Identifying an externality that merits a corrective intervention is much trickier than many people recognize. Three previous posts on supplysideliberal.com give examples of ways in which one person’s actions can hurt someone else, but in a legitimate, laudable way:

1. In “The Wrong Side of Cobb-Douglas: Matt Rognlie’s Smackdown of Thomas Piketty Gains Traction” I argue that building more housing should encouraged, even though it hurts other property owners by reducing the scarcity value of the buildings they own. (Such effects are sometimes called “pecuniary externalities” to distinguish them from the kind of externalities that deserve correction.) This point was initially hard for me to see. 
2. In “Don’t Recognize Racist Externalities with a Pigou Tax,” Robin Green argues that law-abiding and reasonable-rule-abiding individuals whom other people don’t want to live near have the right to move into a neighborhood anyway.
3. In “The Case for Gay Marriage is Made in the Freedom of Religion” I talk about the right to marry someone of the same sex even though it offends others’ religious sensibility as itself an aspect of freedom of religion.   

John Stuart Mill, in On Liberty “Chapter V: Applications,” paragraph 3, addresses this issue of distinguishing between externalities that deserve correction and ways of hurting other people that should be allowed unhindered:

In the first place, it must by no means be supposed, because damage, or probability of damage, to the interests of others, can alone justify the interference of society, that therefore it always does justify such interference. In many cases, an individual, in pursuing a legitimate object, necessarily and therefore legitimately causes pain or loss to others, or intercepts a good which they had a reasonable hope of obtaining. Such oppositions of interest between individuals often arise from bad social institutions, but are unavoidable while those institutions last; and some would be unavoidable under any institutions. Whoever succeeds in an overcrowded profession, or in a competitive examination; whoever is preferred to another in any contest for an object which both desire, reaps benefit from the loss of others, from their wasted exertion and their disappointment. But it is, by common admission, better for the general interest of mankind, that persons should pursue their objects undeterred by this sort of consequences. In other words, society admits no right, either legal or moral, in the disappointed competitors, to immunity from this kind of suffering; and feels called on to interfere, only when means of success have been employed which it is contrary to the general interest to permit—namely, fraud or treachery, and force.

Note that John Stuart Mill is careful not to say that competitive setups are always efficient, saying instead that “Such oppositions of interest between individuals often arise from bad social institutions.” Bad social institutions are definitely worth correction, but one should be careful to blame the designer of the institution rather than those who participate in it. Also, in such cases, one should be careful not to cross the line from correction of incentives to punitive action. 

For economists and others involved in making public policy, the distinction between externalities that should be corrected and legitimate ways of hurting other people such as 

1. pecuniary externalities from providing market competition  
2. moving into the neighborhood of people who are prejudiced  
3. offending religious sensibilities by marrying someone of the same sex.

Making the distinction is tough. I wrestle with it in these other John Stuart Mill posts:

• John Stuart Mill on Being Offended at Other People’s Opinions or Private Conduct
• John Stuart Mill on Freedom from Religion