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.