others.

Understanding externalities is essential in economics as they illustrate how market transactions can impact individuals and communities beyond the immediate participants. They highlight the importance of considering the wider societal effects of economic activities, which can justify governmental intervention when market outcomes do not fully account for these external inflations or benefits.