What is an externality in economic terms?

An externality refers to the impact of an economic activity on third parties who are not directly involved in the transaction. These impacts can be either positive or negative. When an externality occurs, the actions of individuals or businesses can inadvertently affect others, typically in ways that are not reflected in market prices.

Choosing the option that states an externality is a harm or benefit caused to others by certain economic activities captures the essence of what defines externalities. For instance, pollution generated by a factory imposes a negative externality on nearby residents, as they suffer from poor air quality, which is not accounted for in the production cost of the factory. Conversely, a well-maintained garden in a neighborhood can provide a positive externality by enhancing property values and aesthetic enjoyment for the community members nearby.

Understanding externalities is crucial in economics as they highlight situations where market failures occur, often necessitating government intervention or regulation to promote efficiency and equity in the marketplace.