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An externality arises when a firm or person engages in an activity that affects the well-being of a third party, yet neither pays nor receives any compensation for that effect. If the impact on the third party is adverse, it is called a externality. The following graph shows the demand and supply curves for a good with this type of externality. The dashed drop lines on the graph reflect the market equilibrium price and quantity for this good. Shift one or both of the curves to reflect the presence of the externality. If the social cost of producing the good is not equal to the private cost, then you should shift the supply curve to reflect the social costs of producing the good; similarly, if the social benefit of producing the good is not equal to the private benefit, then you should shift the demand curve to reflect the social benefit of consuming the good. Supply Demand Supply PRICE (Dollars per unit) Demand 10:44 24x O 12/9/2 3 Q Search