Which of the following best describes an externality?

• A. A benefit enjoyed solely by the producer
• B. A cost incurred solely by the consumer
• C. A cost or benefit not reflected in market prices
• D. A direct transaction between two buyers

Answer: (C)

The concept of an externality refers to the impacts of economic activities that affect third parties who are not directly involved in the transaction. In particular, option C correctly identifies an externality as a cost or benefit that is not reflected in market prices. This means that the true cost to society or the true benefit to society of an economic activity is not captured through the pricing mechanisms of the market.

For example, pollution from a factory may impose costs on the surrounding community (like health issues or environmental degradation) that are not accounted for in the price of the factory's products. Similarly, a well-maintained park might provide enjoyment and increase property values in the area, which are benefits not typically included in any transaction related to the park. Recognizing these externalities is crucial because it highlights the limitations of market prices in capturing the full impact of production and consumption decisions on society.

This understanding can lead to public policies aimed at addressing these externalities, such as regulation or taxation to internalize these costs or benefits, thus helping align private incentives with social welfare.