Don Boudreaux discusses a couple of cases that I tell students are illustrations of externality abuse. Here is the link found in the above comment to his second case.
The case that involves Wal-Mart moving to town and older businesses in town going out of business is surely not an externality source of market failure. If it were, then competition in general would be a source of market failure. On the contrary, the Wal-Mart case is an illustration of the very process by which we believe market competition moves economic activity toward efficiency. My favorite definition of externality is: an unintentional, nonmarket, interdependence. The Wal-Mart case cannot be a source of externality market failure because the interdependence in question occurs through the market process.
The case of workers desiring more leisure time also involves a market interdependence. Further, it is an interdependence chosen by the workers themselves. An externality is an effect of economic activity that is external to the market. The choices of employers and employees are not at all external to the market.
This is not to say that when we consider either of these issues that we may not discover inefficiency. It is only to say that we don't have externality sources of market failure to worry ourselves about. Instead, I suggest we should be looking for sources of government failure. Wouldn't government policy that restricts the number of hours a worker can work annually be a likely source of inefficiency? Efforts to argue that the government policy is correcting an externality is turning the entire concept of efficiency upside down.
Many times Wal-Mart moves into a town completely through the voluntary choices of individuals. But, also there are many times that local government is asked prevent Wal-Mart from moving in. If government agrees, this would be a source of government failure, not a source of externality market failure. I believe there are also many times that local government actually subsidizes (or bribes some would say) Wal-Mart to move into town. Such government actions would be a government failure, not an act to correct a market failure.
Unfortunately, policy analysis today seems over-run with such illustrations of assertions of market failures that aren't. Of course, this is bad enough, but the situation is seen to be much worse when it is realized that such abuses of the externality concept often mask the true source of inefficiency which is government failure.
As I often tell my students: JUST SAY NO TO EXTERNALITY ABUSE!!!!