Which of the following best describes an externality in economics?

• A. A profit earned by a firm in a perfectly competitive market.
• B. A price change resulting from shifts in supply and demand.
• C. A cost or benefit that affects a third party who is not directly involved in the transaction.
• D. A government tax imposed on producers.

Answer: (C)

Verified step by step guidance

1. Understand the concept of an externality: it refers to a situation where a cost or benefit from an economic activity affects a third party who is not directly involved in the transaction.
2. Recognize that externalities can be either positive (benefits) or negative (costs) and are not reflected in market prices.
3. Evaluate each option by checking if it involves an impact on a third party outside the buyer-seller relationship.
4. Identify that a profit earned by a firm or a price change due to supply and demand shifts are direct outcomes of market transactions and do not necessarily affect uninvolved third parties.
5. Conclude that a government tax is a policy tool and not an externality itself, whereas a cost or benefit affecting a third party fits the definition of an externality.