External costs are costs associated with the production of goods which are not entirely borne by producers. The industrial pollution of fishing waters decreases the yield to the fishing industry. However, the lost revenue to the fishing industry is not considered a cost to the firms generating the pollution. The result is an over-allocation of resources to the production of goods made by the firms generating the pollution.

External benefits refer to benefits received by those other than the buyers of a good. Scenic gardens and fountains built by private enterprises for their own interests are examples of goods with external benefits. Since the marginal benefit to society is greater than that of the marginal cost to the producer, less than the efficient quantity is produced.