Externalities:

Externalities occur when one person's action affect another person's well being and the relevant costs and benefits are not reflected in market prices. In other words, externalities mean the economic effects, which occur from the production or the use of goods to other parties or economic units. It can arise between producers and/or between consumer and producer.

Example: There are external benefits from education. Children gain from educated parents, society benefits as education reduces crimes, social unrest, unemployment and welfare costs. An educational system that includes acceptable social values, improves communications, and strengthens democratic institutions is beneficial to the society. There are external costs of production in the form of pollutions and other disamenities that pollutes the atmosphere.

An externality occurs in economics when the decision maker does not bear all of the costs or reap all of the gains from his action. Society consumes more or less of the good depending upon the competition in the market. Society benefits if the world around the pears on making the decision benefits more than he does.

Example: Individual decision makers under consume areas of education or safety. Goods will be over consumed if the cost to the world exceeds the costs to the individual making the choice in areas such as pollution or crime etc. The figure clearly indicates that problem of an externality usually concerns the results of market activity. Economists see voluntary exchanges as mutually beneficial to both parties in an exchange. Either the consumption of the product (perfume or  other luxuries) or its production may have external effects. Those who suffer from external costs do so involuntarily, while those who enjoy external benefits do so free. The left hand side of the diagram shows consumption externalities (like perfume), while the right hand side shows production externalities (like those produced by a perfume factory).