Externalities and Market Failure
An externality occurs when a transaction imposes costs or benefits on third parties who did not choose to participate. Pollution is the classic negative externality: a factory emitting sulfur dioxide imposes health and crop damage costs on downwind communities, but these costs are not reflected in the factory's product price. The market 'fails' because the true cost to society exceeds the private cost to the producer, leading to overproduction and excessive pollution. Positive externalities also exist: a farmer who maintains wetlands provides flood control and water purification benefits to downstream communities without compensation. Environmental policy aims to 'internalize' externalities by making polluters pay the full social cost of their emissions.