Environmental economics is a sub-field of economics concerned with environmental issues. It has become a widely studied subject due to growing environmental concerns in the twenty-first century. Environmental economics "undertakes theoretical or empirical studies of the economic effects of national or local environmental policies around the world. Particular issues include the costs and benefits of alternative environmental policies to deal with air pollution, water quality, toxic substances, solid waste, and global warming."

Environmental economics is distinguished from ecological economics in that ecological economics emphasizes the economy as a subsystem of the ecosystem with its focus upon preserving natural capital. While environmental economics focuses on human preferences, by trying to balance protecting natural resources with people's needs for products and services. Due to these differences it can be seen that ecological economics takes a more holistic approach to traditional economic theories, while environmental economics fits within traditional economic theories.

One survey of German economists found that ecological and environmental economics are different schools of economic thought, with ecological economists emphasizing "strong" sustainability and rejecting the proposition that human-made ("physical") capital can substitute for natural capital. And environmental economics focusing on the efficient allocation of natural resources in order to fulfill human wants.

Although the term "environmental economics" became popular beginning in the 1960s, the entwinement of the two fields of environmentalism and economics started much earlier. Starting with economist Marquis de Condorcet in the 18th century, who had an interest in the link between economic activity and environmental issues. This was seen in his usage of externalities while analyzing environmental issues.

During the classical period of economics, Adam Smith realized while the market is able to allocate private goods efficiently for most goods, it fails to do so in some environmental circumstances. It is within these scenarios where the market fails, that the government needs to take action. This is seen in his quote "Erecting and maintaining certain public works and certain public institutions which it can never be for the interest of any individual, or small number of individuals to erect and maintain; because the profit would never repay the expense to any individual or small number of individuals, though it may frequently do much more than repay it to a great society." Thomas Robert Malthus also was another classical economist whose work led to the beginnings of environmental economists. Malthus' theory of population argued that agricultural productivity faces diminishing returns, which ultimately limits the exponential growth of human populations. This thought process later led economists to think about the relationship between resource scarcity and economic development. David Ricardo's writings connected the natural environment and the standard of living which further helped to develop environmental economics later on. He stressed that the value of land varies based on how fertile it is. The last classical economist to add to environmental economics was John Stuart Mill. In his Principles of Political Economy, he wrote that the management of the environment cannot be done by the market and individuals, and is instead a governmental obligation, "[I]s there not the earth itself, its forests and waters, and all other natural riches, above and below the surface? These are the inheritance of the human race, and there must be regulations for the common enjoyment of it. What rights, and under what conditions, a person shall be allowed to exercise over any portion of this common inheritance cannot be left undecided. No function of government is less optional than the regulation of these things, or more completely involved in the idea of civilized society."

Environmental economics became increasingly more popular in the 19th century. This is when the Resources for the Future (RFF) was established in Washington, D.C. This independent research organization applied economics to environmental issues. During this time H. Scott Gordon released his paper "Economic Theory of a Common Property Resource: The Fishery" which claimed that open access fisheries can be exploited leading to economic rents to be dissipated. Another important paper adding to environmental economics at this time was "Spaceship Earth" by Kenneth E. Boulding. This paper describes the physical limits of earths resources and how technology cannot truly help humans push those limits. Finally, Ronald Coase created an economic solution to environmental issues, which solidified environmental economics as a sub field of economics. He believed that there were two solutions 1) to tax the creator of the polluter and to create regulation that put the burden of action on the polluter or 2) the sufferer must pay the polluter to not pollute.

Central to environmental economics is the concept of market failure. Market failure means that markets fail to allocate resources efficiently. As stated by Hanley, Shogren, and White (2007): "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." This results in an inefficient market that needs to be corrected through avenues such as government intervention. Common forms of market failure include externalities, non-excludability and non-rivalry.

An externality exists when a person makes a choice that affects other people in a way that is not accounted for in the market price. An externality can be positive or negative but is usually associated with negative externalities in environmental economics. For instance, water seepage in residential buildings occurring in upper floors affect the lower floors. Another example concerns how the sale of Amazon timber disregards the amount of carbon dioxide released in the cutting.^{[better source needed]} Or a firm emitting pollution will typically not take into account the costs that its pollution imposes on others. As a result, pollution may occur in excess of the 'socially efficient' level, which is the level that would exist if the market was required to account for the pollution. A classic definition influenced by Kenneth Arrow and James Meade is provided 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 economic terminology, externalities are examples of market failures, in which the unfettered market does not lead to an efficient outcome.