An externality arises in a market when there are costs or benefits that are external to a market transaction, in the sense that they are incurred (enjoyed) by a third party but are not reflected in market prices. This leads to a misallocation of resources in society. The preferred allocation of resources within a market occurs when marginal social cost (MSC) is equal to marginal social benefit (MSB). If MSB is greater than MSC, then an increase in consumption of an extra unit of the good adds more to social benefit than to social cost, so society is better off. The reverse is true where MSC is greater than MSB.
■ Private cost or benefit: a cost that is incurred (or a benefit that is enjoyed) by an individual (firm or household) as part of its economic activities
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