Every externality involves people or firms interacting in ways that don't involve the market – perhaps they breathe the same air or drive on the same highways. However, not every non-market interaction results in an externality. An externality only arises when people or firms pursue their own interests so relentlessly that they fail to consider the effects that their actions have on others.

An agent – that is, a person or firm – can be persuaded to recognize the interests of others by compensating him for his beneficial acts and forcing him to compensate others for his harmful acts. When this kind of compensation occurs, every agent will recognize the interests of other agents because doing so advances his own interests.

Much of the economic study of externalities centers on the role of explicit monetary compensation in the control of externalities. Our discussion of this issue will proceed in three steps. First, we will examine the meaning of “appropriate compensation” and its impact upon market transactions. Second, we will consider some of the reasons why compensation might not occur. Lastly, we will consider the role of the government in controlling externalities in the absence of appropriate compensation.

NEGOTIATED COMPENSATION

When one person's actions affect another's welfare, someone will be searching for a compromise. That person might be the initiator of the action, or the person whose welfare is affected by the action.