Environmental problems are mainly the result of two types of market failure, public goods and externalities. A public good is a commodity whereby its consumption by one individual does not preclude its consumption by another individual. The problem with no-exclusive public goods is that if a producer provides a unit of the public good all individuals benefit. This results in the free-rider problem where each consumer has an incentive to enjoy the benefits of the public good, but does not contribute to it. Externalities result when a firm or consumer is directly affected by the actions of other agents without their consent.
Externalities are often the result of poorly defined property rights.
Environmental effects are not always incorporated into the production costs of producers, and as a result can lead to inefficient decisions from the point of view of society as a whole. For example, decreases in water quality from silt or nutrients do not generally enter into the profit-maximizing decisions of agricultural producers. Similarly, farmers are not generally compensated for protecting wildlife habitat on their land. This lack of market signals can lead to excessive use of natural resources and under-provision of public benefits. The key policy question is whether environmental damages, or the under-provision of environmental goods and services, are large enough to merit corrective intervention.