Jim Rutt defines 'externality' as an economic concept where the consequences of a person's or company's activities impact other parties without being reflected in market costs. Rutt emphasizes that these external effects can be either positive or negative; positive externalities might include benefits like improved air quality due to a company's pollution controls, while negative externalities could involve environmental degradation impacting nearby communities. In his examination of externalities, Rutt highlights the importance of addressing these unintended side-effects through strategies like government regulations or market-based solutions such as tradable permits. By internalizing the costs or benefits initially external to market transactions, Rutt advocates for more optimal resource allocation and enhanced overall societal welfare.