When a company pollutes, it produces a negative externality.  This means that society has been negatively affected by the polluter.

The ideal level of pollution is the level at which the marginal costs to society of polluting equal the marginal benefits to society that come from polluters producing goods and services.  Without some degree of regulation, corporations will not take all marginal social costs into account, and will thus produce at a level that is excessively damaging to the environment.

To achieve maximum economic efficiency, the government should allow pollution up to the point where marginal benefits equal marginal costs, as shown by the intersection of the two curves above.  Of course, these are only theoretical curves, and are difficult to derive in real life.

Drawing a line straight down from this intersection point leads to the level of allowable pollution that maximizes economic efficiency, P₀.  This is the optimal level of pollution.

If the allowable level was left of that point, polluters would lose less than society would gain, but this net gain could be taken further.  If we move to the right of the optimal level, the costs to polluters would outweigh the gains to society.

As the level of pollution prevented goes up, meaning that you move to the right in the graph, the marginal cost increases.  This is because eliminating small to medium amounts of pollution may be relatively easy, but total elimination of pollution may cost considerably more.  Also, those companies that have great difficulty in reducing pollution, and incur great costs in removing it, will be forced to reduce pollution so that the economy can achieve extremely high levels of pollution prevented.

The marginal benefits curve also decreases with increasing rapidity as we move right.  This means that a small pollution reduction will be felt less if the environment is excellent than if the environment is very poor.