What best describes a negative externality?

• A. It imposes costs on third parties not involved in the market
• B. It increases overall welfare
• C. It is always accounted for in market price
• D. It has no impact on social welfare

Answer: (A)

A negative externality occurs when the actions of a producer or consumer impose costs on people who are not involved in the market transaction. This is exactly what it means to say it imposes costs on third parties not involved in the market. Because these costs aren’t reflected in the market price, the market outcome is inefficient: too much of the good is produced or consumed from a social standpoint, and overall welfare falls. It does not increase welfare, and it is not typically priced into the market, which is why it affects social welfare. An example is pollution from a factory harming nearby residents who don’t participate in the market transaction. Policy tools like taxes or regulations aim to internalize these costs so private decisions better reflect social costs.