Final answer:
An externality is a spillover effect of a market exchange that affects third parties not directly involved in the transaction, potentially leading to market inefficiencies. Externalities can be positive or negative, and they may require government intervention to correct market outcomes.
Step-by-step explanation:
An externality is a situation where a market exchange impacts a third party not involved in the transaction, causing either a positive externality(external benefits) or a negative externality (external costs). These spillover effects mean that the true cost or benefit of a product is not reflected in the market price, influencing producers' and consumers' behaviors in ways that can lead to market inefficiencies.
For instance, consider a factory that pollutes a river while manufacturing a product. The buyers of the product and the factory owner are engaged in the market exchange, but the impact of the pollution on the local ecosystem and community is an externality. The community bears the cost of the pollution, a negative externality, without participating in the economic transaction.
In the case of a positive externality, imagine someone who gets a vaccine, which not only protects them from illness but also reduces the spread of disease, benefiting others who are not party to the original service exchange.
Positive externalities can lead to underproduction (since suppliers may not realize the full demand including these benefits), while negative externalities can lead to overproduction (as producers may not account for the full social costs). To address externalities, government intervention through taxes, subsidies, or regulations is often necessary.