The basic principles of environmental policy are based on the theory of externalities. The problem of externality may be interpreted as an unintended and uncompensated side effect of a person's or firm's activity on others. In a formal way, environmental externalities occur when the consumption and production choices of one person or firm enters the utility or production function of another entity without the said entity's consent or compensation.
In many instances, the problem of externality creeps into many government policies having spill over effects. For example, free electricity offered to farmers for irrigation purposes results in over-extraction of ground water, which depletes the water table. In this case the private cost of lift irrigation borne by the farmer is the price paid by him, but a larger social cost is involved in terms of reduced availability of water to others. Overall, there is a difference between private marginal cost and social marginal cost in the presence of externalities; social marginal cost of pollution being always higher than private marginal cost. As the producer of a polluting good takes into account the private cost while deciding on the level of output, there is excessive supply than the optimal level.