Externalities comprise efficiency aspects and equity aspects. The pote
ntial Pareto improvement criterion usually applied in analysis of the
economics of externalities is solely concerned with efficiency aspects
because it bypasses the question of interpersonal utility comparison.
However, in the practice of policymaking, equity issues are often at
least as important. This paper contains a partial equilibrium analysis
of the question of to what extent optimization and compensation of an
external cost are compatible under different schemes of regulation an
d internalization, and in different model settings: the standard textb
ook model, a model in which defensive activities on behalf of the vict
im are allowed for, and a model in which dynamic aspects of entry - ex
it behaviour are investigated.