Which statement best describes how externalities are treated in social welfare accounting?

• A. Externalities are ignored in welfare calculations.
• B. Externalities are addressed by adjusting government budgets only.
• C. Externalities are included by adding their social costs or benefits into the social welfare measure.
• D. Externalities do not affect societal welfare.

Answer: (C)

Social welfare accounting aims to measure society’s overall well‑being by including all effects that spill over to others, not just those captured in market prices. Externalities are effects of economic activity on third parties that prices do not reflect, so to capture the true impact on welfare they must be added into the social welfare measure as social costs or social benefits. Ignoring them would understate or overstate welfare, and focusing only on government budgets misses broader spillover effects beyond public finances. Externalities do affect societal welfare because they change the total costs and benefits to everyone in society. Therefore, adding the social costs or benefits of externalities into the social welfare measure is the best way to describe their treatment.