Externalities are costs or benefits not reflected in market prices. Which example is a negative externality?

Externalities are costs or benefits not reflected in market prices. Which example is a negative externality?

• A. Pollution from a factory affecting nearby residents
• B. A farmer receiving a price premium for soil health
• C. A city bicycle program increasing traffic efficiency
• D. A private market transaction with no spillover

Answer: (A)

Externalities show up when the price of a good or activity doesn’t reflect all the costs and benefits it creates for others. A negative externality happens when people other than the buyer and seller bear costs from the activity without being compensated, so social costs exceed the private costs and the market pushes too much of the activity. Pollution from a factory affecting nearby residents is a classic negative externality because the health, cleanup, and environmental costs borne by those nearby aren’t paid for by the factory. The market price of the factory’s output doesn’t include these social costs, leading to more pollution than is socially optimal. The other scenarios involve either private gains or public benefits that don’t impose costs on others in the same way: a farmer getting a price premium for soil health is a private benefit signal, a city bicycle program that improves traffic efficiency provides a positive externality, and a private market transaction with no spillover has no externalities.

Externalities show up when the price of a good or activity doesn’t reflect all the costs and benefits it creates for others. A negative externality happens when people other than the buyer and seller bear costs from the activity without being compensated, so social costs exceed the private costs and the market pushes too much of the activity.

Pollution from a factory affecting nearby residents is a classic negative externality because the health, cleanup, and environmental costs borne by those nearby aren’t paid for by the factory. The market price of the factory’s output doesn’t include these social costs, leading to more pollution than is socially optimal.

The other scenarios involve either private gains or public benefits that don’t impose costs on others in the same way: a farmer getting a price premium for soil health is a private benefit signal, a city bicycle program that improves traffic efficiency provides a positive externality, and a private market transaction with no spillover has no externalities.