Abstract:Underlying some of the most pressing environmental problems are the interlinked resource and environmental stock externalities with threshold effects. Using a simple dynamic model, it is shown how in the face of such externalities the static market-based policy instruments such as Pigouvian taxes should be modified. It is shown that even if for an initial period there is going to be no pollution stock damage, the optimal policy still requires that abatement begins immediately and at increasing rates. Simulation of the model for the case of fossil fuel burning and the consequent global warming shows that the optimal carbon tax, and therefore the optimal control strategy, is particularly sensitive to changes in the marginal abatement cost and the level of fossil fuel demand. Policy simulations contrast the optimal control policy with, and estimate the welfare losses from, alternative policies deriving from arbitrary tax paths. The latter include: (i) a no-tax policy, (ii) a constant carbon tax rate, (iii) the European Community's proposed carbon tax path, and (iv) a delayed optimal tax path.