Question

An externality is a cost or benefit arising from an economic activity that falls on

A) consumers but not producers.
B) producers but not consumers.
C) consumers or producers.
D) someone other than consumers or producers.
E) foreigners.

Answer 1

An externality occurs when an economic activity affects a third party who is not part of the exchange, and it can have a negative or positive impact on the third party. Parties imposing a negative externality would have an incentive to reduce production, while parties generating a positive externality would have an incentive to increase production if compensated for the external benefits.

Step-by-step explanation:

An externality occurs when an exchange between a buyer and seller has an impact on a third party who is not part of the exchange. An externality, which is sometimes also called a spillover, can have a negative or a positive impact on the third party. If those parties imposing a negative externality on others had to account for the broader social cost of their behavior, they would have an incentive to reduce the production of whatever is causing the negative externality. In the case of a positive externality, the third party obtains benefits from the exchange between a buyer and a seller, but they are not paying for these benefits. If this is the case, then markets would tend to underproduce output because suppliers are not aware of the additional demand from others. If the parties generating benefits to others would somehow receive compensation for these external benefits, they would have an incentive to increase production of whatever is causing the positive externality.