Which statement best defines an externality in economics?

• A. An externality is a cost or benefit that affects a third party who is not directly involved in the transaction.
• B. An externality is the price at which supply equals demand in a market.
• C. An externality is the total revenue a firm receives from selling its product.
• D. An externality is the amount of goods and services produced by a firm.

Answer: (A)

Verified step by step guidance

1. Step 1: Understand the concept of an externality in economics. An externality occurs when a decision causes costs or benefits to third parties who are not directly involved in the economic transaction.
2. Step 2: Identify the key elements of an externality: it involves a third party, and the effect can be either positive (benefit) or negative (cost).
3. Step 3: Compare the given statements to the definition of an externality. The correct statement should mention the impact on third parties outside the transaction.
4. Step 4: Recognize that the other options describe different economic concepts: equilibrium price, total revenue, and quantity produced, which are unrelated to externalities.
5. Step 5: Conclude that the best definition of an externality is the one stating it is a cost or benefit affecting a third party not directly involved in the transaction.