Externality Defined An externality is present when the activity of one entity(person or firm) directly affects the welfare of another entity in a way that is outside the market mechanism Negative externality: These activities impose damages on others Positive externality: These activities benefits on others2 Externality Defined • An externality is present when the activity of one entity (person or firm) directly affects the welfare of another entity in a way that is outside the market mechanism. – Negative externality: These activities impose damages on others. – Positive externality: These activities benefits on others