Carbon dioxide (CO2) is a greenhouse gas and scientists expect the increasing concentrations of CO2 in the atmosphere to lead to increases in global temperatures. These higher temperatures could affect social welfare in a number of different ways. For example, extreme weather conditions such as droughts are predicted to occur more frequently in a warmer world, and the melting of the ice caps and thermal expansion of the oceans would lead to rising sea levels. As the firms and households currently emitting CO2 do not directly face the costs of their own emissions, the costs of CO2 are a classic example of an externality. Externalities are costs (or benefits) from an activity that do not directly affect those involved in that activity.
Externalities lead to a so-called market failure because economic agents make decisions that make sense from their own perspective but are damaging to society as a whole. If a good is associated with a negative externality, the social costs from producing it will be larger than the private costs. Therefore, as self-interested economic agents will only consider the private costs and benefits when deciding whether to undertake an activity, the free market will lead to too much of the damaging good being produced.
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