Which of the following best defines externalities?

Externalities are best defined as costs or benefits that affect third parties who are not directly involved in a transaction. This concept highlights the broader impact that economic activities can have beyond the immediate buyers and sellers. For instance, when a factory produces goods, it may emit pollution that affects the health and property of nearby residents who have no stake in the production or consumption of that product. This negative externality illustrates how the factory's activities impose costs on third parties, leading to market outcomes that may not reflect the true societal costs of production.

Conversely, a positive externality occurs when a third party benefits from an economic transaction without having to pay for that benefit. For example, an individual who plants trees not only enhances their property value but also provides environmental benefits such as improved air quality and increased wildlife habitats that positively impact the surrounding community.

Understanding externalities is crucial for economists and policymakers, as they often call for solutions or interventions to correct market failures resulting from these external effects, ensuring that the social costs and benefits are reflected in market transactions.