Describe what is meant by externalities.

Externality is when the a third party not involved in production or consumption activities is impacted by these economic activities.

Externality is a form of market failure.

Externality could be postive or negative.

Positive externality - externality is positive when the benefits of economic activities to a third party exceeds its cost. An example am activity that generates positive externality is research and development. For example, research in the medical field has led to the discovery of cures to deadly diseases. The benefit of the research to the society exceeds its cost. Government can promote activities with positive externality by giving subsidies.

Negative externality is when the benefits of economic activities to a third party is less than its cost. An example of negative externality is pollution. A cigarette smoker is harming those around him. The cost to the people around him is more than its benefits. Government discourage activities that generates negative externality by taxation which makes prices higher. This type of tax is known as pigovian tax.