An externality is the effect of one household or firm's actions upon another, which is not brought about by market adjustments. Cigarette smoking imposes a 'negative externality' on non-smoking. Investing in your children's education creates a positive externality for other members of society.

Note that effects that travel through markets are not externalities. If a firm uses more steel in its production process and that drives up the price of steel which in turn affects the profitability of another firm - that is NOT an example of one firm imposing an externality on another. It is simply firms competing for resources through the market mechanism.

Externalities should be thought of as missing property rights. Sulphur dioxide emission is an example. Until the 1990s heavy industry could emit sulphur dioxide into the atmosphere without cost to itself. But the action of emitting SO2, by air quality, imposed a large negative externality on households and other firms. To eliminate the externality, the US Federal government auctioned rights to emit SO2. Those rights could then be traded in a new market for SO2 rights. The Government sets the total level of rights to be auctioned at the point where the value to society of production that one more ton of emission permits is just equal to the cost of reduced air quality from that last ton of SO2.

An important example of positive externalities are network externalities. In many networks the value of being connected depends upon how many other households or firms are connected. For instance being connected to a telephone network is more valuable the more people there are that you can ring. Each new connection imposes a positive 'network externality' on the existing users.