Economics studies two forms of externalities.  An externality is something that, while it does not monetarily affect the producer of a good, does influence the standard of living of society as a whole.

A positive externality is something that benefits society, but in such a way that the producer cannot fully profit from the gains made.  A negative externality is something that costs the producer nothing, but is costly to society in general.

Examples of positive externalities are environmental clean-up and research.  A cleaner environment certainly benefits society, but does not increase profits for the company responsible for it.  Likewise, research and new technological developments create gains on which the company responsible for them cannot fully capitalize.

Negative externalities, unfortunately, are much more common.  Pollution is a very common negative externality.  A company that pollutes loses no money in doing so, but society must pay heavily to take care of the problem pollution caused.

The problem this creates is that companies do not fully measure the economic costs of their actions.  They do not have to subtract these costs from their revenues, which means that profits inaccurately portray the company's actions as positive.  This can lead to inefficiency in the allocation of resources.

Because neither the market nor private individuals can be counted on to prevent this inefficiency in the economy, the government must intervene.

The government's basic goal is to force companies to internalize externality costs.  This means that if a company's pollution creates economic costs (for example, the medical bill of a patient who gets sick from pollution), then the government will force the company to pay that cost.  In this way, the company can more accurately compare revenues and expenses and decide whether production is indeed profitable.

To achieve its goal, the government can use one of several types of regulation.  It can create pollution limits, tax companies for polluting, or hand out tradable pollution permits.