Þ Externalities arise when the actions of one agent (A) affects the utility or production function of another agent (B), and there is no offsetting compensation (monetary or otherwise) of B by A.
Example:
 | Let V denote the maximum amount a specific buyer would be willing to pay for good X (say, a pack of cigarettes). |
| Let P denote the market price of good X (cigarettes) if the market is competitively structured--i.e. P = PC. |
Þ Let V = $1.75 per pack and P = $1.25 per pack. If there are no externalities, the net increase in the total surplus (TS) resulting from a transaction is given by:
D TS = V - P = $1.75 - $1.25 = $0.50
L But smoking produces passive smoke--an unwelcome spillover for nonsmokers, who must suffer without recompense.
ð Let W denote the maximum amount an agent affected by passive smoke would be willing to pay to be rid of it. Let W = $0.55. Taking into account externalities, the change in the total surplus is given by:
D TS = (V - P) - W = ($1.75 - $1.25) - $0.55 = ($0.05)
Hence, Transaction decreases the total surplus.
J Solution: Impose an excise tax sufficient to raise the price above $1.75.
Moral of the story: Market forces cannot be trusted to allocate resources efficiently in the case where production or consumption activities generate spillovers. Hence, regulation in the form of pollution taxes, effluent fees, subsidies, etc. can, by their effect on resource allocation, improve social welfare.