Chapter three: Welfare Economics and the Environment

3.1. Efficiency and Optimality

At any point in time, an economy will have access to particular quantities of productive
resources. Individuals have preferences about the various goods that it is feasible to produce
using the available resources. An „allocation of resources‟, or just an „allocation‟, describes
what goods are produced and in what quantities they are produced, which combinations of
resource inputs are used in producing those goods, and how the outputs of those goods are
distributed between persons.In this we make two assumptions. First, that no externalities exist
in either consumption or production; roughly speaking, this means that consumption and
production activities do not have unintended and uncompensated effects upon others. Second,
that all produced goods and services are private (not public) goods; roughly speaking, this
means that all outputs have characteristics that permit of exclusive individual consumption on
the part of the owner .In the interests of simplicity, but with no loss of generality, we strip the
problem down to its barest essentials. Our economy consists of two persons (A and B); two
goods (X and Y) are produced; and production of each good uses two inputs (K for capital and
L for labour) each of which is available in a fixed quantity .Let U denote an individual‟s total
utility, which depends only on the quantities of the two goods that he or she consumes. Then
we can write the utility functions for A and B in the form:
UA = UA(XA, YA)
UB = UB(XB, YB)
The total utility enjoyed by individual A, denoted UA, depends upon the quantities, XA and
YA, he or she consumes of the two goods. An equivalent statement can be made about B‟s
utility. Next, we suppose that the quantity produced of good X depends only on the quantities
of the two inputs K and L used in producing X, and the quantity produced of good Y depends
only on the quantities of the two inputs K and L used in producing Y. Thus, we can write the
two production functions in the form:
X = X(KX, LX)
Y = Y(KY, LY)
Each production function specifies how the output level varies as the amounts of the two
inputs are varied. In doing that, it assumes technical efficiency in production. The production
function describes, that is, how output depends on input combinations, given that inputs are
not simply wasted. Consider a particular input combination KX1 and LX1 with X1 given by the
production function. Technical efficiency means that in order to produce more of X it is
necessary to use more of KX and/or LX.

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The marginal utility that A derives from the consumption of good X is denoted UAX; that is,
UAX= ∂UA/∂XA. The marginal product of the input L in the production of good Y is denoted as
MPYL; that is, MPYL= ∂Y/∂LY. Equivalent notation applies for the other three marginal
products. The marginal rate of utility substitution for A is the rate at which X can be
substituted for Y at the margin, or vice versa, while holding the level of A‟s utility constant. It
varies with the levels of consumption of X and Y and is given by the slope of the indifference
curve. We denote A‟s marginal rate of substitution as MRUSA, and similarly for B.
The marginal rate of technical substitution as between K and L in the production of X is the
rate at which K can be substituted for L at the margin, or vice versa, while holding the level
output of X constant. It varies with the input levels for K and L and is given by the slope of
the isoquant. We denote the marginal rate of substitution in the production of X as MRTSX,
and similarly for Y.
The marginal rates of transformation for the commodities X and Y are the rates at which the
output of one can be transformed into the other by marginally shifting capital or labour from
one line of production to the other. Thus, MRTLis the increase in the output of Y obtained by
shifting a small, strictly an infinitesimally small, amount of labour from use in the production
of X to use in the production of Y, or vice versa. Similarly, MRTKis the increase in the output
of Y obtained by shifting a small, strictly an infinitesimally small, amount of capital from use
in the production of X to use in the production of Y, or vice versa. With this notation we can
now state, and provide intuitive explanations for, the conditions that characterize efficient and
optimal allocations.
3.1.1. Economic efficiency
An allocation of resources is said to be efficient if it is not possible to make one or more
persons better off without making at least one other person worse off. A gain by one or more
persons without anyone else suffering is known as a Pareto improvement. When all such
gains have been made, the resulting allocation is sometimes referred to as Pareto optimal, or
Pareto efficient. A state in which there is no possibility of Pareto improvements is sometimes
referred to as being allocatively efficient, rather than just efficient, so as to differentiate the
question of efficiency in allocation from the matter of technical efficiency in production.
Efficiency in allocation requires that three efficiency conditions are fulfilled – efficiency in
consumption, efficiency in production, and product-mix efficiency.
Efficiency in consumption
Consumption efficiency requires that the marginal rates of utility substitution for the two
individuals are equal:

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MRUSA = MRUSB (3.1)
If this condition were not satisfied, it would be possible to rearrange the allocation as between
A and B of whatever is being produced so as to make one better off without making the other
worse off.

Figure 3.1. Efficiency in consumption

Figure 3.1 shows what is involved by considering possible allocations of fixed amounts of X
and Y between A and B. The top right-hand corner, labeled A0, refers to the situation where A
gets nothing of the available X or Y, and B gets all of both commodities. The bottom left-hand
corner, B0, refers to the situation where B gets nothing and A gets everything. Starting from
A0 moving horizontally left measures A‟s consumption of X, and moving vertically
downwards measures A‟s consumption of Y. As A‟s consumption of a commodity increases,
so B‟s must decrease. Starting from B0 moving horizontally right measures B‟s consumption
of X, and moving vertically upwards measures B‟s consumption of Y. Any allocation of X and
Y as between A and B is uniquely identified by a point in the box SA0TB0. At the point a, for
example, A is consuming A0AXa of X and A0AYa of Y, and B is consuming B0BXa of X and
B0BYa of Y. The point a is shown as lying on IAIA, which is an indifference curve for
individual A. IAIA may look odd for an indifference curve, but remember that it is drawn with
reference to the origin for A which is the point A0. Also shown are two indifference curves
for B, IB0IB0and IB1IB1. Consider a reallocation as between A and B, starting from point a and
moving along IAIA, such that A is giving up X and gaining Y, while B is gaining X and giving
up Y. Initially, this means increasing utility for B, movement onto a higher indifference curve,
and constant utility for A. However, beyond point b any further such reallocations will
involve decreasing utility for B. Point b identifies a situation where it is not possible to make

3
individual B better off while maintaining A‟s utility constant – it represents an efficient
allocation of the given amounts of X and Y as between A and B. At b, the slopes of IAIA and
IB1IB1 are equal – A and B have equal marginal rates of utility substitution.
Efficiency in production
Turning now to the production side of the economy, recall that we are considering an
economy with two inputs, L and K, which can be used (via the production functions of
equations 3.2) to produce the goods X and Y. Efficiency in production requires that the
marginal rate of technical substitution be the same in the production of both commodities.
That is,
MRTSX= MRTSY (3.2)
If this condition were not satisfied, it would be possible to reallocate inputs to production so
as to produce more of one of the commodities without producing less of the other. Figure 3.2
shows why this condition is necessary. It is constructed in a similar manner to Figure 3.1, but
points in the box refer to allocations of capital and labour to the production of the two
commodities rather than to allocations of the commodities between individuals.

Figure 3.2. Efficiency in production

At X0 no capital or labour is devoted to the production of commodity X – all of both resources

is used in the production of Y. Moving horizontally to the left from X0 measures increasing
use of labour in the production of X, moving vertically down from X0 measures increasing use
of capital in the production of X. The corresponding variations in the use of inputs in the
production of Y – any increase/decrease in use for X production must involve a decrease/
increase in use for Y production – are measured in the opposite directions starting from origin

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Y0. IXIX is an isoquant for the production of commodity X. Consider movements along it to
the „southeast‟ from point a, so that in the production of X capital is being substituted for
labor, holding output constant. Correspondingly, given the full employment of the resources
available to the economy, labor is being substituted for capital in the production of Y. IY0IY0
and IY1IY1 are isoquants for the production of Y. Moving along IXIX from a toward b means
moving onto a higher isoquant for Y – more Y is being produced with the production of X
constant. Movement along IXIX beyond point b will mean moving back to a lower isoquant
for Y. The point b identifies the highest level of production of Y that is possible, given that the
production of X is held at the level corresponding to IXIX and that there are fixed amounts of
capital and labour to be allocated as between production of the two commodities. At point b
the slopes of the isoquants in each line of production are equal – the marginal rates of
technical substitution are equal. If these rates are not equal, then clearly it would be possible
to reallocate inputs as between the two lines of production so as to produce more of one
commodity without producing any less of the other.
Product-mix efficiency
The final condition necessary for economic efficiency is product-mix efficiency. This
requires that

Figure 3.3.product-mix-efficiency

MRTL= MRTK= MRUSA = MRUSB (3.3)

This condition can be understood using Figure 5.3. Given that equation 5.3 holds, so that the
two individuals have equal marginal rates of utility substitution and MRUSA = MRUSB, we
can proceed as if they had the same utility functions, for which II in Figure 3.1 is an
indifference curve with slope MRUS. The individuals do not, of course, actually have the
same utility functions. But, given the equality of the MRUS, their indifference curves have

5
the same slope at an allocation that satisfies the consumption efficiency condition, so we can
simplify, without any real loss, by assuming the same utility functions and drawing a single
indifference curve that refers to all consumers. Given that Equation 3.2.holds, when we think
about the rate at which the economy can trade off production of X for Y and vice versa, it
does not matter whether the changed composition of consumption is realized by switching
labor or capital between the two lines of production.
Consequently, in Figure 3.3 we show a single production possibility frontier, YMXM, showing
the output combinations that the economy could produce using all of its available resources.
The slope of YMXM is MRT. In Figure 3.3 the point a must be on a lower indifference curve
than II. Moving along YMXM from point a toward b must mean shifting to a point on a higher
indifference curve. The same goes for movement along YMXM from c toward b. On the other
hand, moving away from b, in the direction of either a or c, must mean moving to a point on a
lower indifference curve. We conclude that a point like b, where the slopes of the
indifference curve and the production possibility frontier are equal, corresponds to a product
mix – output levels for X and Y– such that the utility of the representative individual is
maximised, given the resources available to the economy and the terms on which they can be
used to produce commodities. We conclude, that is, that the equality of MRUS and MRT is
necessary for efficiency in allocation. At a combination of X and Y where this condition does
not hold, some adjustment in the levels of X and Y is possible which would make the
representative individual better off. An economy attains a fully efficient static allocation of
resources if the conditions given by equations 3.1, 3.2 and 3.3 are satisfied simultaneously.
Moreover, it does not matter that we have been dealing with an economy with just two
persons and two goods. The results readily generalise to economies with many inputs, many
goods and many individuals. The only difference will be that the three efficiency conditions
will have to hold for each possible pairwise comparison that one could make, and so would
be far more tedious to write out.
3.1.3. The social welfare function (SWF) and optimality
A SWF can be used to rank alternative allocations. For the two-person economy that we are
examining, a SWF will be of the general form:
W = W(UA, UB) (3.4)
The only assumption that we make here regarding the form of the SWF is that welfare is non-
decreasing in UA and UB. That is, for any given level of UA welfare cannot decrease if UB
were to rise and for any given level of UB welfare cannot decrease if UA were to rise. In other
words, we assume that WA = ∂W/∂UA and WB = ∂W/∂UB are both positive. Given this, the

6
SWF is formally of the same nature as a utility function. Whereas the latter associates
numbers for utility with combinations of consumption levels X and Y, a SWF associates
numbers for social welfare with combinations of utility levels UA and UB. Just as we can
depict a utility function in terms of indifference curves, so we can depict a SWF in terms of
social welfare indifference curves.Figure 3.4 shows a social welfare indifference curve WW
that has the same slope as the utility possibility frontier at b, which point identifies the
combination of UA and UB that maximises the SWF.The reasoning which establishes that b
corresponds to the maximum of social welfare that is attainable should be familiar by now –
points to the left or the right of b on the utility possibility frontier, such as a and c, must be on
a lower social welfare indifference curve, and points outside of the utility possibility frontier
are not attainable. The fact that the optimum lies on the utility possibility frontier means that
all of the necessary conditions for efficiency must hold at the optimum. Conditions 3.1, 3.2
and 3.3 must be satisfied for the maximisation of welfare.

Figure 3.4.maximized social welfare

Also, an additional condition, the equality of the slopes of a social indifference curve and the
utility possibility frontier, must be satisfied.

(3.5)
The left-hand side here is the slope of the social welfare indifference curve. The two other
terms are alternative expressions for the slope of the utility possibility frontier. At a social
welfare maximum, the slopes of the indifference curve and the frontier must be equal, so that
it is not possible to increase social welfare by transferring goods, and hence utility, between
persons. While allocative efficiency is a necessary condition for optimality, it is not generally
true that moving from an allocation that is not efficient to one that is efficient must represent

7
a welfare improvement. Such a move might result in a lower level of social welfare. This
possibility is illustrated in Figure 3.5. At C the allocation is not efficient, at D it is.However,
the allocation at C gives a higher level of social welfare than does that at D. Having made this
point, it should also be said that whenever there is an inefficient allocation, there is always
some other allocation which is both efficient and superior in welfare terms. For example,
compare points C and E. The latter is allocatively efficient while C is not, and E is on a
higher social welfare indifference curve. The move from C to E is a Pareto improvement

Figure 3.5. Welfare and efficiency

Where both A and B gain, and hence involves higher social welfare. On the other hand, going
from C to D replaces an inefficient allocation with an efficient one, but the change is not a
Pareto improvement – B gains, but A suffers – and involves a reduction in social welfare.
Clearly, any change which is a Pareto improvement must increase social welfare as defined
here. Given that the SWF is non-decreasing in UA and UB, increasing UA/UB without
reducing UB/UA must increase social welfare. For the kind of SWF employed here, a Pareto
improvement is an unambiguously good thing. It is also clear that allocate efficiency is a
good thing (subject to the same qualification) if it involves an allocation of commodities as
between individuals that can be regarded as fair. Judgments about fairness, or equity, are
embodied in the SWF in the analysis here. If these are acceptable, then optimality is an
unambiguously good thing. To anticipate, we shall see that what can be claimed for markets
is that, given ideal institutional arrangements and certain modes of behavior, they achieve
allocate efficiency. It cannot be claimed that, alone, markets, even given ideal institutional
arrangements, achieve what might generally or reasonably be regarded as fair allocations.
Before looking at the way markets allocate resources, we shall look at economists‟ attempts

8
to devise criteria for evaluating alternative allocations that do not involve explicit reference to
a social welfare function.
3.1.3. Allocation in a market economy
Efficiency given ideal conditions
A variety of institutional arrangements might be employed to allocate resources, such as
dictatorship, central planning and free markets. Any of these can, in principle, achieve an
efficient allocation of resources. Here, we are particularly interested in the consequences of
free-market resource allocation decisions. This is for three, related, reasons. First, for
dictatorship and central planning to achieve allocative efficiency it is necessary that the
dictator or central planner know all of the economy‟s production and utility functions. This is
clearly infeasible, and is one of the reasons that attempts to run economies in these ways have
been unsuccessful. The great attraction of free markets as a way organizing economic activity
is that they do not require that any institution or agent have such knowledge. That is the
second reason for our concentration on markets – they are decentralized information-
processing systems of great power. The third reason is that the modern welfare economics
that is the basis for environmental and resource economics takes it that markets are the way
economies are mainly organized. Environmental and resource issues are studied, that is, as
they arise in an economy where markets are the dominant social institution for organizing
production and consumption.
The market economy is now the dominant mode of organizing production and consumption
inhuman societies. Welfare economics theory points to a set of circumstances such that a
system of free markets would sustain an efficient allocation of resources.
The „institutional arrangements „include the following:
1. Markets exist for all goods and services produced and consumed.
2. All markets are perfectly competitive.
3. All transactors have perfect information.
4. Private property rights are fully assigned in all resources and commodities.
5. No externalities exist.
6. All goods and services are private goods .That is, there are no public goods.
7. All utility and production functions are „well behaved‟.
In addition to these institutional arrangements, it is necessary to assume that the actors in
such a system– firms and individuals, often referred to jointly as „economic agents‟ or just
„agents‟ – behave in certain ways. It is assumed that agents always strive to do the best for

9
themselves that they can in the circumstances that they find themselves in. Firms are assumed
to maximize profits, individuals to maximize utility.
An efficient allocation would be the outcome in a market economy populated entirely by
maximizes and where all of these institutional arrangements were in place. Before explaining
why and how this is so, a few brief comments are in order on these conditions required for a
market system to be capable of realizing allocative efficiency. First, note that, as we shall see
in later sections of this chapter where we discuss public goods and externalities, arrangements
5 and 6 are really particulars of 4. Second, note that 4 is necessary for 1 – markets can only
work where there are private property rights and justice system to enforce and protect such
rights .Third, that an important implication of 2 is that buyers and sellers act as „price-takers‟,
believing that the prices that they face cannot be influenced by their own behavior. No agent,
that is, acts in the belief that they have any power in the market. Finally, note that these are
very stringent set of conditions, which do not accurately describe any actual market economy.
The economy that they do describe is an ideal type, to be used in the welfare analysis of
actual economies as a benchmark against which to assess performance, and to be used to
devise policies to improve the performance, in regard to efficiency criteria, of such actual
economies. We now explain why a market allocation of resources would be an efficient
allocation in such ideal circumstances. Consider, first, individuals and their consumption of
produced commodities. Any one individual seeks to maximize utility given income and the
fixed prices of commodities.

Figure 3.6. Utility maximisation

Figure 3.6, refers to an individual in a two-commodity economy. The line YmaxXmax isthe
budget constraint. Ymax is the amount of Y available if all income is spent on Y, Xmax is
consumption if all income is spent on X. The slope of the budget constraint gives the price

10
ratio PX/PY. Utility maximization requires consumption X* and Y* correspond ingto point b
on the indifference curve U*U*.Consumption at points on YmaxXmax to the left or rightof b,
such as a and c, would mean being on a lower indifference curve than U*U*. Consumption
patterns corresponding to points to the northeast of YmaxXmax are not attainable with the given
income and prices. The essential characteristic of b is that the budget line is tangential to an
indifference curve. This means that the slope of the indifference curve is equal to the price
ratio. Given that the slope of the indifference curve is the MRUS, we have:

In the ideal conditions under consideration, all individuals face the same prices. So, for the
two individual, two-commodity market economy, we have

Comparison of equation 3.6 with equation 3.1 shows that the consumption efficiency
condition is satisfied in this ideal market system. Clearly, the argument here generalizes to
many-person, multi-commodity contexts. Now consider firms. To begin, instead of assuming
that they maximize profits, we will assume that they minimize the costs of producing a given
level of output. The cost-minimization assumption is in no way in conflict with the
assumption of profit maximisation.On the contrary, it is implied by the profit maximization
assumption, as, clearly, a firm could not be maximizing its profits if it were producing
whatever level of output that involved at anything other than the lowest possible cost. We are
leaving aside, for the moment, the question of the determination of the profit-maximising
level of output and focusing instead on the prior question of cost minimization for a given
level of output. This question is examined in Figure 5.9, where X*X* is the isoquant
corresponding to some given output level X*.The straight lines K1L1, K2L2, and K3L3 are
isocost lines. For given prices for inputs, PK and PL, an isocost line shows the combinations of
input levels for K and L that can be purchased for a given total expenditure on inputs. K3L3
represents, for example, a higher level of expenditure on inputs, greater cost, than K2L2.

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 Figure 3.7. Cost minimisation

The slope of an isocost line is the ratio of input prices, PK/PL. Given production of X*, the
cost-minimizing firm will choose the input combination given by the point b. Any other
combination, such as a or c, lying along X*X* would mean higher total costs. Combinations
represented by points lying inside K2L2 would not permit of the production of X*. The
essential characteristic of b is that anisocost line is tangential to, has the same slope as, an
isoquant. The slope of an isoquant is the MRTS so that cost-minimizing choices of input
levels must be characterized by:

In the ideal circumstance, all firms, in all lines of production, face the same PK and PL,
which means that

which is the same as equation 3.2, the production efficiency condition for allocative
efficiency – cost minimizing firms satisfy this condition. The remaining condition that needs
to be satisfied for allocative efficiency to exist is the product mix condition, equation 3.3,
which involves both individuals and firms. In explaining how this conditions is satisfied in an
ideal market system we will also see how the profit-maximizing levels of production are
determined. Rather than look directly at the profit- maximizing output choice, we look at the
choice of input levels that gives maximum profit. Once the input levels are chosen, the output
level follows from the production function. Consider the input of labor to the production of X,
with marginal product XL. Choosing the level of XL to maximize profit involves balancing the
gain from using an extra unit of labour against the cost of so doing. The gain here is just the
marginal product of labor multiplied by the price of output, i.e. PXXL. The cost is the price of

12
labour, i.e. PL. If PLis greater than PXXL, increasing labour use will reduce profit. If PL is less
than PXXL,increasing labour use will increase profit. Clearly, profit is maximized where PL=
PXXL.
The same argument applies to the capital input,and holds in both lines of production. Hence,
profit maximisation will be characterized by

which implies

Using the left-hand equalities here, and rearranging, this is

(3.8b)

Now, the right-hand sides here are MRTLandMRTK, as they are the ratios of marginal
products in the two lines of production and hence give the terms on which the outputs change
as labor and capital are shifted between industries. Given that the left hand sides in equations
3.8a and 3.8b are the same we can write

Figure 3.8. Profit maximisation

Showing that the marginal rate of transformation is the same for labor shifting as for capital
shifting. Referening back to equation 5.8, we can now write

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Showing that the profit-maximizing output levels in the ideal market economy satisfy the
product mix condition for allocative efficiency, equation 3.6.
This completes the demonstration that in an ideal market system the conditions necessary for
allocative efficiency will be satisfied. We conclude this section by looking briefly at profit-
maximizing behavior from a perspective that will be familiar from an introductory
microeconomics course. There, students learn that in order to maximize profit, a firm which
is a price-taker will expand output up to the level at which price equals marginal cost.
Figure3.8 refers. For output levels below X*, price exceeds marginal cost so that increasing
output will add more to receipts than to costs, so increasing profit as the difference between
receipts and costs. For output levels greater than X*, marginal cost exceeds price, and
reducing output would increase profit. This is in no way inconsistent with the discussion
above of choosing input levels so as to maximize profit. It is just a different way of telling the
same story. In order to increase output, assuming technical efficiency, more of at least one
input must be used. In thinking about whether or not to increase output the firm considers
increasing the input of capital or labor, in the manner described above. For the case of labor
in the production of X, for example, the profit-maximizing condition was seen to be PL
=PXXL, which can be written as
Which is just marginal cost equals price, because the left-hand side is the price of an

additional unit of labor divided by the amount of output produced by that additional unit.
Thus if the wage rate is £5 per hour, and one hour‟s extra labor produces 1 tons of output, the
left-hand side here is £5 per tones the marginal cost of expanding output by one tone is £5. If
the price that one tone sells for is greater(less) than £5 it will pay in terms of profit to increase
(decrease) output by one tone by increasing the use of labor. If the equality holds and the
output price is £5, profit is being maximized. The same argument goes through in the case of
capital, and the marginal cost equals price condition for profit maximization can also be
written as

14
.
Market Failure, Property Rights and Externalities

Allocation in a Market Economy

Necessary conditions for markets to produce efficient allocations:

1. Markets exist for all goods and services produced and consumed

2. All markets are perfectly competitive.

3. All transactions have perfect information

4. Private property rights are fully assigned in all resources and commodities.

5. No externalities exist.

6. All goods and services are private goods. That is, there are no public goods.

7. All utility and production functions are 'well behaved'.

8. All agents are maximizers.

3.1 Markets and Property Right

A central question in resource and environmental economics concerns efficiency. By modern

economics, given the necessary conditions (eg, well-defined and enforceable private property

rights) markets will bring about efficiency in allocation. Because property rights do not exist,

or are not clearly defined, for many environmental resources, markets fail to allocate those

resources efficiently.

 Price signals fail to reflect true social costs and benefits, justifying government policy

intervention to seek efficiency gains. Most environmental services are used without

being traded in the market. Much of the mismanagement and inefficient use of natural

resources and environmental degradation can be explained in terms of market and

policy failure.

15
Defining market failure

Neoclassical economics is concerned with markets for goods allocating scarce resources to

alternative uses, and prices being established which reflect the scarcity of and levels of

demand for goods. We live in a particular environment, breathing the air. However, we do

not pay a price for the air, as there is no market in air. As a result, we cannot reflect our

preference for breathing clean rather than dirty air through the market. This is an example of

market failure.

Market failure occurs when the conditions for perfect competition are not met. If the market

fails, then government intervention designed to correct the market failure may bring benefits

to society. However, government intervention may fail to secure these benefits, even making

matters worse and resulting in market failure. This is known as government failure. The

market mechanism leads to the socially optimal outcome only under very specific conditions.

However, it is highly unlikely that these conditions will be fully satisfied. The existence of

perfect competition in reality as it is defined is itself highly unlikely.

For example, we require that prices will result from the realization of all possible markets

working and existing. This is only likely to occur when a complete and effective system of

property rights exist, including property rights to environmental goods such as clean air.

When either condition is not satisfied, markets fail, and this can, deliberately or

unintentionally, bring about undesirable consequences. Market fails when one of the

assumptions not fulfilled.

1. Lack of market for environmental services (unpriced environmental assets)

2. lack of property rights

3. existence of externalities (positive or negative)

4. Collectively Consumed Goods (public goods)

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 5. Imperfect (Incomplete) information

3.3 Property rights

A central idea in modern economics is that, given the necessary conditions, markets will

bring about efficiency in allocation. For this to happen, well-defined and enforceable

private property rights are one of the necessary conditions. The manner in which

producers and consumers use environmental resources depend on the property rights

governing those resources. In economics, property rights refer to a bundle of entitlement

defining the owner‟s rights, privileges, and limitations for use of the resources.

 Entitlements to resources can be owned by individuals, groups, the government or

nobody. Clear examination of such entitlements is exceptionally important to

analyze economic changes and predict the likely response of economic agents to

changes in economic environment. It also helps one to understand how

environmental problem arise from government and market allocations.

 In general, property rights can be vested in individuals only as in capitalist

economy, or only in the state as in centrally planned economies. In individual

property right ownership types, all benefits and costs associated with the

ownership and use of the resource are borne by the owner. And in state property

ownership type, the government owns and controls the property. However, the

above property right entitlements are at the boundaries of the extreme. In between

the two, there are the following three types of property ownership entitlements:

common property, open access property, and public goods

3.3.1 Efficient property rights (PR) structure

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An efficient property right structure that would produce efficient allocations in a well-

functioning economy has four main characteristics. i.e., property rights are efficient if they

satisfy the following four basic properties:

 Universality (specificity) – purely owned by an individual. Private ownership of

all resources with completely specified entitlement determines what can and can‟t

be done with the resources.

 Exclusivity (ownership) – ownership is the legal mechanism for conveying

property rights to a resource. According to this element, all benefits and cost

accrued as a result of owning and using the resources should accrue to the owner

and only to the owner. Generally exclusivity is about all benefits and costs

accrue to owner.

 Transferability – all property rights should be transferable from one owner to

another in a voluntary exchange. This feature allows resources to be allocated to

their highest valued use.

 Enforceability – property rights should be secured from involuntary seizure or

encroachment by others. Enforceability requires that property rights be

enforceable and enforced when there is violation.

An owner of a resource with a well-defined property right has a strong incentive to use that

resource efficiently because a decline in the value of that resource represents a personal loss.

When well-defined property rights are exchanged, as in a market economy, this exchange

facilitates efficiency. That is, well defined property right coupled with well performing

market ensures efficiency both the producer and the customer attain their respective

maximum possible satisfaction level. That is, in a system with well-defined property rights

18
and competitive markets in which to sell those rights, producers try to maximize their surplus

and consumers theirs satisfaction. The price system then, induces those self-interested parties

to make choices which are efficient from the point of view of society as a whole.

Property right attributes

 the right to use the property

 The right to earn income from the property

 The right to transfer the property to others

 Non owners and authority system recognize this attributes of resource attached to

owner. If one individual has a right, someone else has a corresponding duty to

respect that right, and it is the authority system that ensures the proper execution

of such rights. When one or both two conditions (well defined property right

structure or competitive market) are violated, there arises the problem of market

failure.

3.3.2 Common pool resources & tragedy of the common

The commons or common pool resource is any resource which is shared by a group of

people. Such things as the air we breathe and the water we drink come from commons. In

many parts of the world; new land for farming and grazing land for stock, fish from the sea,

and wood for fuel and housing are treated as commons. Common-pool resources are shared

resources characterized by non-exclusivity and divisibility.

 Non exclusivity implies that resources can be exploited by anyone, while

 Divisibility means that the capture of part of the resource by one group

subtracts it from the amount available to the other groups. Examples: fish

stocks in the oceans, forests, arable land - with no specific owner, shared by

all.

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Tragedy of the commons

 The tragedy of the commons describes a situation when overuse of common goods

leads to depletion of the common resource. Described in 1833 by William Forster

Lloyd on herders sharing a common parcel of land on which they are each entitled to

let their cows graze.

 Well known example: an article by G. Hardin (1968) "The Tragedy of the Commons"

described the individuals acting in rational self-interest will results overuse of the

resources, overpopulation.

3.4 Public goods and Market Failure

The other causes of market failure that emerges due to improbable property right assignment

is the cases of public goods. Public goods, defined as those that exhibit both consumption

indivisibilities and non-excludability.

 Non-exclusive refers to a circumstance where, once the resource is provided, even

those who fail to pay for it can‟t be excluded from enjoying the benefit it confers

or a person cannot be prevented from using it (radio signals, national defense) or

people cannot be kept from enjoying the good.

 Consumption is said to be indivisible (non rival) when one person‟s

consumption of a good does not diminish the amount available for others.

Several common environmental resources are public goods, including clean air, clean water,

and biological diversity, etc. Excludability feature of public goods entails that inefficiency

also results because each person is able to become a free ride on the other‟s contribution.

 A free rider is someone who derives the benefits from commodity without

contributing to its supply. Because of the consumption indivisibility and non-

20
 excludability properties of the public good, consumers receive the benefits of any

amount purchased by other people. When this happens, it tends to diminish incentives

to contribute and the contributions are not sufficiently large to finance the efficient

amount of the public good. Therefore, in the absence of government intervention, the

market tends to undersupply public goods, if it supplies after all.

 Free-rider problem: Free rider consumes the good (receives the utility) but does

not pay for the goods. If good is not excludable, there is an incentive to be a free

rider because (the supplier cannot prevent the non-payers from the consumption).

The markets are able to find the optimal solution, if the information can be carried through -

the market price provides this kind of information. In order to create a price for something, it

is necessary to establish property rights. The non-existence or absence of the enforceability of

the property rights leads to the failure to “internalize” externalities. Here, the external effect

is an untraded and unpriced product arising because the victim has no property rights that can

be exploited to obtain compensation for the external effect.

3.5 Externalities and Market Failure

Definition and types of externalities

The typical efficient market outcome relies on the existence of a Market. There might be

cases when the market either does not exist or when it is not functional. In such situations, the

situation of the consumers and producers is not driven by the market processes. Without

market processes at work, it is impossible to attain the efficient market outcome. Situations

when the (property) rights of some of the market participants are affected by the actions of

some other market participants, and these impacts are not compensated (the parties in

question do not enter a market), are called externalities.

21
They are defined as third party (or spill-over) effects arising from the production and/or

consumption of goods and services for which no appropriate compensation is paid.

 When the exclusivity characteristic of an efficient property right structure is violated,

externalities arise. Externality said to arise when an individual or a producer does not

bear all the consequences of his/her action.

 An externality exists whenever the welfare of some agent, either a firm household,

depends not only on his or his activities, but also on activities under the control of

some other agent.

 Note that in a perfectly competitive market, all benefits are reflected in demand

curves and all costs are reflected in supply curves of the firm. And the resulting net

benefit, at output defined at the intersection of demand and supply, (societal surplus)

is the maximum possible. Thus, when markets function well, there is no externality

and the resulting net benefit to the society is the maximum possible. But there are

cases when the demand and costs functions of firms do not reflect all the benefits and

the costs to the firms. And when this happens, we say there is a problem of

externality.

 Commonly we distinguish between two types of externalities depending on whether

the externally affected party is damaged or benefited. Next, we will see the different

types of externality with the associated inefficiency.

a) Positive externality (external economy)

Positive externality is said to exist when an agent gets benefit without payment to the parties

involved directly in production and/ or consumption of goods and services.

 Example of positive externality include: a beehive owner located closer to a flower

grower and the owner of the beehive make use of produce of the flower grower

without paying for it, an individual located around a rich household and this
22
 individual use the road built by the rich without paying for it, and the vaccine taken

by an individual helps others not to be effected to the diseases.

In all the above examples, social benefit outweighs private benefits. The total benefit to the

society from the production of, for example the flower is greater than the individual benefit

accrued to the flower. Using the marginal concept, the marginal social benefit (MSB) is

greater than the marginal private benefit (MPB). The difference between the two (measured

as a vertical distance between the two curves) is called the marginal external benefit

(MEB), i.e.,

MSB=MPB+MEB

The total benefit from a product is shown by the area under the demand curve of the product.

Hence, the social benefit from the production of the flower is indicated by the demand curve

of the society (Ds) and the individual benefit by individual (private) demand curve (Dp).

Price MSC

Dp Ds

Qp Qs Quantity

Figure 2:5: Positive externality

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Note that in figure 2.5, Ds and DP represent societal demand (benefit) and private demand

(benefit) curves respectively.

 With positive externality the social benefit curve always lies above the private benefit

curve and the difference between the two is called external benefit which is the

measure of extra net benefit earned to the society.

 From the figure, given its demand and the costs function, the producer will produce

only Qp output level at the intersection point between the costs and private demand

function. This output level is not optimal from society perspective. The welfare of the

society will be maximized if Qs output level is produced.

The figure also shows that the price actually charged for output involving positive externality

is less than what the society is willing to pay. Thus positive externality allocates resource less

efficiently under prices resources of the society. In general, with positive externality, the

market leads to under production, resource underutilization and inefficiency (less than

optimal prices of goods and services).

 Positive externalities exist when the marginal social benefit of production and or

consumption (MSB) exceeds the marginal private benefit (MPB.

b) Negative externality (external diseconomy)

Negative externality involved costs that are inflicted upon other parties without

compensation in the process of compensation or production.

 Example of negative externality include: pollutants dumped into a river by a firm that

negatively affect production and health of firms and households, the effect of cigarette

smoke from a smoker on welfare of people of the surrounding, inconvenience created

owing to loud music opened late at a night from the neighbor.

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 In all the above examples, the private costs of production or consumption is lower than

the social costs. The different between the two is the costs borne by a third party called

the external cost.

 Equivalently, the existence of negative externality implies that the private marginal

costs (MPC) are lower than the marginal social costs (MSC) and the difference is

the costs incurred by a third party for each additional output level: the marginal

external costs (MEC). That is,

MSC=MPC+MEC

Graphically, this is shown in such a way that the MSC curve lies above and to the left of the

MPC. At each output level the vertical distance between the MPC and the MSC curve is the

MEC.

Price MSC

Ps MPC

Pp

Dd

Qs Qp Quantity

Figure 2.6: Negative Externalities

 From the above figure it can easily be seen that the socially optimal output level Qs is

obtained at the intersection point between the costs and the benefit curve to the

society. Corresponding to this output level, the price the society is willing to pay

equals Ps. But the private producers, faced with MPC and Dd curves, will set output

25
 at Qp level and price at Pp. and these price and output maximizes the net benefit of

the firm but not the society. The society desires to pay higher price and get lower

output than available by the market.

 The result of the existence of negative externality is that in the economy too much

output and too much pollution are produced. Besides, the prices of products

responsible for the problem are low and recycling and re-use are discouraged since

releasing the waste to the environment is cheaper. As long as the incentives are

external, there are no incentives to search for ways to yield less pollution per unit of

output.

3.6 .Imperfect Information

Imperfect information will lead people to make wrong decision. E.g. if individual A is

smoker and individual B is not and B doesn‟t find that smoke unpleasant, and is unaware of

the danger of passive smoking. Then, individual B hurt because of lack of information. How

it is relevant to Natural & Env‟tal resource?

If people have no information about the danger of pollution and the effect of resource

degradation, then it will end up with crisis. So the solution is information must be provided

by the government or by private individuals. The government may provide services that are

not provided by the market because of imperfect information (e.g. insurance).

Policy failure occurs when:

 Government policy interventions necessary to correct market failures are not taken, or

over correct or under correct the problem (e.g., lack of management of open access

forests).

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  Government decisions exchange rate controls, price ceilings, subsidies or taxes that

create incentives for unsustainable resource use, inappropriate land reforms which

create tenure insecurity, nationalization of resources without the means to control and

manage it are responsible for distorting market prices.

3.3.5. Government Failure

Government failure refers to situations where allocate efficiency may have been reduced
following government intervention in markets designed to correct market failure.
When does government step in?
o To correct shortages or surpluses
o To provide when the market does not or cannot provide some goods or
services.
o To regulate and correct where there is perceived inequality or inefficiency
o To protect individuals and groups in society and provide a safety net for those
unable
to help themselves
o To reduce poverty
o To influence property rights
How does government intervene?
Taxation – to redistribute and provide incentive or disincentive effects
Subsidies – to encourage production/consumption
Regulation – guides, codes of practice, legislation, independent regulators
Identifying property rights – ownership of property, e.g. intellectual property, granting
of patents, etc.
Direct provision of goods and services – health, education, etc.
How does Government Failure manifest itself?
• Distortion of markets – e.g. rent control, minimum wage, agricultural subsidies,
taxes on fuel
• Welfare impact – erosion of consumer surplus and producer surplus – e.g. tariff
support for manufactured goods and food
• Disincentive Effects – High taxes hampering business expansion or enterprise,
Welfare benefits reducing, the incentive to find work

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• Short termism – solving the „hot topics‟ of the day rather than the long term
important issues – e.g. ID cards versus pension crisis?
• Electoral Pressure-Desire to get elected and pass „popular‟ policies to capture votes.
E.g. spending on public services at the risk of higher inflation and future interest
rates?
• Imperfect information: Lack of knowledge of, Prices, Value, Costs, Benefits, Long
term effects, Behavioural changes, External costs and benefits, Value of producer and
consumer surplus. All mean less than efficient allocation may result from government
intervention

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 4: ENVIRONMENTAL VALUATION

4.1. Values for the Environment

Human activity strongly relies on the natural environment. Environmental resources are put

to different and sometimes competing uses by people. They form the ecological processes on

which life depends, they provide inputs to the production of goods and services, amenity and

they act as sinks for waste and pollution. Environmental resources also have value beyond

their direct use and many environmental resources are not traded in markets and so do not

have an obvious price

 A central idea in modern economics is that, given the necessary conditions, markets

will bring about efficiency in allocation. Many environmental resources or are not

traded through markets, and so will not have market prices. Though environmental

effects do not have a price that does not mean they do not have value.

In order to make efficient decisions, these values need to be estimated in some way. There

are various ways of doing this and collectively called valuation techniques.

What is Value?

 First, the economic view of “value” is anthropocentric. This means value is

determined by people and not by either natural law or government. Second, value

is determined by peoples‟ willingness to make trade-offs. When an individual

spends money on one good, there is less available for other goods.

 Non-market goods are goods that are not typically traded in markets. Air quality,

wildlife habitat, clean water, biodiversity, scenic landscapes, and lack of climate

change. But, time and other opportunities are sometimes sacrificed in order to

29
 obtain both market and non-market goods. Examining these trade-offs can serve

as a basis for valuing non-market goods.

4.2. Categories of Environmental Benefits

In this sense, the total economic value (TEV) of environmental amenities comprises explicit

use benefits as well as implicit non-use benefits.

Total economic value = use value + non-use value

1. Use value

The benefits people get from direct use of a good.

Types of use value

There are three types of use value

1. Direct use value (DUV) - goods and services directly consumed by users and the value

which we get directly from consuming some environmental resource. The direct use

value is derived from goods, which can be extracted, consumed or directly enjoyed. It is

also therefore known as extractive or consumptive use value. This includes products

(e.g., edible, ornamental, medicinal, inputs into production process), recreation, waste

assimilation, fertility of soil, fish from the sea, timber from forest, using tree for fuel,

water from stream, etc.

2. Indirect use value (IUV) - Indirect use value is referred to as non-extractive use value,

derived from the services that an environmental resource provides. Indirect benefits

arising from ecological systems. More generally, indirect use values may be described as

the benefits individuals experience, indirectly, as a consequence of the primary

ecological function of a given resource. These include biological support – links to other

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 species and habitats, physical protection or defense function, flood control, climate

regulation, global life support – functions that aid in supporting life on Earth.

3. Option value – the amount a person would be willing to pay to preserve the option of

being able to experience a particular environmental amenity in the future; the willingness

to preserve the environment even if one is not currently using it. It is sometimes treated

as a special case of use value.

2. Non-use value

Non-use values are defined as those benefits or welfare gains/losses to individuals that arise

from environmental changes independently of any direct or indirect use of the environment.

They are less direct, less tangible benefits to society, independent of any present or future

use. Examples are Existence Value, Bequest Value, Stewardship Value, and Altruistic Value.

1. Bequest value – a willingness to pay to leave behind environmental resource and

quality for future generations. Bequest value refers to the fact that an individual

values having an environmental resource or general environmental quality available

for his/her children or grandchildren to experience. It is the satisfaction gained

through the ability to endow a natural resource on future generations. For example,

many of us are concerned with future damages from global warming and would be

willing to pay to reduce them, despite the fact that the vast majority of the damages

are expected to affect the earth long after our generation is gone.

2. Existence value – a willingness to pay simply to help preserve the existence of some

environmental amenity. Existence value refers to the fact that an individual‟s utility may

be increased by the knowledge of the existence of an environmental resource even though

the individual has no current or potential direct use of the resource. An individual may

never have opportunity to see an Abyssinian wolf but places value on preserving the

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 species. People wish to maintain or improve environmental assets out of sympathy for

animals and nature or from moral conviction. Example; Protection of endangered

species

Figure 4.1 TEV of environmental benefits

4.3. Approaches to measure values (Valuation Techniques)

What is Environmental Valuation?

 Environmental valuation can be defined as the process of assigning quantitative

values to the benefits provided by the environmental and natural resources.

 Concerned with the analysis of methods for obtaining empirical estimates of

environmental values, such as the benefits of improved river water quality, or the cost

of losing an area of wilderness to development.

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  Environmental valuation is the process of placing monetary value on the

environmental impact. It can also be defined as pricing of environmental impacts

such as environmental degradation.

Economic value of any benefit is measure in terms of what the minimum amount an

individual is willing to give up the consumption of goods and services in order to obtain some

other goods and services. The inclusion of monetary estimates of the economic value of non-

marketed environmental and natural resources allow for more formal consideration of these

values in the decision making for natural resource management.

An obvious basis for economic value is given by the willingness to pay and receive payments

for items exchanged in market transactions. For goods and services that can be sold at the

market, the value of the goods or services to be consumed is easily referred from its price in

the market. Environmental and natural resources like food, timber, energy, recreation, and

materials for which there are economic markets can be most easily valued and are most

tangible.

However, the majority of the flow goods and services associated with environmental and

natural resources are non -marketable goods for which prices and monetary values are

difficult to obtain. For instance the provision of water by watersheds, pollination of crops by

birds and bees, filtering pollutants by wetlands, coastal protection by wetlands and seaside

vegetation, and aesthetic values are not exist in any economic market. But economists

develop techniques that used to value non-marketable environmental and natural Resources.

 Environmental valuation is largely based on the assumption that individuals are

willing to pay for environmental gains and, conversely, are willing to accept

compensation for some environmental losses.

The Need to Value the Environment

33
There are two reasons why we need to value the environment;

1. Environment providing value to human being (it is base for life)

2. Many environmental goods and services have no market prices

Measuring damage is simple than measuring benefits, because benefits are not typically

market transaction. We can measure damages directly, by looking at damages and the value

of what is lost, or we can infer damages indirectly from the behavior of individuals.

4.3.1. Economic Valuation Techniques

Many environmental resources and services do not have well defined property rights. For

example clean air, such resources are used but without traded through market and will not

have market prices. But the resource has value despite the lack of price. It has either negative

or positive value since it brings a positive or negative change on the well-being of the society.

In order to make efficient decision, such values need to be estimated through different

environmental valuation techniques.

Methods for measuring values (non-market valuation) of environmental goods and services

may be classified in to two broad categories.

1. Revealed Preference Approach: infer the value of environmental goods from other

market transactions. They are also called observed Methods, indirect proxy methods,

surrogate market approaches. Data obtained from observations of people acting in real-

world settings. They are based on actual behavior of people reflecting utility

maximization subject to constraints.

 Note that revealed preference approaches get at use values, but not non-use values.

Example: it is possible to use revealed preference approach for consumptive use

34
 values of farming, forestry, fishing, grazing, hunting, mining, that contribute to

resource depletion.

 It includes travel cost, simulated markets and market prices and hedonic pricing.

2. Stated preference techniques: ask individuals hypothetical questions about their

willingness to pay. They also called Hypothetical methods.

 A stated preference method of valuation involves finding an individual‟s willingness

to pay for goods by posing a set of questions regarding preferences directly to the

individual.

 What would you do if …?

 How much would you be willing to pay for …?

 It includes contingent valuation methods (CVM), contingent ranking and choice

experiment.

Willingness to Pay (WTP)- is the maximum amount of money an individual would give up

in exchange for all the benefits associated with an environmental resource.

• It is the value placed on an environmental good in terms of money.

• We can think of WTP as the area under an individual‟s demand curve.

• That is, an individual can be said to be willing to pay an amount equal to the total

benefits received from the environmental good.

Willingness to Accept (WTA) - is the opposite of WTP. It holds in the case in which the

individual is the owner of the resource. WTA is the minimum total amount of money an

individual would accept to forego all the benefits associated with an environmental resource.

Example: if there is pasture land used by some farmers for grazing and that area is potential

35
for underground water extraction, then WTA what the farmer claim to leave the land. Since,

WTP is bounded by an individual‟s budget constraint we can assume: WTP<WTA.

4.3.2 Revealed Preference Approach

These are based on the observed behavior of individuals with respect to related markets.

Examples,

Travel Cost Method (TCM)

The travel cost model is a method for valuing environmental resources associated

with recreational activity and was first proposed by Harold Hotelling in 1947.

TCM derives the value of a recreational site from revealed information on the

time and costs people spent to get there. The basic premise is that travel cost to a

site can be regarded as the price of access to the site. Mainly used in outdoor

recreation, fishing, hunting, boating, national park

The travel cost method looks at how far visitors travel to come to a site. By placing a value

on the cost of travel, we can infer the value of the site. The travel cost includes both direct

costs (e.g. airfare) and indirect costs (e.g. the opportunity cost of travel time).

Travel cost for individual i to site j, Cij

Cij = DCij + TCij + Fj, i=1, …, n; j =1, …, m

DCij = distance costs

TCij= time costs (opportunity cost of labour)

Fj = entrance fee

It needs survey on the following questions:

36
 – How many days did you use the site?

– Where are you from?

– How much did it cost to get there?

– What is the total length of your stay?

Advantages of the TCM include:

 Closely approximates the more conventional empirical techniques used by

economists to estimate economic values based on market prices.

 The method is based on actual behavior rather than what people say they would do in

a hypothetical situation.

 The method is relatively inexpensive to apply.

Some problems with TCM:

 Multi-purpose trips: The simplest models assume that individuals take a trip for a

single purpose, to visit a specific recreational site. Thus, if a trip has more than one

purpose, the value of the site may be overestimated and it can be difficult to apportion

the travel costs among the various purposes.

 Defining and measuring the opportunity cost of time, or the value of time spent

traveling, can be difficult.

 The availability of substitute sites will affect values.

 Those who value certain sites may choose to live nearby. If this is the case, they will

have low travel costs, but high values for the site will not be captured by this method.

Hedonic Pricing Method

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The hedonic pricing method is used to estimate the value of environmental amenities that

affect prices of marketed goods. For example, it can be used to estimate economic benefits or

costs associated with environmental quality, including air pollution, water pollution, or noise

and environmental amenities, such as aesthetic views or proximity to recreational sites.

The basic premise of the hedonic pricing method is that the price of a marketed good is

related to its characteristics, or the services it provides. The method is based on the

assumption that the prices people pay for goods are influenced by the set of characteristics

that they consider important when purchasing the good.

The HPM may be used to estimate economic benefits or costs associated with:

 environmental amenities (such as aesthetic views or proximity to recreational sites)

or,

 Environmental quality (including the effects of air, water pollution, or noise

pollution).

In general, the price of a house is related to the characteristics of the house and property

itself, the characteristics of the neighborhood and community, and environmental

characteristics. For example, if all characteristics of houses and neighborhoods throughout an

area were the same, except for the level of air pollution, then houses with better air quality

would cost more. This higher price reflects the value of cleaner air to people who purchase

houses in the area.

Estimation of hedonic price function

Ph = f (Si, Nj, Ak, Qm)

Ph = house price

Si = site/property characteristics (rooms, garage, garden, etc.)

38
 Nj = neighbourhood characteristics

Ak = accessibility (link with other neighbourhoods)

Qm= environmental quality

The HP function tells us by how much property price changes for a change in environmental

quality.

Advantages of the HPM include:

 It can be used to estimate values based on actual market transactions. Since, property

markets are relatively efficient in responding to information, so can be good

indications of value.

 The method is versatile and can be adapted to consider several possible interactions

between market goods and environmental quality. Moreover, estimated values

obtained from one study can be used in other policy areas.

 The method can be adapted to consider several possible interactions between market

goods and environmental quality.

Disadvantages of the HPM include:

 The scope of environmental benefits that can be measured is limited to things that are

related primarily to housing prices.

 The method only captures people‟s WTP for perceived differences in environmental

attributes and their direct consequences. If people aren‟t aware of the linkages (lack of

perfect information), the value will not be reflected in home prices.

39
  The method assumes that people have the opportunity to select the combination of

features they prefer, given their income. However, the housing market may be

affected by outside influences, like taxes, interest rates, or other factors.

4.3.3 Stated Preference Approach

Contingent Valuation Method (CVM)

The Contingent Valuation Method (CVM) is used to estimate economic values for all

kinds of ecosystem and environmental services. It is a direct method of valuation.

This method uses interview techniques to ask individuals to place values on

environmental goods and services. The most common approach in the CVM is to ask

individuals the maximum amount of money they are willing to pay (WTP) to use or

preserve a good or service. Alternatively the respondents could be asked the

maximum amount of money they are willing to accept in compensation (WTA) to

forgo the given environmental good or service

It can be used to estimate both use and non-use values, and it is the most widely used

method for estimating non-use values. Examples of CVM applications include:

 improvements in water quality for fishing or swimming

 improvements in visibility from reduced pollution

 preservation of endangered species

The key elements of a CVM survey are:

 A description of the good to be valued. The situation before and after any proposed

change in environmental quality and subsequent provision of the good/service should

be clearly stated.

40
  A detailed description of the “payment vehicle”, i.e. the means by which the

respondent would pay for the change in provision of the good/service. The most

common payment vehicles are user fees and tax increases.

 The procedure to elicit the respondent‟s valuation. The actual valuation can be

obtained in a number of ways, for example, asking the respondent to name an amount,

having them choose from a number of options. The respondent could also be asked

whether they would pay a specific amount.

Some problems in CVM

 Strategic bias: respondents may over- or under-state bids to influence possible

outcomes or not telling the truth (Individuals may report benefits higher or lower than

their true benefits)

 Framing Bias: People's answers may vary according to the context in which a

question is put.

 For example, answers to a WTP question may differ depending on whether

the starting point of the initial value is $0 or $100.

 For example… start: $0 or start: $100 response: $10 response: $110

 Not well- formed Preferences: People may not have well-formed preferences (e.g.

WTP and WTA) for unfamiliar goods. Since, Survey respondents often have very

little prior knowledge of the amenity to be valued.

 Not well- formed Preferences: People may not have well-formed preferences (e.g.

WTP and WTA) for unfamiliar goods. Since, Survey respondents often have very

little prior knowledge of the amenity to be valued.

41
  The observed discrepancy between willingness to pay (WTP) and willingness to

accept (WTA).

Other techniques

 The loss of agriculture productivity from soil erosion (productivity loss);

 Medical expenditure due to air pollution (cost of illness);

 Averting or mitigating environmental impacts (response/preventative cost);

 Replacing environmental goods or services (replacement costs);

Replacement costs: Potential expenditures incurred in replacing/restoring the function of the

environmental resource that is lost is used as proxies for environmental resource and

ecosystem values.

 Cost per unit of output (cost-effectiveness); and

 A close substitute (substitute costs).

 Damage costs avoided: The method attempts to value the functions of environmental

goods and services by estimating the costs (e.g. flood prevention) that would be

incurred if the environmental service (e.g. catchment function) were not present.

42
 CHAPTER FIVE: OPTIMAL RESOURCES ALLOCATIONS

5.1. Allocation of natural resources

Natural resources can be defined as natural assets or endowments from which we derive

value (utility). A broad definition would include environmental assets such as wilderness

which, while they can be destroyed by human activity, do not have to be consumed in order

to have value. We could also include the environment as a provider of ecosystem services or

as an assimilator of waste. Here we adopt a narrower definition, however, and focus on

natural resources that must be extracted or harvested in order to have value, either directly or

as inputs into production processes. Natural resources are broadly classified in to two:

Renewable and Nonrenewable resources.

In general, because natural resources are stocks they are extracted or harvested over more

than one period. The efficient and optimal use of natural resources therefore has an inherent

time dimension. Economic efficiency is classified in to two:

a. Static efficiency: concerned with allocation of resource in specific point of time

(ignores time factor).

b. Dynamic efficiency: concerned with allocation of resource over a period of time.

Two important facts make efficiency a point of concern in natural resource and

environmental economics

i. The natural environment is a complex system of resource stock, which provides a

variety of valuable service flows to society.

ii. Environmental resources are available in limited quantity.

43
5.2 Allocation of Non-Renewable Resources

Non Renewable resources: are those which do not exhibit economically significant rate of

regeneration. The quantity of these resources tends to be fixed for a fairly long period of time

(hundreds of years). They are resources whose potential resources can be exhausted.

 Non-renewable resources include fossil-fuel energy supplies like oil, gas and coal

and minerals copper and nickel.

 They are formed by geological processes over millions of years and so, in effect,

exist as fixed stocks which, once extracted, cannot be renewed.

Their depletion rate is affected by the demand for and the durability of the products built with

the resources and the ability to reuse the products.

 Except where demand is totally price inelastic, higher price tend to reduce the

quantity demand.

 Durable product last longer, reducing the need for newer ones

 Reusable products provide a substitute for new products

5.2.1. Measurement of Stock of Depletable Resources

Three classifications of exhaustible resources:

 Current Reserves: is the total quantity (stock) of known resources reserves that

can profitably be extracted at current prices. The magnitude of these current

reserves can be expressed as a number. If you have part of that resource which

cannot profitably exploited, it is not part of the current reserve.

 Potential Reserve: is the resource that you can potentially extract or reserves that

could be recovered at higher prices. The amount of resource potentially available

44
 depends up on the price people are willing to pay for those resources. The higher

the price the larger the potential reserve. These are most accurately defined as a

function rather than a number

Q = f (P)

 Resource Endowment: represent the natural occurrence of resource in the

earth‟s crust. The entire geological supply of resources (including those not yet

discovered). Since prices have nothing to do with the size of the resource

endowment, it is a geological rather than an economic concept. It represents the

upper limit on the availability of terrestrial resources.

5.2.2. Measuring Resource Scarcity

Possible Measures of Resource Scarcity

1. Reserve- to-use ratio (a physical indicator):

If consumption is per year this ratio indicates the time that is left until the resource is

depleted. If the ratio is 30 it means that with the current consumption rate 30 years is left for

the resource to be depleted. There is no economic concept in it.

2. Real resource price:

We could use price as indicator of scarcity. But if you want to use price as a measure of

scarcity, you will be advised to use the real price. Price tells us a number of things.

If the real price of the resource increases over time, it implies the resource becomes more and

more scarce. Change in price over time is an indicator of the supply of that good.

45
  Although price is a best measure, it has some problems. Sometimes price

may not reflect the scarcity of the resource. This is true under the

following situations.

 Price control- lead to artificial prices so we could not use prices as a measure

of scarcity

 Subsidy-if government subsidize, prices becomes low not because the

resource is cheap but it is subsidized.

Under such situations price do not tell us the scarcity of the resource. Price is a good indicator

of scarcity when we have competitive market.

3. Marginal Extraction Cost (MEC)

It is the additional cost of extracting a unit of resource. As the resource becomes more and

more scarce, we will expect MEC to increase because as we extract more and more of non

renewable resource, we go deep to get some more resource which in turn increases cost of

extraction.

5.2.3 The Hotelling Model of Resource Depletion

 Hotelling (1931) showed that the price for a nonrenewable resource will rise at

the real interest rate in efficient market equilibrium. The central question in

non-renewable resource economics is: given consumer demand and the initial

stock of the resource, how much should be harvested in each period, so as to

maximize profits?

 Assume the extraction cost and the price P of the resource in the market. Risk

free interest rate on the investment in the economy is r% per year. Then the

owner of the resource can either extract today or hold it to extract in the future.

46
There are two factors influencing extraction decision here; any resource extracted today not

available in the future, and any resource left untouched may fetch higher price in the future.

There are two comparable advantages for the owner; rate of interest and the increase in

price in the future.

 If rate of interest is greater than the increase in price per unit, it extracts today and

invests the money.

 If otherwise it holds the resource to extract in the future and get higher return.

 Since a reallocation of extraction from a period with a lower discounted price to a

period with a higher discounted price would increase present value.

 From Hotelling‟s perspective competitive mine owners, maximizing the present value

of their initial reserves, would be forced to extract so that price rose at the rate of

interest.

Exercise 2:

If today‟s gold price is USD 804.20 and some analysts expect it to reach USD 850 in one

year‟s time, would a gold mine owner with an interest (discount) rate of 8 % go for a high or

low extraction rate today?

Given today‟s gold price P0  804.20 and

Expected Price P1= 850

N= one year and

Discount (interest) rate r  8% ,

a) Present value of gold price one year is = 850/(1+0.08)

= 850/1.08

47
 = 787.03 Then, The current price of gold is 804.2 and

the present value of 850 UDS one year is 787 USD which is less than the current price which

is 804.2 USD. Hence, the gold mine owner will go for high extraction today.

 Note: The relationship between interest rate with price, extraction rate and life time of

the gold, Hotelling showed under the assumption of a perfectly competitive

environment with zero marginal costs and constant demand, prices should grow at the

rate of interest a result which has become known as the Hotelling rule.

5.2.4 The Costs of Extraction

There are two costs to using a resource (e.g. oil), today:

1. Extraction cost

• How much does it cost to obtain the resource?

• Obviously, only sell if P ≥ MEC (marginal extraction cost).

2. User cost

• The opportunity cost of not having the resource to sell in the future

• As a result, the price of the resource will be greater than the MEC.

The owner of a resource, such as oil, has two options to make money for next year:

1. Sell all the oil now, and invest the profits at interest rate i.

2. Wait and sell the oil next year.

In order to make wise decisions, let us look at two cases.

Case A: Expected price next year rises less than the rate of interest:

48
 • P1 – MEC > (P2- MEC)/ (1+i), the owner of the oil is better off selling the oil

now and investing it.

• Leads to lower prices now (greater supply) and higher prices next year (lower

supply).

Case B: Expected price next year rises faster than the rate of interest:

• P1 – MEC < (P2 - MEC)/ (1+i), the owner of the oil is better off waiting to

sell the oil next year.

• Leads to higher prices now (lower supply) and lower prices next year (higher

supply).

• Prices adjust whenever one option (case A or B) looks better. Thus, equilibrium is

reached when the expected price of the oil rises at the rate of interest.

• P1 – MEC = (P2 - MEC)/(1+i), or

• (1 + i)(P1 - MEC) = (P2 - MEC)

49
 5.3. Allocation of Renewable Resources

 Renewable Resources: are those for which the stock can be continually replenished.

 They have a capacity to replenish or regenerate. They are those that have significant

rate of regeneration.

 I.e. for a renewable resource, growth is assumed to take place at “a significant rate”

when viewed from man‟s economic time scale. E.g. if red wood trees regenerate, but

at an insignificant rate, they might be regarded as a non renewable resources.

However, some renewable resources like living populations, such as plants and animals are

also exhaustible if not managed effectively. The growth or decline of these populations in

general depends on the size of the population.

 If through human activity, the population is drawn down beyond the crucial threshold,

the species can become extinct. This is of curse one of the crucial renewable resource

management issue.

For the resource to be regarded as renewable

 It should exhibit economically significant rates of regeneration and

 Their rate of regeneration should be seen in short period of time.

Renewable resources (plants and animals)

 Their continuation and volume of their flow depends crucially on humans.

 They are use dependent (i.e., significantly affected by human activity) e.g. fishery, wild

life, forests.

 Improper use of these resources will lead to extinction of the resources.

Note that the size of these resources depends on

- Biological factor- reproductively

50
 - Human action- level of utilization of the resource

Essential features of Renewable Resources

 Its stock can be increased or decrease: it will increase if the stock is allowed to regenerate

however there is a maximum stock. i.e. no renewable resource can regenerate to the level

above the carrying capacity of the ecosystem

 Renewable resources can be disappeared if the rate of harvest exceeds the rate of natural

growth rate of resources.

5.3.1. The Forest Resource

Forests represent a storable renewable resource. Forests products provide a wide variety of

inputs to our society. Forests:

 Serve as raw material for housing and wood products such as paper products

 Serve as an important source of fuel

 Cleans the air by absorbing CO

2

 Shelter for wild life

 Maintain the watersheds.

Despite all these benefits, a glance at some of the vital signs of the forest resource does not

inspire confidence that is being managed either efficiently or sustainably. Deforestation is

currently proceeding at an unprecedented rate. In 1992 the World Resource Institute reported

that 42 million acres of tropical forests are being destroyed each year as trees are cut for

timber and for clearing land for agriculture and development.

 Deforestation is a serious problem because it has intensified global warming, has

decreased biodiversity, has caused agricultural productivity to decline, has

increased soil erosion and desertification, and has precipitated the decline of

traditional cultures of people indigenous to forests.

51
  Timber shares with many other animate resources the characteristics that it is both

an output and a capital good. Trees, when harvested, provide a saleable

commodity, but left standing they are a capital good, providing for increased

growth the following year. As trees mature very slowly, the manager must decide

not only how to maximize yields on a given amount of land, but also when to

harvest and replant.

Defining Efficient Management

Biological Dimension:

 Trees growth is measured on a volume basis, typically cubic feet, on a particular

site.

 Age-volume relationship is represented by:

S  40t  3.1t 2  0.016t 3

 Volume is a simple (cubic) function of stand age or time.

 Based on this measurement of volume, the data reveal that tree stands go through

distinct growth paths. Initially, when the trees are very young, growth is rather

slow in volume terms. A period of sustained, rapid growth follows with the

volume increasing considerably. Finally, slower growth sets in as the stand fully

matures, until growth stops or even reverses.

52
 Figure 18.1(a) The volume of timber in a single stand over time

25000

20000
Volume of timber

15000

10000

5000

0
0
4.0
8.0
12.0
16.0
20.0
24.0
28.0
32.0
36.0
40.0
44.0
48.0
52.0
56.0
60.0
64.0
68.0
72.0
76.0
80.0
84.0
88.0
92.0
96.0
100.0
104.0
108.0
112.0
116.0
120.0
124.0
128.0
132.0
136.0
140.0
144.0
Years after planting

t = 135 years

Figure 18.1(a) plots the volume of timber over a period up to 145 years after planting, an

early phase of slow growth in volume is followed by a period of rapid volume growth, after

which a third phase of slow growth takes place as the stand moves towards maturity. The

stand becomes biologically mature (reaches maximum volume with zero net growth) at

approximately 135 years. The estimated timber growth equation shows that growth becomes

negative after (approximately) 135 years.

When should this stand be harvested?

 Foresters have come up with a calculation called the Mean Annual Increment (MAI)

which provides the bases for a biological approach to answering this question.

 MAI is calculated by dividing the cumulative volume of the stand at the end of each

decade by the cumulative number of years the stand has been grown up to the decade.

 Mean annual increment (MAI): Mean increase (average product) in timber volume.

MAI = V (t)/t.

53
  According to the biological decision rule, the forests should be harvested at the age

when the MAI is maximized.

5.3.2. The Fishery

 Fishery can be defined as the interaction of fish populations and human harvest activity.

The economically valuable portion of a fish population is a renewable but potentially

exhaustible natural resource. This is because the size of the fish depends on both

biological factor (re-productivity) and human action (level of utilization of the fish). i. e.

fishing reduces the stock of fish, which in turn reduce the rate of natural increase of the

fish population.

Growth Functions: The biological growth process

The biological characterization of the fishery rests on a model initially proposed by Schaefer

(1957). Schaefer model points a particular average relationship between the growth of the

fish population and the size of the fish population.

 The growth rate is the proportional rate at which the fish stock would grow

• The growth rate is small relative to carrying capacity and it is the

difference between population birth and natural mortality

54
Biological growth of fishery

Stock (X)
Xmax - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -

Xmin - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -

Xzero

Time
Three benchmarks:

 At X max the biomass is at its maximum, no more will be added because resource

has reached its carrying capacity, there is not enough food and space for a larger fish

population to live on. Under biological condition the fish grows until the carrying

capacity exhausts. When it is maximum death rate =birth rate.

 At X min  Real risk of population collapse and the population may not survive

 At X0 Population falls to Zero  goes to extinction

Critical depensation

 Suppose that we have a biological resource stock, whose size at time t is denoted

by X , or X (t). In the absence of harvesting, the dynamics of the resource stock or

t

the change in a renewable resource from period t to period t + 1 can be described

by the equation: X t 1 - X t  F(Xt ) - Yt

 The function F (Xt) was referred to as a net growth function.

55
  This function indicates the net amount of new biomass or additional numbers of fish

as a function of the current biomass or current number of fish, Xt. The equation simply

says that change in the resource stock depends on the current stock size (X or X (t)).
t

NOTE:

 If harvest exceeds net growth [Yt > F(Xt)], the fish stock declines (Xt+1 - Xt < 0),

 If harvest is less than net growth [Yt < F(Xt)], the fish stock increases (Xt+1 - Xt > 0)

Consider some habitat for fish which has carrying capacity (K) for fish. Begin with an

unexploited fishery in biological equilibrium (where X = k):

 Suppose that the harvest rate H exceeds even the highest possible population growth

rate for the fishery. Then population X eventually falls to zero. Fishers are “mining”

the fishery. When the harvest of fishery is sustainable?

o A catch level is said to represent a sustained yield whenever it equals the growth

rate of population, since it can be maintained forever. As long as the population

size remains constant, the growth rate (and hence the catch) will remain constant

as well.

o The highest rate of harvest H that can be sustained by the fishery occurs where the

growth rate of the fishery stock is at its maximum. This point is called maximum

sustainable yield (MSY).

 Maximum sustainable yield (MSY) ፡ defined as that population size which yields

the maximum growth. Hence the maximum sustainable yield is equal to its maximum

growth and it represents the largest catch that can be perpetually sustained.

 Maximum sustained yield (MSY) occurs when the rate of growth of the resource

reaches a maximum.

56
 Rate of growth

Fishery
stock X
0 MSY Xmax

Steady-State Equilibrium Harvest

Steady-state equilibrium harvest occurs where

Rate
harvest rate H = biomass growth rate F(X).

F(X*) = H H

F(X)

0 X* Fishery stock X

57
Many factors determine the rate of harvest (H)

 Amount of resource devoted to fishing (Effort, E)

- No. of boats and No. of days

 Size of resource stock (X)

- The larger the stock, the greater the harvest, other things held constant.

H= G (E, X) where H=harvest, E= effort, X=stock

Due to low fishery stocks With high fishery stocks

(Xlow), it takes a higher (Xhigh), it takes a lower
level of effort (E) to level of effort (E1) to
generate the same harvest generate the same harvest
rate. rate.

H = G (E, X)

Fishery
Stock X
0 Xlow X high

What has or can be done to optimally mange fisheries

• Aquaculture (controlled raising and harvesting of fish

• Raising costs of fishing by limiting fishing methods (When to catch, where to catch,

which fish to catch,…)

• Quotas (limiting Total Annual Catch, maybe for specific species)

• Taxes, Tradable quotas Etc.

58
 CHAPTER 6: THE ECONOMICS OF POLLUTION CONTROL

Pollution is a side effect of production. Pollution is defined as the introduction of waste and

harmful products in to an environment that is classed as undesirable. The economics of

pollution control deals with; how severe should environmental standards be for: air quality,

surface water quality, drinking water quality and any other pollutant. In this unit we back to

the flow of wastes in to the system focusing on:

1. What is the appropriate level of waste flows?

2. How to allocate the flows?

6.1 Pollution Taxonomy

- Pollution is the introduction of contaminants into a natural environment that causes

instability, disorder, harm or discomfort to the ecosystem i.e. physical systems or

living organisms. Pollution can take the form of chemical substances or energy, such

as noise, heat, or light.

- Pollutants, the elements of pollution, can be foreign substances or energies, or

naturally occurring; when naturally occurring, they are considered contaminants when

they exceed natural levels.

- The damage caused by waste disposal depends crucially upon the environment's

ability to absorb the waste. The absorptive capacity refers to the environment's ability

to absorb waste products.

59
Examples of absorptive capacity:

 Carbon dioxide is absorbed by plant life

 Organic pollution in waterways can be transformed into less-harmful inorganic

matter by bacteria in the waterways.

If emissions exceed the absorptive capacity of the system, they will accumulate in the

environnent and cause damage.

- Pollution may be defined as the presence/release of certain substances (harmful

environmental contaminants) beyond the absorptive capacity of the earth.

- Most of the substances that cause pollution are naturally present in the environment in

low concentration, and are usually considered to be harmless. Thus a particular

substance is considered as pollution only when its concentration is relatively high and

cause adverse effects.

6.2 Type of Pollutants

A pollutant is a waste material that pollutes air, water or soil.

- Three factors determine the severity of a pollutant:

 its chemical nature,

 the concentration, and

 The persistence.

Depending on the capacity of the environment to absorb waste pollutants can be classified in

to two as:

a. Stock pollutant is a pollutant for which the environment has little or no absorptive

capacity. E.g.

 Non-biodegradable bottles

60
  Heavy metals (e.g., lead)

 Some synthetic chemicals (dioxins and PCB‟s)

b. Fund pollutant is a pollutant for which the environment has some absorptive

capacity. Examples:

 Carbon dioxide

 Waste paper products

6.3 The Efficient Allocation of Pollution

Question: What is the appropriate level of pollution?

• Recall that the optimal level of pollution is not zero.

We need to consider the marginal costs and marginal benefits of pollution.

 The efficient level pollution abatement (or the optimal level of pollution control)

occurs where the marginal abatement cost (MAC) is equal to the marginal damage

cost (MDC).

i.e. MAC = MDC

- The marginal abatement cost (MAC) is the cost of abatement or controlling an

extra unit of pollution. It is also known as the marginal control cost.

- Note that there is a negative relationship between MAC and the quantity of pollution.

The higher the MAC, the lower the quantity of pollution; and vice versa.

61
Cost of pollution MAC

Quantity of pollution

- The marginal damage cost (MDC) is the health or environmental damage caused by

an extra unit of pollution it is also known as the marginal pollution cost.

- Again note that there is a positive relationship between MDC and the quantity of

pollution. The higher the quantity of pollution, the higher the MDC, and vice versa.

- Graphically, the MDC doesn‟t start at zero but at positive amount of pollution because

of the ability of the environment to assimilate certain amount of pollution without any

damage.

62
Cost
MDC

Quantity of pollution

- Graphically, efficient pollution abetment occurs at the intersection of the MAC and

the MDC curves, such as at point Q* in the graph below.

- At points below Q* such amount spent on controlling pollution (MAC) is greater than

the damage due to pollution (MDC). Therefore , the incentive is to reduce the amount

spent on controlling pollution, MAC, thereby raise the quantity of pollution and move

towards Q*.

- On the other hands, at points above Q*, the damage caused by pollution (MDC) is

greater than the amount spent on controlling pollution (MAC). Therefore, the

incentive is to reduce the damage, MDC, by reducing the quantity of pollution, and

move towards Q*.

- Equilibrium will, therefore, occur at Q*, where MAC = MDC, because that is where

the market forces of MAC and MDC will be balanced such that there is no incentive

to change.

63
 Recall that Equilibrium is a situation where market forces are balanced such that there is no

incentive to change. Hence, as long as MDC and MAC are equal, there is no incentive to

change.

Cost MAC
MDC

Total
Total abatement
Emission
cost (MAC)
charge

0 Q* Q0
Quantity of Pollution

- The Ecologist operates at X because they have zero tolerance for damage due to

pollution. The Capitalist; on the other hand, operate at Y because it is cheaper to

pollute than to have pollution abatement.

- The economic optimum occurs where MAC =MDC (or at Q*). At this point, the

damage is not zero, nor the amount be paid for contorting is zero.

6.4 Pollution Control Policy Measures

The techniques used by regulatory agencies, such as the Environmental Protection Agency (EPA), to

control pollution range from charges for the right to pollute to regulations that impose limits to the

amount of a pollutant. Among these are the following:

64
I: Emission Standard

An emissions standard is a legal limit on the amount of a pollutant that an individual source is

allowed to emit. Similarly, it is Limits established by government on the annual amounts and kinds

of pollutants that can be emitted into the air or water by producers or users of certain products.

This is referred to in the literature as the "command and control approach." A uniform

standard is not cost-effective in this case. It is unlikely that the government would be able to

determine the cost-effective allocation.

II: Emission Charge

An emissions charge is a fee, collected by the government, levied on each unit of pollution

emitted.

It is better than emission standards in a number of ways:

• The firms now control in the least cost manner relative to each other, without the

government knowing the costs of pollution control for each firm.

• An iterative method can be used to achieve the efficient allocation by comparing the

pollution abatement goal with actual impacts.

• Firms have an incentive to adopt new technologies in pollution control, while

standards create incentives for firms to hide new control technologies.

The problem with emissions charges is that finding the efficient level can be costly and time

consuming.

III: Transferable Emission Permits

65
Under a transferable emissions permit system, all sources are required to have emissions

permits matching their actual emissions, with each permit

o Specifying how much the firm is allowed to emit and

o Being freely transferable.

Under this system the control authority issues exactly the number of permits needed to

produce the desired emissions level. Severe monetary permit are imposed upon sources

polluting in excess of the amount allowed by its permits. Notice that trading yields the most

cost-effective allocation of clean-up among the two firms. Initial allocation of permits does

not affect efficiency: it only has distributional consequences.

Question: What are the distinctions among standards, permits, and charge systems?

 Standards are not only information intensive or likely no cost effective, but they also

are less likely to encourage innovation in pollution control.

 Permit systems adjust automatically, while the charge system must iterate to a

solution

Problems for charges versus permits:

 Charges do not react to changes in the number of sources.

o Adding sources will not change the permit result, just the value of the permits

being traded.

o Adding sources will increase pollution in the absence of changes in the charge

system.

o Charges will not react to inflation unless they are modified. Permits will

automatically adjust.

o Permits will not enable technological change in pollution control to alter the

overall level of pollution, but a charge system will.

66