Externalities, also called spillover effects, are COSTS (negative externalities) or benefits (positive externalities) associated with a market but not included in the price of a good or service. An external cost occurs when the PRODUCTION or CONSUMPTION of a good inflicts a cost on someone other than the producer or consumer. A standard example of an external cost is pollution. Many producers are allowed to dump wastes into streams or send emissions up their smokestacks. By releasing their wastes into the environment, these firms are avoiding costs of pollution control or mitigation. Because they do not have to bear them, market prices do not reflect these costs, and this encourages greater consumption of their products. Instead, the cost of pollution is transferred to others, either people trying to use the water downstream from the polluter or people breathing the polluted air. Business groups sometimes argue that forcing them to reduce their emissions will make them unable to compete in global markets. Referring to demands for reduction in emissions associated with the use of oil products, President George H. W. Bush once said, “I am an environmentalist too, but we cannot afford these new regulations.” From a business perspective, unless everyone, including international competitors, has to incur the same costs, they will become higher cost producers and less competitive. Developing countries, eager to have new jobs and sources of INCOME, are often willing to ignore negative externalities (spillovers of costs and negative effects onto society) in the name of ECONOMIC GROWTH. The air and water pollution examples illustrate MARKET FAILURE, with an overallocation of resources into production of the polluting firm’s products. These two examples can also be used to illustrate how society can correct the problem. In a market environment, a downstream user of water could simply pay the upstream user not to pollute the water. Naturally the downstream user does not want to pay, but faced with no other choice and needing clean water, paying is one option. More likely the downstream user will complain to a government agency, which in turn will force the polluter to stop. Regulation is one option to correct the problem, but that requires the government agency to develop an appropriate set of regulations and enforce them. Often it is difficult to come up with a standard set of rules that can be applied among many firms and across various industries. In the United States, business managers frequently complain about the time, cost, and lack of logic in many government environmental regulations. Another option is for government to tax the polluting firm based on the amount of pollution it creates. This will encourage the firm to reduce its pollution, alleviating the problem for the downstream user of the water. In the case of water pollution, the third party, the downstream user of the water, can easily be identified and will pressure the upstream polluter to pay to clean up its pollution or internalize the externality. In the case of air pollution from the same factory, it probably will be more difficult to identify the people hurt by the air pollution. If these people do not recognize the impact of the pollution on them, or if only a few citizens complain, the company may not be forced to stop polluting the air. This is the problem of lack of clearly defined property rights. The downstream water user demanded the right to clean water, but no one person or group owns the air. Beginning in the 1970s, the U.S. ENVIRONMENTAL PROTECTION AGENCY (EPA) experimented with an alternative to regulation or taxation of pollution. Recognizing that the environment can accept some level of pollution without being significantly harmed (called environmental carrying capacity) and that some firms can reduce their pollution more cheaply than others, the EPA helped create a market for pollution credits. After defining an acceptable level of overall pollution, firms were given an allocation of pollution credits. Firms that could reduce their emissions most cheaply did so and sold their pollution credits, while firms that would have to incur significant costs to reduce their pollution bought credits. A market for pollution credits was established, allowing firms to choose which was a more efficient method of achieving the government-imposed standard. Some environmental groups also bought pollution credits, reducing the overall supply of credits, thereby increasing the price of polluting, making it more efficient for firms to clean up the air than to continue to pollute. Like an external cost, external benefits are not reflected in the price of a product. An external benefit is derived when some of the benefits of consumption of a good or service are enjoyed by a third party. If, for example, just as Mr. Smith is ready to put his home up for sale, his neighbor cleans up her house and yard, Mr. Smith receives a benefit from her action—that is, his house will probably sell for a higher price due to his neighbor’s efforts. Similarly, everybody benefits from other people being more educated. Education enhances peoples’ productivity, increasing their incomes, reducing overall taxes, and providing the public with better products and services. Recognizing that society benefits from having educated people, U.S. education DEMAND and SUPPLY are both subsidized. This results in a greater quantity of education being produced than would be if consumers had to pay the full cost of education. This is called internalizing a positive externality.