This paper studies urban sustainability from the perspective of externalities. We develop a general spatial equilibrium model of a monocentric city, in which two types of externalities occur. On the one hand, pollution in the industrial center leads to a spatially differentiated deterioration of the environmental quality in the residential area. On the other hand, the existence of the city is explained by agglomeration economies, represented as simple Marshallian external benefits in production. We investigate free-market versus first-best and second-best optimal spatial equilibria, and conclude that the pursuit of environmental goals may sometimes come at the expense of reduced agglomeration economies, but may actually sometimes also stimulate these economies. © 2002 Elsevier Science B.V. All rights reserved.