What goes on inside another man's house is no one else's business. Well, no, not quite. A toilet overflowing, running down the stairs and into the next apartment becomes his neighbor's business when it seeps in under his doorway or along his walls or in through his window. Thus is born the externality.
An externality is brought into this world when the costs or benefits of a particular transaction are shifted onto a third party not participating in the transaction, and without their consent.
For example, I walk past a man in the street who hasn't showered in three weeks. The stench flowing off him causes me to be physically ill, and I throw up my lunch. This is a negative externality. He has forcibly imposed on me a cost without my permission. As a society, we tend to want to suppress such externalities, either by outlawing them (insisting he shower) or by somehow taxing them so people won't engage in such behavior.
On the other hand, imagine me sitting on my favorite beach. A pretty girl in a bikini walks by. She didn't put on that bikini for my benefit; I am, after all, fifty years old and not in her target group. Even so, without ever speaking to the woman or getting up out of my chair, I feel younger just seeing her pass and the rest of my day goes by more smoothly. I have been the unintended recipient of a positive externality.
Now don't jump to any conclusions about me and pretty girls, for while this example is trivial, there are serious issues to be dealt with here. Whenever positive benefits are created for a third party from a private transaction, we have a positive externality. Education. Immunization. National defense. As a society, we tend to want to encourage such activities, either by making them mandatory (immunization) or by somehow subsidizing them so people will engage in more of such behavior (education).
The problem in much of this is properly identifying whether or not an externality exists, who is responsible for it, and who (if anyone) benefits or is made to suffer.
Take pollution. It is the perfect example of a negative externality. My factory is upriver of your town and I dump raw sewage into what will soon be your drinking water. We can identify that an externality exists, we know who is responsible for it, and we know who is forcibly being made to suffer by it. The only question that remains is how to solve it. Do we force the factory owner to process his sludge before dumping it in the river, or do we force the townspeople downstream to build a plant to cleanse their water before drinking it?
Either method involves costs. The factory owner may have to raise prices to cover the cost of processing his sludge, perhaps forcing him to lay off workers or driving him out of business. The townspeople may have to pay higher water prices or suffer a lower standard of living. The town itself may die either way, on account of the more expensive water bills or because of a reputation for shorter life spans.
Thus, externalities make for tough questions, and immensely complicated solutions, none of which are hardly ever perfect. The same arguments that apply to pollution, apply to smoking bans, mega-hog farms, seat-belt use, loud music, the list goes on. And while we're at it, how far downstream does the town have to be before it has a right to force the factory to clean up its sludge? A mile? A hundred miles? In other words, should I still be forced to walk through your smoke when I enter a smoke-free building and fifty people are gathered outside on the front stoop, taking a last puff before they enter? While the smokers don't care and think they have a right, the smoke still gets into my hair and onto my clothes. Now strike out the word "smoker" and write in the words "factory owner" and you get the idea.
But let's return a moment to where we started — "What goes on inside another man's house is no one else's business." In the absence of an externality, this is a true statement. And therein lies the basis for financial privacy, for the right to own a gun, for the right to smoke a cigarette, or a joint, or drink a beer, or watch a dirty movie, or have kinky sex with your girlfriend. Unless the toilet is actually running down the stairs and into your neighbor's apartment, the state should never have a basis for interfering with your private activities. But turn that radio up loud enough and you begin to cost your neighbor his peace and quiet. What some of us would view as a right to play our music loud or smoke whatever we want wherever we want to, others would view as simply being rude. Just as an armed society can be a polite society, if we want to keep what goes on inside our houses a private matter, we have to begin thinking about the guy living hundred miles downstream of us.