Markets in licenses and efficient pollution control programs

[Introduction] Artificial markets have received some attention as a means of remedying market failure and, in particular, dealing with pollution from various sources. Arrow has demonstrated that when externalities are present in a general equilibrium system, a suitable expansion of the commodity space would lead to Pareto optimality by bringing externalities under the control of the price system. Since his procedure is to define new commodities, each of which is identified by the type of externality, the person who produces it and the person who suffers it, his conclusion is pessimistic. Each market in the newly defined commodities involves but one buyer and one seller, and no forces exist to compel the behavior which would bring about a competitive equilibrium