The economic system is modeled as existing within a larger natural system which supplies raw material resources to the economy and absorbs residual (waste) products from it. Some natural resources are renewable (e.g., fisheries, solar energy); others are exhaustible (e.g., petroleum reserves and mineral deposits).

Management of natural resources involves problems of intertemporal allocation: how much should be used in different time periods. Time imparts an opportunity cost to resource use, if using it in the current time period precludes using it in any other time period.  Markets discount the future relative to the present.  Economic theory suggests resources should be used in a manner that equalizes discounted opportunity costs over time.

Intergenerational equity implies we ought to maintain resource sustainability.  But how can exhaustible resource use be "sustainable" over an infinite time horizon?  In the naive view, sustainability implies we shouldn't use exhaustible resources at all.  In fact, we can meet the sustainability objective by developing technologies to continually reduce our resource dependence as we gradually deplete those resources.

As noted in the opening lecture, the earth’s waste assimilation capacity is a natural resource. In the case of non-cumulative pollutants which are quickly neutralized, this assimilative capacity is a renewable resource; in the case of cumulative or persistent pollutants which are not quickly neutralized, the earth’s assimilative capacity is an exhaustible resource. These are relative concepts: a pollutant may be non-cumulative up to a certain concentration, above which the earth’s assimilative capacities are degraded so that the pollutant becomes cumulative.

We can model the economy in two segments: firms which purchase natural resources and labor, borrow capital and rent land from households, in order to produce consumer goods and services; and households which purchase consumer goods and services from firms, and provide firms with labor, land, capital and other factors of production. A circular flow of goods and services from firms to households and factors of production (labor, land and capital) from households to firms is matched by a circular counter-flow of money payments from household to firms for goods and services, and from firms to households for factors (wages, rents, dividends and interest). Producers use raw material inputs, and generate production residuals; some residuals are recycled in the production process, others are discharged into the environment. Similarly, consumers generate consumption residuals, some of which are recycled while the rest are discharged. The quantity of raw materials used equals output of goods and services plus production residuals, minus recycled producer and consumer residuals.

This diagram suggests several ways of reducing raw material use and pollution discharges:

1. increase the efficiency of raw material use  Promote energy efficiency, etc.so that firms require less raw materials to produce a given amount of output.
2. reduce residuals  Promote low-residual industries and technologies, and low-residual consumer goods.
3. increase recycling  Divert a higher proportion of production and consumption residuals back into the production process.

We can conceptualize a trade-off relationship between production of market goods and environmental quality, represented as a production possibility frontier (PPF). Where we are located on the PPF is a social choice. Technology gradually shifts the PPF outward along the goods axis, and possibly along the environmental quality axis too.  We can conceptualize a collective social welfare function (SWF, some combination of everybody's individual utility), and hopefully follow a growth path where our social choices yield the market goods/environmental quality combinations that maximize social welfare.  How closely we follow this path depends on the efficiency of our political processes.

Environmental policies typically address air, water and land pollutants as distinct problems, although these are often interconnected. Pollution from multiple sources (e.g., automobile exhaust) is often commingled so that individual emittors’ accountabilities are difficult to determine. Pollution damages vary by receptor type and location, and depend on pollutant concentrations, which themselves vary in time and space. Pollution effects may be synergistic, so that the damages from pollutants in combination are worse than the sum of the damages they generate individually.

We can categorize pollutants in various ways:

• Some pollutants are emitted from point sources such as smokestacks or wastewater discharge pipes. These are typically easier to identify and control than nonpoint-source pollutants such as pesticide or nutrient runoff.
• Some pollutants are persistent and cumulative, so that emissions in one time period can cause damages over a long time horizon.  Others are short-lived and rapidly assimilated, so that emissions and damages are largely contemporaneous.
• Some pollutants are relatively immobile and remain localized; others may diffuse rapidly, be commingled from dispersed sources and  regional or global environmental problems.
• Some emissions are continuous; others are episodic.