Specifically review the micro economic relating to externalities and the relative merits of alternative policy instruments. An externality is a cost or benefit from an economic transaction that parties ‘external’ to the transaction bear. Externalities can be either positive, when an external benefit is generated, or negative, when an external cost is imposed upon others. They occur when a decision causes costs or benefits to third parties, often, though not necessarily, from the use of a public good (for example, production which causes pollution may impose costs on people making use of the public good air). In other words, the participants do not bear all of the costs or reap all of the gains from the transaction. As a result, in a competitive market too much or too little of the good may be produced and consumed from the point of view of society, depending on incentives at the margin and strategic behaviour.