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The existence of external benefit and external cost leads to misallocation of resources. External cost For example, when drivers are not liable for the health damage of car exhaust, drivers will equate only marginal private cost with marginal benefit. But if drivers are forced to pay for the health damage of car exhaust, their marginal cost will go up by the amount of the external cost.
High transaction costs are very often at the root of the problems discussed under the heading of externalities, especially in those situations where the external costs or benefits accrue to very large numbers of third parties and therefore a contractual agreement to internalize the externality is extremely costly to negotiate.