When individuals or firms make decisions about production, consump­tion and investment, they generally consider only their own costs and benefits, not the environmental or social consequences (externalities).

Consideration of the pollution they create does not enter into their decisions. It is laws which force the polluter to take notice of these external costs by prescribing limits to what can be discharged or emitted.

While legislation is aimed at directly changing the behaviour of pol­luters by outlawing or limiting certain practices, economic instruments, in theory, aim either to make environmentally damaging behaviour cost more or to make environmentally sound behaviour more profitable. Economic instruments do not tell polluters what to do; rather, polluters find it expensive to continue in their old ways. Individuals or firms can then use their superior knowledge of their own activities to choose the best way of meeting environmental standards.

Not all pricing and taxation measures employed by a government are aimed at environmental protection. They may be used to promote other goals and may in fact have adverse impacts on the environment. Economic instruments differ in that they are intended to:

• provide a financial stimulus to change

• encourage voluntary action

• involve government authorities

• maintain or improve environmental qualities.

Economic instruments are supposed to be more economically efficient than legislative measures in that pollution reductions can be made for less cost. Regulations are said to be inefficient because they require pol­luting discharges from all firms to meet uniform standards regardless of the firm's ability to meet them. Alternatively, they require all firms to install particular pollution control technologies regardless of a firm's ability to pay for them. While this will improve environmental quality it is said to be at a high cost.

There are two main types of economic instruments:

• Price-based measures, which use fees, charges and taxes to internalise environmental costs and benefits.

• Rights-based measures, which 'create rights to use environmental resources, or to pollute the environment, up to a pre-determined limit, and allow these rights to be traded' (Commonwealth 1990).

Advocates of price-based measures argue that better use should be made of pricing and taxation arrangements to achieve a more efficient allocation of natural resources. For example, with an effluent charge, each firm would pay a set rate for each unit of pollution and those firms which find it cheaper to reduce their pollution than to pay the charge can do so. Those for which it would cost more than the charge to reduce their pollution can choose to pay the charge instead. In this way, pollu­tion is reduced most by those who can do it cheaply, and is therefore a more cost-efficient way of achieving a limited amount of pollution reduction.

With rights-based measures, rights - for example, to discharge a certain amount of pollution - are assigned by government, and markets are set up to allow those rights to be bought and sold. Firms which can reduce their pollution more cheaply than others can sell their excess rights to firms for which it would be expensive to reduce their pollu­tion. In this way, economists argue, a given level of air or water quality could be achieved more efficiently with a lower aggregate cost to the firms involved.

Both price-based and rights-based measures are based on market principles. In the case of price-based measures, an economist would say that a price is set and demand determines the quantity of pollution that is discharged. In the case of rights-based measures, the quantity of pol­lution is set and demand determines the price to be paid to discharge it.