Introduction

Abstract

In the last decades, environmental problems have received increasing attention. Eminent examples are global warming, pollution of the world oceans and deforesting of the tropical rain forest. From an economic point of view, environmental problems are externality problems leading to market failure. In order to illustrate this, consider a producer who manufactures a consumption good. On the one hand, this economic activity causes production costsas, for example, costs of material, labor and capital inputs. On the other hand, producing the consumption good usually generates emissions like smoke, wastewater or solid waste. The emissions cause environmental damage which leads to environmental costs.A market economy typically comprises markets for material, labor and capital. Hence, the producer has to pay for these production inputs and accounts for marginal production costs in her manufacturing decision. In contrast, the market economy usually fails to provide price signals for environmental assets. The producer pollutes the environment for free and does not account for marginal environmental costs in her production decision. Therefore, the price of the consumption good is inefficiently low since it does not reflect full social costs. The inefficiently low price leads to an inefficiently high quantity of the good with the consequence that the production process of the good is too environmental intensive. This argumentation can be found, for example, in Baumol and Oates (1988) or Tietenberg (1996).