Yesterday I discussed how market failure originated as an acausal phenomenon. Externalities are no different.
The basic intuition underlying the idea of externalities is that people impose costs on each other. This is a bit weird since cost, in the economic sense, is necessarily something contained within the choosing individual, but the intuition is understandable. Yet, as is so often the case in economics, unpracticed intuition is not very reliable.
It might seem weird to suggest that economists have treated externalities as acausal phenomena. After all, externalities and the external costs that defines them have a clear cause. Pollution is produced by firms. Careless neighbors reduce the surrounding property values. And so on. One party imposes a cost on another.
Yet Coase showed things are not so simple. Economists had utterly ignored the question of why the seeming victim simply put up with the imposed cost. Externalities, Coase explained, are not caused by one party but by two.
Pre-Coase, economists did not bother to explain half of what is necessary to create an externality. There was the active, choosing party that imposed a cost, and the passive victim whose behavior went unexplained.
Understanding the full cause of externalities allows us to make sense of the concept of external costs, or rather, it allows us to see the nonsense of it. If the "victims" of externalities are passive agents, not really economic actors at all, then it makes some sense to talk of costs being imposed on them. But if they are active economic agents choosing to bear the cost as the best of their alternatives, then the external cost is not external at all. They internalize it.
Maybe it seems like the cost is still created by the "aggressor," even if the "victim" chooses to bear it. This is also wrong. The cost is created by both of them, the aggressor by making smoke, for example, and the victim, by choosing to stay in the smoke-infested area. Nothing external is going on, just two parties choosing their best alternatives based on the costs, which are thus internalized.
From the perspective of the "victim" the externality is clearly irrelevant. Imagine a naturally smokey area that someone chooses to live in for some offsetting benefit. We would all understand that this is no externality, and the cost of the smoke is internalized by its "victim." Why should anything be different if the source of the smoke is unnatural?