In this chapter we develop a simple analytical model describing pollution damages in monetary units, the cost of pollution prevention, and the characteristics of an efficient allocation of pollution emissions. We then use this analytical structure to describe the menu of environmental policy instruments and their comparative properties, and discuss the information needs of designing and implementing the policies. The primary purpose of the chapter is to introduce the main themes of study in environmental economics in their simplest form, to be followed in later chapters by more detailed topical discussions. The chapter also derives three main insights that will reappear in various forms throughout the book. First, for optimal environmental policy, the marginal cost of abatement should be equal to the marginal damage of pollution. Second, if pollutants are homogeneous, the cost of removing the last pollution unit should be equal across the different pollution sources. Finally, market-based instruments that provide incentives through prices – notably emission taxes, tradable emission permits, and per unit subsidies on pollution abatement – are the most effective means of decentralizing efficient abatement decisions. These insights are derived by abstracting from several real-world complexities. Specifically, in this chapter we assume full information, fixed pollution technologies that are separable from output technologies, flow (as opposed to stock) pollutants, fully competitive markets, no pre-existing, non-environmental distortions, and no spatial, temporal, or international dimensions. In Part II of the book we consider generalizations of the model presented here, which accommodate these complexities.

In this chapter we also discuss bilateral voluntary agreements for internalizing pollution externalities, which involves presentation of the celebrated Coase Theorem. Finally, our discussion includes several policy examples drawn from the United States and Europe, which provide context for the conceptual discussion in this and subsequent chapters.

A SIMPLE MODEL OF DAMAGES AND COSTS

Consider an area where a number of polluting firms and affected households are located. For concreteness, suppose the firms are coal-burning electrical plants emitting sulfur dioxide that impacts people living in the area. The firms are output price takers, selling electricity on the national market. People living in the area buy electricity on the national market and therefore do not rely exclusively on the local firms for electricity production.