Efficiency argument in favor of public intervention to mitigate pollution problems are well established. Fundamentally, it is recognized that market failures do occur, with the end result that the true social cost of a product or physical input is not reflected in its price. There failures are termed “externalities” an external effect occurs when the welfare of a household depends not only on its own action, but also on the action of others. If the activity imposes an adverse impact on others, it is termed a negative externality. Polluting activities are a prime example of negative externalities.
When there are pollution externalities, the market mechanism fails to induce the polluter to consider the costs to others of his or her activity. In other words, a free market without corrective intervention would result in pollution, expressed in excess of the “optimal” levels. More specifically, an industry would pollute until its private marginal benefits equaled its private marginal costs.
An externality is manifest when the welfare of those hurt by the pollution, expressed in terms of social benefits and costs, does not influence the pollute because the costs do not directly affect their decisions to pollute (that is, the costs of environmental damage are external to the pollution).
Economic theory suggests that if the monetary value of the environmental damage caused by pollution can be determined, an environmental charge equal to the cost of damage could be established to serve as a disincentive for environmentally harmful behavior. By imposing this charge on polluters, the cost of pollution is internalized, automatically encouraging them to reduce pollution to the optimal level.