Externalities: Definition, Types, and Importance | Test Prep

Externalities: Understanding Spill-Over Effects of Projects

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Question

Externalities:

I. are spill-over effects of a project.

II. are not necessarily harmful and can actually be beneficial.

III. should be ignored in project evaluation, just as sunk costs are.

Answers

Explanations

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A. B. C. D. E. F. G.

C

You should remember three things about externalities:

1. They are spill-over effects from the project under consideration and affect the rest of the firm.

2. They are not necessarily harmful. Many of them can be beneficial ("positive externalities").

3. Unlike sunk costs, which have no future cash flow effects, externalities cannot be ignored in project evaluation since their effects on the cash flows are incremental cash flows themselves.

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