Question

An externality arises when a person engages in an activity that influences the well-being of:

a. buyers in the market for that activity and yet neither pays nor receives any compensation for that effect.
b. sellers in the market for that activity and yet neither pays nor receives any compensation for that effect.
c. bystanders are in the market for that activity and yet neither pays nor receives any compensation for that effect.
d. both a and b are correct.

Answer 1

An externality occurs when an activity affects a third party who neither pays nor receives compensation for the effect.

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, sometimes called a spillover, can have a negative or 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 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 somehow receive compensation for these external benefits, they would have an incentive to increase production of whatever is causing the positive externality.