Our inquiry begins by defining what is meant by an optimal allocation of a resource and by extracting the principles that can be used to design economic incentive policies that fulfill the optimality conditions. Optimality theory can help us understand the characteristics of these economic approaches in the most favorable circumstances for their use and assist in the process of designing the instruments for maximum effectiveness.
What is meant by the optimal allocation of a resource depends on how the “policy target” is defined. Several possible targets have been considered in the literature.5 Chronologically the first forays into instrument design were based on traditional concepts of economic efficiency. The economically efficient allocation of a resource, defined in partial equilibrium terms, maximizes the net benefits to society, where net benefits are defined as the excess of benefits over costs.6 Ignoring corner solutions (i.e., when the optimum involves either no use or total use), efficiency is achieved when the marginal benefit of that last unit used is equal to the marginal cost of its provision.
Because the resulting allocation of responsibility is quite sensitive to both spatial and temporal considerations, defining optimality in terms of efficiency imposes a heavy information burden both on modelers and on those charged with the responsibility for implementing the policies. Not only does an efficiency target make it necessary to track the physical relationships underlying the use of the resource, but it also requires monetizing the consequences (both human and nonhuman). Each of these steps is subject to data limitations and uncertainties.
Even when the information burdens associated with the efficiency criterion can be surmounted, it is not universally accepted as an appropriate criterion outside the discipline of economics. Applying this criterion has several somewhat subtle implications, some of which are quite controversial. Take as just one example the class of pollutants having a major impact on human health. The efficiency criterion implies, all other things being equal, targeting more resources toward controlling those emissions that affect larger numbers of people (because the marginal damage caused by a unit of emissions is higher in that setting). This particular allocation of control resources can result in lower individual risks for those in high-exposure settings. This contradicts a popular policy premise that suggests that citizens should face equal individual risks regardless of where they work or reside.7
To respond to both the information and moral concerns with an efficiency approach, the tradable permit approach starts from a sustainability perspective.8 Whereas efficiency may or may not be consistent with a sustainable allocation,