Final answer:
Externalities in market transactions are uncompensated costs or benefits received by a third party not directly involved in the exchange. These can be positive or negative, such as the pleasure or disturbance from nearby concerts, or the effects of industrial pollution.
Step-by-step explanation:
A market transaction produces an externality if an individual not directly involved in the transaction receives uncompensated external benefits or costs from it. An externality occurs when a market exchange between a buyer and seller impacts a third party who is external to the exchange, often referred to as a spillover. Externalities can be positive or negative.
Examples of Externalities
For example, consider a concert producer building an outdoor arena for country music concerts near your neighborhood. If you love country music, the free music you can hear from your property is a positive externality. However, if you dislike the music, it would be considered a negative externality.
Negative externalities, such as pollution, when not accounted for in market transactions, provide an incentive to reduce the production of the goods causing them. In contrast, positive externalities might lead to the underproduction of a good, because the supplier isn't compensated for the external benefits provided to others. If producers were compensated for these positive effects, they would be encouraged to increase production.