The Theory of Environmental Externalities

One of the core concepts of environmental economics is the theory of environmental externalities. Externalities can be either positive or negative. This chapter considers a form of economic theory called welfare analysis to show in more detail why it is socially preferable to internalize externalities. The idea of a Pigovian tax, which forces polluters to pay for the cost of their social and environmental damages, is intuitively appealing. Implicit in the imposition of a Pigovian tax is the idea that society has a legitimate right to be compensated for any pollution damages. According to the Coase Theorem, the clear assignment of property rights appears to promise efficient solutions to problems involving externalities. Under the principle of eminent domain, governments are permitted to appropriate private property for public purposes. However, the Fifth Amendment of the US Constitution requires that the property owner be fairly compensated.