Explanation:

Consumption, production, and investment decisions ofindividuals, households, and firms often affect people not directlyinvolved in the transactions. Sometimes these indirect effects are tiny.
• But when they are large they can become problematic—whateconomists call externalities. Externalities are among the mainreasons governments intervene in the economic sphere.
• In the case of pollution—the traditional example of a negativeexternality—a polluter makes decisions based only on the directcost of and profit opportunity from production and does notconsider the indirect costs to those harmed by the pollution. Theindirect costs include decreased quality of life, say in the case of ahome owner near a smokestack; higher health care costs; andforgone production opportunities, for example, when pollutionharms activities such as tourism.
• Since the indirect costs are not borne by the producer, andtherefore not passed on to the end user of the goods produced bythe polluter, the social or total costs of production are larger thanthe private costs.
• There are also positive externalities, and here the issue is thedifference between private and social gains. For example, researchand development (R&D) activities are widely considered to havepositive effects beyond those enjoyed by the producer that fundedthe R&D—normally, the company that pays for the research.
• This is because R&D adds to the general body of knowledge, whichcontributes to other discoveries and developments. However, theprivate returns of a firm selling products based on its own R&Dtypically do not include the returns of others who benefitedindirectly. With positive externalities, private returns are smallerthan social returns.