How do externalities typically affect economic decisions?

Externalities refer to the costs or benefits that affect third parties who are not directly involved in an economic transaction. When externalities are present, they typically disrupt the efficient allocation of resources because market participants do not fully account for the societal costs or benefits associated with their actions.

This disconnect can result in market failures, where the outcomes of decisions made by individuals or firms do not reflect the true costs or benefits, leading to overproduction or underproduction of certain goods or services. For instance, pollution from a factory that impacts the health of nearby residents is a negative externality; the factory owner might not bear all the costs of that pollution, resulting in overproduction compared to what would be socially optimal.

In contrast, when externalities are ignored, resources get allocated inefficiently. Thus, externalities can significantly influence economic decisions by leading to outcomes that do not maximize societal welfare, illustrating how they typically result in market failures.