FOR MANY PEOPLE IN EASTERN Canada, there is no better way to relax than to fish in one of the region’s thousands of lakes. But in the 1960s, avid fishers noticed something alarming: lakes that had formerly teemed with fish were now almost empty. What had happened?

The answer was acid rain, caused mainly by coal-burning power plants. When coal is burned, it releases sulphur dioxide and nitric oxide into the atmosphere; these gases react with water, producing sulphuric acid and nitric acid. The result: downwind from the industrial heartland of Canada and the United States was rain sometimes as acidic as lemon juice. Acid rain didn’t just kill fish; it also damaged trees and crops and in time even began to dissolve limestone buildings.

You’ll be glad to hear that the acid rain problem today is much less serious than it was in the 1960s. Power plants have reduced their emissions by switching to low-sulphur coal and installing scrubbers in their smokestacks. But they didn’t do this out of the goodness of their hearts; they did it in response to government policy. Without such government intervention, power companies would have had no incentive to take the environmental effects of their actions into account.

When individuals impose costs on or provide benefits for others, but don’t have an economic incentive to take those costs or benefits into account, economists say that externalities are generated. You may recall that we briefly noted this phenomenon in Chapters 1 and 4. There we stated that one of the principal sources of market failure is actions that create side effects that are not properly taken into account—that is, externalities. In this chapter, we’ll examine the economics of externalities, seeing how they can get in the way of economic efficiency and lead to market failure, why they provide a reason for government intervention in markets, and how economic analysis can be used to guide government policy.

Externalities arise from the side effects of actions. First, we’ll study the case of pollution, which generates a negative externality—a side effect that imposes costs on others. Whenever a side effect can be directly observed and quantified, it can be regulated: by imposing direct controls on it, by taxing it, or by subsidizing it. As we will see, government intervention in this case should be aimed directly at moving the market to the right quantity of the side effect.

Other activities generate positive externalities, a side effect that generates benefits for others—for example, preserving farmland instead of developing it. In this case, government can use subsidies to move the market to the best quantity of the side effect from society’s point of view.

In the case of both positive and negative externalities, achieving the best solution takes place at the margin, setting the benefit of doing a little bit more of something equal to the cost of doing that little bit more.

Lastly, we’ll return to the case of network externalities, a phenomenon we learned about in Chapter 13 that’s particularly common in high-tech industries. We’ll learn about what creates a network externality and why industries that have them are particularly difficult to regulate.