Explain the concept of externalities.

Externalities refer to the spillover effects of economic activities on third parties who are not directly involved in the transaction. These effects can be positive or negative and occur when the actions of producers or consumers have an impact on the well-being of others in society.

Positive externalities occur when the actions of individuals or firms generate benefits for others without receiving compensation. For example, when a company invests in research and development, it may lead to technological advancements that benefit society as a whole.

Negative externalities, on the other hand, occur when the actions of individuals or firms impose costs on others without bearing the full burden of those costs. For instance, pollution from factories can harm the health of nearby residents and increase healthcare costs.

Externalities can lead to market failures as the price mechanism fails to account for the full social costs or benefits of a transaction. To address externalities, governments may intervene through regulations, taxes, subsidies, or the creation of property rights to internalize the external costs or benefits and promote efficient outcomes.