Properties of natural systems and the efficiency of market-based solutions to environmental externalities

This dissertation presents three studies that seek to understand how the interaction between economic and natural systems affects the efficiency of policy instruments to regulate environmental externalities. In the first study, I use a population data set of irrigation wells in Nebraska's Republican River Basin to analyze whether adopting spatially differentiated groundwater markets leads to significant savings in abatement cost while protecting nearby streams. Although the marginal damage of groundwater use on stream flows depends crucially on the location of pumping relative to streams, I find that regulators can generate most of the potential cost savings and maintain current levels of stream flow without spatial differentiation. In the second study, I examine the key features of an efficient tradable permits system to regulate environmental externalities that are lagged and stochastic. I find that optimal tradable permit systems will require trading ratios that may be greater than or less than one, and that the magnitudes of these trading ratios depend on (a) the discount rate, (b) conditional expectations of future states of the affected resource, (c) persistence of the state of the affected resource, and (d) initial conditions. In the third study, I analyze how analytical hydrologic models can inform the effective design and choice of policy instruments to manage groundwater quality. I develop an economic optimization model that explains the role of geophysical parameters in determining optimal groundwater contaminant levels and apply the model to solve a management problem of aquifer contamination from highway deicers. I compare my theoretical results to those from previous economic studies of groundwater pollution and describe how my model can provide a framework to evaluate the potential effectiveness of different policy instruments to manage different classes of groundwater contamination problems. Overall, the dissertation provides a mixed review of the success of traditional market-based schemes in internalizing cost effectively the damages of complex environmental externalities