A situation in which the private costs or benefits to the producers or purchasers of a good or service differs from the total social costs or benefits entailed in its production and consumption. An externality exists whenever one individual's actions affect the well-being of another individual -- whether for the better or for the worse -- in ways that need not be paid for according to the existing definition of property rights in the society. An "external diseconomy," "external cost" or "negative externality" results when part of the cost of producing a good or service is born by a firm or household other than the producer or purchaser. An "external economy," "external benefit," or "positive externality" results when part of the benefit of producing or consuming a good or service accrues to a firm or household other than that which produces or purchases it. Example: If one neighbor decides to repaint his house and spruce up his yard so he can get a better price when selling it, he also at the same time is slightly improving the market value of other houses in the neighborhood, creating a "positive externality" benefitting his neighbors. On the other hand, another neighbor who is a grade-A slob and lets the external appearance of his house run down creates a "negative externality" by depressing the attractiveness and thus the market value of the whole neighborhood.
Externalities of either the "positive" or the "negative" sort create a problem for the effective functioning of the market to maximize the total utility of the society. The "external" portions of the costs and benefits of producing a good will not be factored into its supply and demand functions because rational profit-maximizing buyers and sellers do not take into account costs and benefits they do not have to bear. Hence a portion of the costs or benefits will not be reflected in determining the market equilibrium prices and quantities of the good involved. The price of the good or service producing the externality will tend toward equality with the marginal personal cost to the producer and the marginal personal utility to the purchaser, rather than toward equality with the marginal social cost of production and the marginal social utility of consumption. Thus, normal market incentives for the buyer and seller to maximize their personal utilities will lead to the over- or under-production of the commodity in question from the point of view of society as a whole, not the socially optimal level of production. Goods involving a positive externality will be "underproduced" from the point of view of society as a whole, while goods involving a negative externality will be "overproduced" from the point of view of society as a whole. In our example above, the individual homeowner pays all the cost of sprucing up his home but realizes only part of the benefits created -- so consequently each homeowner will probably not keep his house up as well as he otherwise might if his neighbors could somehow be induced or required to pay him something for their share of the benefits from his labors.
Contracts often can be worked out as a means to "internalize" potential externalities because the existence of the externality implies there is at least the potential opportunity for mutual gains if the "third party" by-standers affected can offer compensation to the buyers or sellers in exchange for adjusting production or consumption levels of the good to a more acceptableble level. For example: If each homeowner in the neighborhood will agree to be legally responsible for maintaining a high common standard of upkeep in exchange for everyone else in the neighborhood also guaranteeing to do the same, then everyone can be financially better off than they would be without the agreement -- which is precisely why we observe such phenomena as homeowners associations and restrictive deed covenants. Or other homeowners in the neighborhood might even band together and agree to finance jointly the entire cost of purchasing, fixing-up, and reselling some particularly run-down homestead in the neighborhood if the expected increase in their individual property values would be greater than their share of the cost of buying out their slovenly neighbor. Unfortunately, where externalities affect very large numbers of third parties (but only to a relatively minor degree in each case), the transaction costs of negotiating such many-sided contracts among them all may often be so large as to make this contractual solution impractical.
Where the transaction costs to arrive at contractual solutions to "externality" problems are prohibitively high, complex modern societies normally provide "second best" remedies to private persons through the courts. Nearly the whole area of "tort" law (including especially law suits for "nuisance" and for "negligence") deals with externality problems in one way or another. People adversely affected by other people's activities may go to court and sue them in an effort to obtain an award of financial compensation for the damages and/or a court injunction requiring their obnoxious neighbors to change their ways in the future. (Of course, filing and prosecuting a law suit is itself a costly procedure, both for the individuals involved and for the taxpayers -- more transactions costs.)
Government regulations or tax policies are often justified to the public as a means of "correcting" the outcome of the market for goods involving especially sizable externalities, especially negative externalities. The government might, for example, place a special tax or licensing fee on the production (or purchase) of a good or service believed to involve significant negative externalities, with the size of the tax or fee to be determined by some estimate of the total costs being imposed on third parties. The government charges would force the sellers (or the buyers) of the good or service to begin to start taking into account these external costs along with their own and would effectively shift the supply curve (or the demand curve) to the left, resulting in somewhat smaller quantities of the good being sold at a somewhat higher price in the new equilibrium after inauguration of the tax -- and thus, somewhat fewer costs will be imposed on third parties. (But note that it is the government that gets to keep the money, not the unfortunate bystanders still suffering the damage!) In the case of a good or service involving a positive externality, government might cope in an analogous fashion by offering to pay subsidies to the producers or consumers of the good or service in question in order to encourage an appropriate expansion of production, or by using government's power to compel obedience without first negotiating mutually agreeable terms of cooperation among the affected parties, government might avoid the sizable transaction costs that would be involved in achieving a contractual solution to the problem by using its law-making or regulatory powers -- for example, a city ordinance requiring all householders to keep their lawns mowed and their houses painted and forbidding them to allow trash or old automobile hulks to litter their front yards.
An important problem with the tax/subsidy approach to remedying externalities problems is, of course, that it may well be impossible or prohibitively expensive for the government to determine the size of the external costs or benefits involved and hence to determine even approximately what an appropriate tax or subsidy rate would be. More generally, there are bound to be transaction costs for all forms of government action, including regulatory or legal strategies for correcting externalities -- costs of gathering information, costs of debating and making policy decisions, and costs of administration or policing once the policy has been made. It will often be the case that the costs imposed on society by government taking corrective action would be larger than the decrease in welfare to society from the externalities that the government action is supposedly designed to cure. In any given case of externality, society may well be better off by simply leaving the externality in place, unless the third-party effects of the externality are truly massive. More precisely, government policy-makers need to devote their attention to the problem of lowering total transaction costs, rather than simply focussing on "fixing" this or that externality problem regardless of costs, if their intention is to maximize social welfare.
One area in which government has a great deal of control over the size of transactions costs throughout the economy is in the design and construction of the legal system. The costs to private firms and individuals of enforcing their contracts and protecting their other property rights are largely determined by the government's arrangements for the legal system. If the legal system is costly and cumbersome and unpredictable, mutually beneficial trades may often not take place because of potentially high transactions costs involved in protecting and enforcing complex property rights and contracts once made. Moreover, negative externalities often arise because certain third party property rights have not been clearly defined or effectively enforced in some aspect of social life, and the law has mandated that social or common ownership will be imposed instead of conventional private ownership and control. Excessive air and water pollution problems are often examples of such negative externalities from flaws in property law. For example, factory owners nearly always refrain from dumping waste products on neighboring privately-owned property for fear of the massive lawsuits they would surely lose -- but they can often get by with dumping noxious waste products into "the public's air" or "the public's river" or "the public's ocean" without having to pay to secure the consent of those who later will be breathing or drinking or eating these poisons (or paying extra to remove them) precisely because the victims often have had no practical legal way of purchasing or selling a fully recognized exclusive property right in the portion of the air or rivers or the oceans (and their wildlife) on which they nevertheless depend.