Our emphasis thus far in Part II of the book has been partial equilibrium, in the sense that we have focused only on the polluting sector in our consideration of environmental policy. When studying competitive markets from this perspective, we have consistently found that the optimal pollution level occurs at the point where firms’ marginal abatement costs are equal to society's marginal damages. Furthermore, the short run performance of the full suite of incentive-based policies was equivalent. Importantly, the extent to which the different policies raise revenue for the government was important only for equity, and did not play a role in efficiency comparisons. Thus emissions could be taxed or abatement subsidized, and pollution permits auctioned or freely distributed, and the only difference was in who captured the environmental scarcity rents. Things were slightly different in the long run, in that abatement subsidies could cause excess entry and were therefore inferior to emissions taxes. Nonetheless, we found that permit schemes that do not raise revenue perform equally to their auctioned counterparts, so long as total emissions are capped when firms enter or leave the market. The ability to separate equity considerations from efficiency outcomes was touted as an important source of flexibility available to the environmental regulator.

A question we have not yet examined is the extent to which these partial equilibrium results continue to hold when we consider how environmental policy might spill over into other markets. We saw in Chapter 5, for example, that environmental policy raises the output price of the polluting good. This can affect the demand for other consumption goods, impact households’ labor supply decisions, and cause changes in real income. More importantly, pollution externalities are usually not the only sources of distortions in an economy. Government revenue is often raised via proportional labor taxes, thereby encouraging the overconsumption of leisure, and causing potentially substantial welfare losses. Other factor input markets are also distorted, as are many product markets through value added taxes or subsidies. It is natural to ask how these pre-existing distortions might interact with environmental policy, causing us to alter the conclusions obtained when such spillover effects are ignored.

Thinking on this topic emerged along two lines. The first focused on the potential for environmental policy to result in a “double dividend”.