A shadow economy is in evidence when:

• A. all social costs and benefits are fully accounted for in market transactions
• B. economic activities are conducted outside of government regulation and taxation
• C. the government provides subsidies to encourage legal business operations
• D. externalities are internalized through Pigovian taxes

Answer: (B)

Verified step by step guidance

1. Step 1: Understand the concept of a shadow economy. A shadow economy refers to economic activities that are not reported to the government and therefore escape regulation, taxation, and official statistics.
2. Step 2: Recognize that when all social costs and benefits are fully accounted for in market transactions, the economy is considered 'formal' or 'regulated,' not shadow.
3. Step 3: Note that government subsidies to encourage legal business operations are part of formal economic policy and do not describe a shadow economy.
4. Step 4: Understand that internalizing externalities through Pigovian taxes is a method to correct market failures within the formal economy, not an indicator of a shadow economy.
5. Step 5: Conclude that the defining characteristic of a shadow economy is economic activities conducted outside government regulation and taxation, which means these activities are hidden from official oversight.