Economics 9708/33 — October/November 2019

Background Concept

An externality is a spillover effect — a cost or benefit that arises from the production or consumption of a good or service but that is not reflected in the market price. The key elements are:

• It affects a third party who is not a direct participant in the transaction (neither the buyer nor the seller).
• No compensation is paid for the effect (the price does not adjust to account for it).
• Externalities can be positive (benefits to third parties) or negative (costs to third parties).

Externalities are a form of market failure because the market price only reflects private costs and benefits, not social costs and benefits. This leads to overproduction of goods with negative externalities and underproduction of goods with positive externalities.

Understanding the Question

This is a multiple-choice question asking which of the four options is not an example of an externality. The question tests whether you can apply the definition precisely. Three of the options describe genuine spillover effects on third parties. One describes a transaction that is entirely private — it affects only the direct participants. The task is to spot the one that does not involve a third party.

Approach

Read each option and ask: who are the direct participants in the transaction described? Who else is affected? Is the effect on the third party uncompensated? If the answer to the last two questions is yes, it is an externality. If the effect is entirely within the direct transaction, it is not.

Step-by-Step Reasoning

Option A: A new firm pays its workers higher wages than other firms. The direct participants are the firm (the employer) and the workers (the employees). The higher wage is a private cost to the firm and a private benefit to the workers. No third party is affected by this transaction itself. (The fact that other firms might now have to raise wages to compete is a market adjustment, not an externality — those other firms are participants in the labour market, not uninvolved third parties.) Therefore A is not an externality.

Option B: The flowers planted by a householder give pleasure to neighbours. The direct participants are the householder (the planter) and possibly the garden centre where the flowers were bought. The neighbours are third parties — they receive a benefit (pleasure from the view) without paying for it. This is a positive consumption externality.

Option C: Immunisation of children reduces the risk of infection to others. The direct participants are the children and their parents/healthcare providers. Other people in the community are third parties who benefit from reduced risk of catching the disease (herd immunity). This is a positive consumption externality.

Option D: Installation of security cameras in a city centre results in an increase in thefts elsewhere. The direct participants are the city authorities (or businesses) installing the cameras and the camera supplier. The people in the areas where thefts increase are third parties who bear a cost (higher crime risk) without compensation. This is a negative production externality (the security measure displaces crime rather than reducing it overall).

Key Takeaways

• An externality always involves a third party who is not part of the transaction.
• A transaction that only affects the direct participants (buyer and seller) is not an externality, even if it has wider market consequences.
• Positive externalities confer uncompensated benefits on third parties; negative externalities impose uncompensated costs.
• The key test: is there an effect on someone who did not choose to be part of the transaction and receives no compensation?

Common Mistakes

• Confusing market adjustments with externalities. Option A might seem like an externality because the higher wage could affect other firms. But those other firms are participants in the labour market, not uninvolved third parties. The wage increase is a market signal, not a spillover.
• Thinking any benefit to others is an externality. A benefit is only an externality if it is uncompensated and arises from a transaction the beneficiary is not part of. If a neighbour pays the householder for the view of the flowers, it ceases to be an externality.
• Overlooking the 'no compensation' condition. Option D is an externality because the victims of the displaced thefts receive no compensation. If the city compensated them, it would be internalised.

Things to Be Careful About

• Read each option carefully — the question asks for the one that is not an externality, so the three that are externalities are distractors.
• Focus on the transaction described, not on broader consequences. The higher wage in A is a private matter between employer and employee; the effect on other firms is a market response, not a spillover.
• Remember that externalities can be positive or negative — both count as externalities. The question does not ask for a particular type, just whether it is an externality at all.