Market Mechanisms: Understanding the Options

All environmental pollution, including emissions of greenhouse gases (GHGs), imposes costs on people who did not create the pollution. This is an example of an economic externality—a consequence or side effect of an action that is not experienced by the individual or entity from which it originates, and that is not reflected in prices. The damages and associated costs to society that GHGs cause through climate change (e.g., increased extreme weather events, rising sea levels, and loss of biodiversity) are not paid for by the entities that emit those gases, so those costs are not reflected in the market prices of goods and services. Because polluters do not have to account for the costs associated with the damages that greenhouse gases create, society produces and consumes too many pollution-creating products (like fossil fuels) resulting in additional GHG emissions being put into the atmosphere. Market-based policies aim to correct this form of market failure (an instance where economic resources are allocated inefficiently). They do this by constructing systems that cause the “external” costs associated with pollution to be incorporated in the polluting entity’s MARKET MECHANISMS: UNDERSTANDING THE OPTIONS U.S. POLICY