Externalities:

An important source of market failure is the presence of externality. An externality typically is an unintended and uncompensated side effect of one person's or firm's activities on another. For example, the health effects of smoke emissions from vehicles. factories and cigarettes. Construction activity in one's house may cause seepage in the neighbor's house.

These side effects occur because of technical interdependence in consumption or production. This interdependence, however, is not reflected in market prices. The action of one economic agent affects the utility or profit level of another economic agent, but not through its effects on prices. We provide a fomlal definition of externality below.

Definition : An externality exists whenever the well-being (consumer or the production possibilities firm are directly ufficfed by the actions of another ugent in the economy. In the above definition, any effects that are transmitted through prices are excluded. External effects of this sort are categorized as technological (or nonpecuniary).

Let us distinguish the externality as defined above from another concept. Pecuniary externality.v (term given by Viner) arise when the external effect'is transmitted through altered prices. Suppose that a new firm moves into an area and drives up the rental price of land. That increase creates a negative effect on all those paying rent and therefore, can be considered as an externality. This pecuniary externality, however, does not cause a market failure because the resulting higher rents are reflecting the scarcity of land. The land market provides a mechanism by which parties call bid for land; the prices that result reflect the value of the land in its various uses.

Without pecuniary externalities, the price signal would fail to sustain an efficient allocation. These externalities are present in any competitive market but create no inefficiency.

We can divide externalities into consumption externality and production externality. Consumption externality exists when the utility of one agent is affected directly by the actions of another agent. The other agents could be either consumers or firms. For example, some agents' consumption of tobacco, alcohol, loud music, etc. generates an externality for other consumers. Similarly, a paper mill that discharges industrial waste into the river generates an externality for consumers who use the river for swimming.
A production externality is analogous to consumption externality. The difference is that we deal with production fuilctions instead of utility functions. For example, the production of smoke by a steel mill may directly affect the production of clean clothes by a laundry, or the production of honey by a beekeeper might directly affect the output of an apple orchard next door.

'The external effects need not always be detrimental to those affected by them. There could be positive externalities as well. Acolnmonly cited example here is the beauty of a rose garden enjoyed by not only the owner but also the passers by.