Define "externality." Give an example of an external cost. Explain why resources will not be allocated efficiently if externalities are present. How can the problem of externalities be addressed?

What will be an ideal response?

An externality is a cost or benefit resulting from some activity or transaction that is imposed or bestowed on parties external to the activity or transaction. An example of an external cost is air pollution. Firms do not take external costs into consideration when determining the profit maximizing output level. If external costs exist, then marginal cost is not a good measure of the cost to society of producing an additional unit of the product. Externalities can be addressed through government regulation or voluntary agreements among those affected by the externality.