What is an externality?

• A. A cost or benefit to buyers and sellers only
• B. A cost or benefit that affects third parties not involved in the market
• C. A cost borne by the government
• D. A phenomenon that only affects production costs inside the market

Answer: (B)

Externalities are costs or benefits that affect people who aren’t participating in the market transaction. They occur when the actions of buyers or sellers impose effects on bystanders that the market price doesn’t reflect. A negative externality, like pollution from a factory, harms nearby residents who aren’t paying for that harm. A positive externality, like vaccination or a well-educated neighbor whose benefits spill over to others, helps people who aren’t paying for it. The key idea is the impact on third parties outside the market, which is why prices don’t fully capture the social costs or benefits. This misalignment can lead to inefficient resource use, and governments often intervene to internalize these effects through taxes, subsidies, or regulatory measures.