Which of the following transactions fails to produce gains from trade for both buyers and sellers due to the presence of externalities?

• A. A factory sells its products to consumers, but the production process pollutes a nearby river, harming local residents.
• B. A bookstore sells textbooks to college students at market price.
• C. A homeowner hires a gardener to improve their private backyard.
• D. A farmer sells organic vegetables directly to consumers at a local market.

Answer: (A)

Verified step by step guidance

1. Step 1: Understand the concept of gains from trade. Gains from trade occur when both buyers and sellers benefit from a transaction, typically because the buyer values the good more than the seller's cost of producing it.
2. Step 2: Recognize what externalities are. Externalities are costs or benefits from a transaction that affect third parties who are not directly involved in the trade. These can be negative (e.g., pollution) or positive (e.g., a well-maintained garden improving neighborhood aesthetics).
3. Step 3: Analyze each transaction to see if externalities are present. For example, a factory polluting a river imposes a negative externality on local residents who are not part of the transaction, which means the social cost is higher than the private cost.
4. Step 4: Identify that when negative externalities exist, the transaction may not produce gains from trade for society as a whole, because the harm to third parties offsets the private gains to buyers and sellers.
5. Step 5: Conclude that the transaction involving the factory polluting the river fails to produce gains from trade for all parties due to the negative externality, while the other transactions involve private goods without significant external effects.