"So what happens if we compensate the victims according to how much pollution they are exposed to? The costs of staying are reduced and the cost/benefit ratio shifts in favor of staying. That is, the victim is willing to bear more pollution costs to stay--the demand for pollution increases! This is a classic moral hazard problem. The solution to the problem actually creates the incentive for more of the problem.I believe the conclusion is correct, but I don't think using the term "victim" fits with the normative analysis of efficiency.
So are there anyways to compensate victims of pollution using revenues from a pollution tax without distorting the incentives? Sort of. A lump sum payment to all victims--that is a payment independent of the amount of damages the victim incurs--will not distort the victims' incentives. By simply making a payment of $100 to each victim, the victim still must bear the additonal (marginal) cost of each unit of pollution. The marginal damage from the last unit of pollution is the relevant cost in the benefit/cost decision. A lump-sum payment doesn't change that cost."
If the normative criterion for evaluating the allocation of resources is pareto optimality, then I don't think there is a victim when there is market failure. Rather there is just an inefficient allocation of resources. This normative perspective then suggests there may be an explicit role for government to play in the economy, and this role is not to make things "right" for the victims of the market failure. Rather, the role is to achieve an efficient allocation of resources. The normative framework of economic efficiency seems to me to be intended to take a specific "social point of view" with respect to economic activity. As such, I don't think efficiency can identify specific "victims." Instead, the "victim" of an inefficient allocation of resources is some concept that relates to the entire economy and not to specific identifiable people. When we use efficiency to discuss pollution, we might ask who is at fault for causing the external cost. Such a question seems to me to fit with the "victim" terminology, but I think this too is a use of language that is off the mark for efficiency analysis. The fault is not the actions of any specific individual, even if he or she is a polluter. The fault is found, for efficiency analysis, in an institutional structure that does not internalize the entire marginal social cost of resource utilization decisions.
I would suggest that the term "victim" is much more appropriate to the normative perspective of individual liberty. In this case, we would be looking for harm caused to some individual (or to a set of individuals), which results from the actions of another or others. If there is harm caused by the actions of another or of others, then it would seem quite natural and appropriate to say that the person harmed is a victim of the actions of another or of the actions of others. Further, on this normative perspective the idea of having those causing harm compensate those who are harmed (the victim or victims) is quite direct and obvious.
I suggest that using terms like "victim" when discussing efficient policy with respect to pollution really amounts to adding a second normative framework to the discussion. Or, using such terms perhaps is the result of paying too little explicit attention to the nature of the normative framework which is being used to evaluate environmental policy alternatives. Often times efficiency and liberty are normative frameworks that point to the same policy choices, but there are some policy issues for which these normative frameworks point to different policy choices. It seems to me that pollution is one of the issues where these normative frameworks point to different policies. For example, getting an efficient level of pollution (generally greater than zero pollution) is really not going to satisfy the normative perspective of individual liberty since the efficient pollution will mean there is still uncompensated harm to some which is caused by the economic behavior of others. And, as Tim essentially points out with his explanation, if "victims" are compensated with the revenue from a corrective pollution tax, then the result will be inefficient. The result in other words would actually be more consistent with the normative perspective of individual liberty, and it would not be consistent with efficiency.