What is considered a negative externality?

A negative externality refers to a situation where a cost is imposed on a third party who is not directly involved in an economic transaction. This means that when one party makes a decision that leads to adverse effects on another party, those effects are considered negative externalities.

For example, if a factory produces goods and in the process emits pollution, nearby residents may suffer health issues or diminished quality of life as a result, despite having no part in the factory's production decisions. This pollution constitutes a cost that the local community must bear, even though they are not participating in the economic activity of the factory.

Recognizing negative externalities is crucial for understanding market failures, where the social costs of production exceed the private costs borne by producers. In such cases, government intervention or regulation may be required to address these externalities, either through taxes, subsidies, or other forms of policy.

The other options do not capture the essence of negative externalities. A cost that benefits a third party describes a positive externality, while profit from a transaction and a warranty agreement do not directly relate to externalized costs imposed on third parties.