The market is supposed to be a system of voluntary exchanges made by people acting for their own advantage so that everyone who takes part in the market gains. However, it is obvious that, even if this were true, the operation of the market affects those outside the market and can have consequences beyond the transactions being made. These 'spillover effects' have been called 'externalities' by economists, indicating that they are external to the market and to economic theory.

In economists' terms, an externality occurs when production or consumption by a firm or consumer directly affects the welfare of another firm or consumer and those causing the damage are not financially accountable for it. Such externalities can have good or bad effects, but negative externalities are most common. For example, a company that discharges its effluent into a river affects fishers and other users of the water downstream. Yet the market does not take account of this, and the environmental costs do not appear in the company's account books. The ESD working group on manufacturing pointed out that:

The failure to fully incorporate environmental costs into prices implies that the manufacturers responsible for the environmental costs, and/or the consumers of their products, are receiving an implicit subsidy at the expense of the environment. (ESD Working Groups 1991a, p. 92)

This is sometimes referred to as privatising the benefits and socialising the costs.

The presence of these externalities challenges the claim of economists that the free market provides the best means of allocating resources; it is another example of ways in which the market may fail to protect the environment. Economists have responded by arguing that external costs and benefits should be 'internalised' by adjusting prices so that the person buying the goods or services causing the external cost is obliged to pay for it. This can be done by means of a tax&emdash;for example, on coal mining to cover the medical expenses of those miners who are suffering from black lung disease. The additional costs may also provide an incentive to the coal industry to find ways to prevent miners from getting this disease.

Daly and Cobb (1989) argue that such adjustments are done to save face and to avoid restructuring the basic economic theory. They point out that internalisation becomes extremely difficult with pervasive externalities, because of the difficulties involved in working out a proper tax that will cover the external costs of a complex problem&emdash;such as the potential for greenhouse warming:

Even when the physical consequences are not in dispute the evaluation of the economic loss is subject to wide disagreement and uncertainty. Should cost be evaluated at how much the public would be willing to pay to avoid the change? Or at how much it would cost to actually undo the change and put things back the way they were? (p. 141)

The assumption in internalising the costs is that the greenhouse effect can be paid for&emdash;when really it should be avoided in the first place. The usual way for economists to deal with this problem would be to work out what the greenhouse warming costs were likely to be and then add that cost to the price of goods, so allowing the market to work out what quantities of greenhouse gases would be produced. Daly and Cobb (1989, pp. 142&endash;3) argue that it should work the other way round: a decision should first be made about the quantities of gases that can be emitted. This would limit the supply of goods and the market could then establish the prices of those scarcer goods. In other words, the market economy should be constrained by biophysical limits, and market prices would in turn reflect those limits. These new prices would then have 'internalised' the value of sustainability.

The idea of limits is, of course, alien to macro-economics. At the micro-economic level (that is, when dealing with particular goods and services), economists put forward the notion that an activity will only increase until the cost of each extra unit equals the benefit of each extra unit. However, the idea of an optimal output at the macro-economic level is heresy in the world of economists. Daly and Cobb admit that what they are suggesting would require 'something of a paradigm shift … in order to admit the Trojan Horse of "carrying capacity" into the citadel of economic theory' (p. 146).

There are other ways of internalising environmental costs without relying on the pricing mechanism. One example is to require a company to take its water downstream from its discharge point. Legislation can also cause costs to be internalised if it forces companies to pay for cleaning up their wastes.

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