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Environmental economics is a branch of economics which deals with environmental issues. Environmental economics is different from Ecological economics in that it lays stress on the economy as a subsystem of the ecosystem with its concentration on preserving natural capital. In a survey, German economists established that ecological and environmental economics are separate schools of economic thought, with ecological economists stressing upon "strong" sustainability and rejecting the thought that natural capital can be substituted by human-made capital.

Market failure is one of the core concepts of environmental economics. Market failure implies that markets fail to allot resources well. As Hanley, Shogren, and White (2007) have stated in their textbook Environmental Economics: "A market failure occurs when the market does not allocate scarce resources to generate the greatest social welfare. A wedge exists between what a private person does given market prices and what society might want him or her to do to protect the environment. Such a wedge implies wastefulness or economic inefficiency; resources can be reallocated to make at least one person better off without making anyone else worse off." Market failures may take various forms, which commonly include most externalities, non-excludability and non-rivalry.

  • Externality: the fundamental idea is that an externality exists when a person makes a choice that affects other people that are not accounted for in the market price. For example, a firm emitting pollution will generally not take note of the costs that its pollution imposes on others, resultant may be, pollution in excess of the 'socially efficient' level may occur. A classic definition influenced by Kenneth Arrow and James Meade is given by Heller and Starrett (1976), who define an externality as “a situation in which the private economy lacks sufficient incentives to create a potential market in some good and the nonexistence of this market results in losses of Pareto efficiency.” In terms of economics, externalities are instances of market failures, in which the free market does not lead to an efficient outcome.
  • Common property and non-exclusion: When it is extremely costly to prevent people from right to use to an environmental resource for which there is rivalry, market distribution is likely to be inefficient. The challenges linked with common property and non-exclusion has been recognized for a long period now. "Commons" refers to the environmental asset itself, "common property resource" or "common pool resource" refers to a property right regime that makes allowance for some collective body to work out schemes to exclude others, thereby permitting the capture of future benefit streams; and "open-access" means, no ownership in the sense that property everyone owns nobody owns. The elementary problem is that if people do not pay heed to the scarcity value of the commons, they can end up expending too much effort, over harvesting a resource (e.g., a fishery). Hardin gives a theory that in the absence of restrictions, users of an open-access resource will exploit it more than if they had paid for it and had exclusive rights, resulting in environmental degradation.
  • Public goods and non-rivalry: Public goods are another form of market failure, in which the market price does not capture the social benefits of its provision. For instance, fortification from the risks of climate change is a public good since its provision is both non-rival and non-excludable. Non-rival implies climate protection given to one country does not diminish the level of protection to another country; non-excludable implies that it would be too costly to exclude anyone from receiving climate protection. A country's inducement to invest in carbon abatement is reduced because it can "free ride" off the hard work of other countries.

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