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Chapter 2

The Economic Approach:Property Rights,

Externalities, and Environmental Problems

© 2012 Pearson Education, Inc. All rights reserved. 2-2

Chapter 2 The Economic Approach:Property Rights, Externalities, and Environmental Problems

• Introduction• The Human-Environment Relationship• Environmental Problems and Economic Efficiency• Property Rights• Externalities as a Source of Market Failure• The Pursuit of Efficiency• An Efficient Role for Government


Introduction

• This chapter introduces the general conceptual framework used in economics to approach environmental problems.


The Human—Environment Relationship

• The Environment as an Asset–The environment is viewed as a

composite asset that provides a variety of services.

–E.g., environment provides raw materials, goods and services; and energy. • Goods and services: biodiversity, air, water,

wetlands etc.


The Human—Environment Relationship

– Inputs are used to produce outputs. Household consume inputs, firms use inputs to produce outputs.• Direct Consumption: Air, Water, Recreation etc.• Inputs to production: Oil, Natural Gas, Minerals,

Timber etc.

–Outputs recycled back to the inputs. (e.g., paper recycled and go back to become raw materials.)


FIGURE 2.1 The Economic System and the Environment


Environment as an Asset

• The relationship between environment and the economic system can be considered a closed system.

• Closed system vs. Open system• Closed system: A system where there are no inputs

and no outputs of energy and matter received/used from outside the system. (E.g., we use all the raw materials from that is available in the earth)

• Open system: A system which imports or exports energy or matter from outside. (E.g., importing things from outer space.)


• Implication of treating our planet as a closed system => two laws of thermodynamics that govern the environment.

1. The first law of thermodynamics• Energy and matter can neither be created

nor destroyed.



1. The first law of thermodynamics• Energy and matter can neither be created

nor destroyed.–The mass of materials flowing into the

economic system from the environment has either to accumulate in the economic system or return to the environment as waste.

–Excessive waste can depreciate the asset => climate change can lead to flooding in coastal areas; smog can deteriorate scenic areas etc.



FIGURE 2.1 The Economic System and the Environment


– The first law of thermodynamics• Coal-fire electricity plants (Common and

Stagl, 2005):– The coal is heated which produces electricity.– A byproduct of this process is waste heat that

is transported away as cooling water or gases.– In addition, various waste gases are emitted

into the atmosphere, which causes, pollution, such as acid rain.



2. The second law of thermodynamics: “entropy increases”• The amount of energy unavailable for work

increases.• i.e., Conversion from one form of energy to

another is not completely efficient; and the consumption of energy is an irreversible process.

• It is also called as entropy law.– E.g., Increased extraction of minerals by the

production process leads to an increase in wastes.



• In what way should we utilize these services?–The optimal use depends on the efficiency criteria that we follow.

–It is important to distinguish between what should be done and what is being done.

Definitions


• The Economic Approach1. Positive Economics

• An attempt to describe what is, what was and what will be.

–Current unemployment rate ~5% (Fact)

• Here is where the models come into play–What will happen if the price of corn

increases by 10%?–What are the consequences of

implementing a tradeable permit system on SO2 for utility companies?

Definitions


2. Normative Economics•Attempting to answer what ought to be.

•Normative economics often involve value judgement.

»That unemployment rate is too low/too high

»Should we use tradable permit system to control SO2 pollution? What is the best way of doing it?

Definitions


• Many times the two methods should be combined to provide policy recommendations.

• Example of positive and normative economics– Raising minimum wage to $10/hour

– If the minimum wage is raised to $10/hr, what will happen? (positive economics)

– Are these consequences what we prefer? If not, what should instead be done? (normative economics)

Definitions


Concept 1: Environmental Problems and Economic Efficiency

• Static Efficiency– The chief normative criterion to choose among

various outcomes at one point in time is called static efficiency.

– An allocation of resources is said to satisfy the static efficiency criterion if the economic surplus derived from those resources is maximized by that allocation.

– Economic surplus is the sum of consumer’s surplus plus producer’s surplus.


–Consumer surplus• Consumer surplus is the difference between

total willingness to pay for the good and the actual cost of the good. (What they are willing to pay and what they actually pay)

–Consumer surplus is measured as the area under the demand curve minus the consumer’s cost (price).

• Total willingness to pay is a measure of the total value received from a good.

Environmental Problems and Economic Efficiency


FIGURE 2.2 The Consumer’s Choice

Shaded area = Total Willingnessto pay


–Producer surplus• Producer surplus is the difference between

the amount that a seller receives minus what the seller would be willing to accept for the good

• The producer surplus is designated by area B, the area under the price line that lies over the supply curve, bounded from the left by the vertical axis and the right by the quantity of the good.



FIGURE 2.3 The Producer’s Choice


Economic Surplus


– Some points to note:-,• The demand curve measures how much a

person (or a group) is willing to pay for an additional amount of the goods or services. It measures the marginal benefit of utilizing the last unit of the the goods or services.

• The area under the demand curve is the total willingness to pay (WTP) for a certain amount of goods or services.

• The supply curve is the marginal cost curve for a competitive firm.



Economic Surplus

• The demand curve for a product is given by QD = 400-4Q and the supply curve is given by Qs = 4Q.


Economic Surplus

• Equilibrium price and quantity:400 – 4Q = 4QÞ8Q = 400Q* = 50 unitsP* = 4(50) = $200

• Consumer Surplus:(1/2)($400 – $200)*(50) = $5000

• Producer Surplus(1/2)($200– $0)(50) = $5000


Economic Surplus

• TWTP = (50*200) + (CS) = $15,000


Concept 2: Property Rights

• In economics, property rights refers to a bundle of entitlements defining the owner’s rights, privileges, and limitations for use of the resource.

• The manners in which consumers and producers use environmental resources depends on the property rights governing these resources.

• When property rights are not well defined, it creates inefficiency.


• Property Rights and Efficient Market Allocations– A property right is an entitlement held by either an

individual or a state.• Efficient Property Right Structures

1. Exclusivity—All the benefits and costs should only accrue to the owner.

2. Transferability—Property rights should be transferable from one owner to another in a voluntary exchange.

3. Enforceability—Property rights should be secure from seizure or encroachment by others. (No-one can take what belongs to you!)

Property Rights


• Well defined property rights create an incentive to use resources efficiently otherwise they face personal loss.– Farmers who own land have an incentive to

fertilize and irrigate it because the resulting increased production raises income. Incentive is to increase the value of that land.

– Resources for which the asset value cannot be captured will typically be overexploited (e.g., common pool resources).

Property Rights


• Well defined property rights create static efficient allocation.–Self-interested parties make choices that

are efficient from society’s point of view.

–Sellers try to maximize their surplus and sell at a price they think is best for them.

Property Rights


–Given that price, consumer try to maximize their surplus and decide how much to purchase.

–This maximizes the total economic surplus

• Static Efficiency => Efficient Allocation

Property Rights


FIGURE 2.4 Market Equilibrium


Under Perfect Competition– In the short run, producer surplus = profits +

fixed cost.

– In the long run, producer surplus = profits + rent.• Rent is the return to a scarce input owned by the

producer. • Under perfect competitions, long-run profits and

economic rent equal zero. – Long run profits equal zero because no entry

barriers and everyone enters the market until profits are exhausted.

Scarcity Rent


• Scarcity Rent– Most natural resource industries, however,

give rise to rent and , therefore, producer’s surplus is not eliminated by competition even with free entry.

– Scarcity rent is the producer surplus that persists in the long-run competitive equilibrium due to fixed supply of the resource.

Property Rights


Sources of Inefficiencies

• Externalities• Common pool resources• Public Goods• Imperfect Market Structures• Government Failure


Concept 3: Externalities as a Source of Market Failure

–Market failure can be the result of a property right system that fails to achieve exclusivity, transferability, or enforceability.

• If an agent making a decision does not bear all of the consequences (costs and benefits) of that decision, then the characteristics of exclusivity is violated. This results in what is know as externality.


Concept 3: Externalities as a Source of Market Failure

–Externalities exist whenever the welfare of some agent depends not only on his or her activities, but also on activities under the control of some other agent.•Externalities = third party effects•Example: A steel plant that pollutes a river used for recreation.


Concept 3: Externalities Example

• Consider a scenario where upstream, there is a steel mill dumping waste into the river water, while in the downstream, there is a hotel where the customers use the river for recreational activities.


Concept 3: Externalities Example

– If different owners for the two firms, efficient allocation is not achieved.

–Steel firm does not bear the cost of reduced business in hotel because of them dumping waste in the river. • Dump too much waste in the river• Negative Externality!


Concept 3: Externalities

• Marginal private costs (producer’s cost) = It is the cost of producing an additional unit of a commodity paid by those producing the commodity.– This is the firm’s private supply curve.

• Marginal external costs (everyone else’s cost): Any additional costs associated with the production of the good that are imposed on others but that producers do not pay.


Concept 3: Externalities

• Marginal social costs (all costs to the society) = The private marginal cost to producers plus the marginal external cost.

MSC = MPC + MEC


FIGURE 2.5 The Market for Steel

• If we ignore the externality, supply curve = private MC curve, (MCp).– Quantity = Qm

• Because, the producers of the steel mill do not pay the cost to the society (including for the reduction in tourists for the hotel), their cost curve is below the social cost.



• If we account for the impact of waste in the river for the hotel and the environment,– Higher social MC, (MCs)– Efficient allocation = Qm

lower than private allocation.



1. The private market equilibrium will be at a point where too much still is being produced. (Qm>Q*).

2. The private market reaches equilibrium, but does not take into account the third party effect (or damages in this case) to the downstream party.



3. At the private market equilibrium, marginal social costs are higher than marginal benefits, resulting in a deadweight loss.


• Conclusions from Figure 2.5:• The output of the commodity is too large. (Qm > Q*)

• Too much pollution is produced. (Steel mill does not bear the cost for dumping, so they dump too much waste.)

• The prices of products responsible for pollution are too low. (Efficient price = P*)

• No incentive to search for ways to yield less pollution per unit of output if costs are external. (Steel mill does not have any incentive to account for the environment/hotel business.)

• Recycling and reuse of the polluting substances are discouraged due to the cheap external cost.

Externalities as a Source of Market Failure


Types of Externalities1. External cost (external diseconomy)

• Negative externality• It imposes costs on a third party.

– Water pollution.

2. External benefit (external economy) • Positive externality• It imposes benefits on a third party.

– Scenic area, vaccines etc.

Overview of Externalities


Types of Externalities3. Pecuniary externalities

• It exists when the external effect (positive or negative) is reflected through changes in prices.

– New firm moves to an area and drives up the price of rental land.

– This creates a negative effect on all those paying rent.

Overview of Externalities


shrimp farming in thailand

In Tha Po Village in Thailand, more than 1100 hectares of mangroveswamps have been cleared for commercial shrimp farms.

- Private Benefits: Shrimp harvesting lucrative business.- Beneift of Mangroves: Storm protection, protection from soil

erosion, fish nursery.

- Social Costs: The villagers experienced decline in fish catch, and suffered storm damage and water pollution.


shrimp farming in thailand


shrimp farming in thailand: Private value of shrimp farmv/s mangroves


shrimp farming in thailand: Discarding the subsidies

As shrimp farmers are subsidized, they do not take into account external costs of pollution, so their profit is ~$9600.


shrimp farming in thailand: Public Lens v/s Private Profit

• The cost to restore the shrimp farm back to productive use was about $11,000.

• The benefit to the society in terms of storm protection, cyclone protection, fish nurseries was about $12,000

• Result: Fewer social benefit and high private benefit. => Inefficient allocation


Example of Externality

Assume energy is produced in a perfectly competitive industry. The industry inverse supply curve is estimated as MCP = P = 2Q. The inverse demand for energy is MBS = P = 40 – 8Q, where P is the price per kilowatt hour (KWh) and Q is the number of Kilowatt hours (KWh).


Example of Externality

1. Find the equilibrium price and quantity of energy produced by power plants.

2. Now, suppose that the power plants release suflur dioxide (SO2), which results in acid rain in areas outside the energy market (i.e., negative externality). The damage, or marginal external cost (MEC) is estimated to be $0.50 for each KWh produced (i.e., MEC = 0.50Q). Calculate the socially optimal level of output and price for the energy industry.

3. Graph your answers in part 1 and 2.


Types of property rights

• Property rights create different incentive for resource use (or misuse):– Private property regimes

• Individuals hold entitlement.

– State-property regimes• Governments own and control property. E.g., parks

and forests.– Common-property regimes

• Property is jointly owned and managed by a specific group.

• Common property regimes generally result in overexploitation of the resource.

• Over-fishing in local fisheries or over-hunting happens.


Types of property rights

– Open access regimes or Res nullius• No one owns or exercises control over the

resources.• Used on a first come, first served basis.

– Leads to “tragedy of the commons”– Mentality: If I don’t get it, someone else will =>

Individuals use it until the resource gets exhausted.


Tragedy of the commons

• “A dilemma arising from the situation in which multiple individuals, acting independently and rationally consulting their own self-interest, will ultimately deplete a shared limited resource, even when it is clear that it is not in anyone’s long-term interest for this to happen”


Market Failure: Common Pool Resources

• Open access regime:– Common pool resources

• Non-exclusive and divisible.– Non-exclusive: Resource can be exploited by

anyone. Access cannot be denied.– Divisible: Capture will be eliminated from the

original amount available. – E.g., Unrestricted hunting access of the American

bison, unregulated groundwater withdrawal etc.


Private v/s Public Goods

• Private goods are–Excludable: If you don’t pay, you won’t

get the good.–Rival: If you consume a certain amount

of the good there is less to consume for others.


Market Failure: Public Goods

• Public goods are – Non-excludable: If you don’t pay, you can still

get the good.• Nonexcludability refers to a circumstance

where, once the resource is provided, even those who fail to pay for it cannot be excluded from enjoying the benefits it confers.


– Indivisible (Non-Rival): You consumption of the good does not diminish the amount available for others.• Consumption is said to be indivisible when

one person’s consumption of a good does not diminish the amount available for others.

– Examples include Street lights, Charming landscape, Clean air, National defense, Biological diversity etc.



• Public goods will be underprovided in a private market because of free-riders.– A free-rider is someone who derives benefits

from a commodity without contributing to its supply.

– E.g., Someone who does not pay taxes cannot be excluded from the provision of national defense.



FIGURE 2.7 Efficient Provision of Public Goods (1 of 3)

Individual A’s demand curve (WTP) for preserving biodiversity = OA.



Individual B’s demand curve (WTP) for preserving biodiversity = OB.



• Market Demand = sum of individual demand.

• Assume constant MC


FIGURE 2.7

• Free market efficient allocation => (MC=MR) =(Q*)

• However now,– Different WTP (OA vs

OB)– B/c of no excludability,

consumers understate their WTP to place the burden on others.

– Free rider = inefficiency = Q* is not produced.


• Efficient level of diversity • The allocation that maximizes economic surplus is Q*

(in the previous graph), the allocation where the demand curve meets the marginal cost curve.

Public Goods


• However, competitive market would not result in efficient allocation:• Since people have different marginal willingness to pay,

the efficient pricing would require charging different prices.

• The producers would have no basis to differentiate the prices between person A and person B.

• Since the good is not excludable, consumers have an incentive to understate the importance of the good and place the burden to others.

• Thus, efficiency results because each person can become a free rider without paying an efficient amount for its supply.

• There is no financing and the good is undersupplied.

Public Goods


Market Failure: Imperfect Market Structures

• Markets that are not competitive will exhibit inefficiencies.

• Monopoly: when product is sold by a single seller. (MB>MC)


• A cartel is a group of producers who form a collusive agreement to gain monopoly power. E.g., OPEC restricts output and raises the price of oil to gain monopoly power.



–Monopolies will supply too little of a good at too high a price.

–At the monopoly output, marginal benefits are greater than marginal costs. Net benefits are not maximized and there is a deadweight loss.

–Monopolies tend to maximize producer surplus rather than the total economic surplus.



• In a perfectly competitive market,– Efficient point (Static

efficiency) at• MC=MB (Demand)• G*,B*

• Surplus:– Producer surplus = GCH.– Consumer surplus = IGC.– Total economic surplus =

IHC.



FIGURE 2.8 Monopoly and Inefficiency

• In a monopoly market,– MR lies below the demand

curve– Produce where MC=MR– Quantity supplied = OA– Price = OF



• In a monopoly market,– Producer Surplus = FEDH– Consumer Surplus = IFE– Total Economic Surplus =

IHDE

• Deadweight loss = ECD– Loss of economic

efficiency when equilibrium is not achieved.



Suppose, MB = 20-q; MC = q and MR = 40-2q.

Plug, MR = MC => 40 = 3qÞQ* = 40/3

Plug this Q in the demand curve to find the price.ÞP* = 20 – (40/3) => 20/3


Other sources of inefficiency: Government Failure

• Political Institutions can also be source of inefficiency.Government Failure–Rent seeking

• Rent seeking is the use of resources in lobbying and other activities directed at securing protective legislation.

– Take many forms like protection from imports, price floors (producers), price ceilings (consumers) etc.


Other sources of inefficiency: Government Failure

• Rent seeking behavior may persuade government officials to pursue options that are beneficial to a specific interest group and would not maximize social net benefits.

• Examples include agricultural producers seeking price supports, and consumer groups seeking subsidies.


• If you do not account for externality;– Private MC (MCp) = D

• (Qm, Pm)

• If you account for externality and impact on environment,– Social MC (MCs) = D

• (Q*, P*)– Efficient Allocation

FIGURE 2.9 The Market for Steel Revisited


• If the company ignores externality and only cares about subsidy,– Private MCp shifts down

b/c of subsidy• Increased production• Lower price• Higher pollution

• Deadweight loss = ABC– Increased environmental

inefficiency due to social policy.

FIGURE 2.9 The Market for Steel:Govt. subsidizes steel production market


The Pursuit of Efficiency

• Possible remedies environmental problems– Align the individual objective with societal

objective.

Private Resolution Through Negotiation• The simplest means of restoring efficiency • E.g., if a downstream firm is hurt by

upstream polluter, it could negotiate or bribe the upstream polluter to reduce pollution.

– “Victim Pays” [May not seem fair]


FIGURE 2.10 Efficient Output with Pollution Damage

If the resort offers a payment of C+D, would the steel company be better off by decreasing their production to Q*?

Currently, the steel company is producing Qm output.



If they refused the payment, the producer surplus = A+B+D

If the still company accepted the compensation, the producer surplus = A+B+ payment = A+B+C+D



The steel company is better off by C if they accept the payment.



• The negotiations raises two questions:1. Should the property right always belong

to the party who held it first (in this case the steel company)?

2. How can environmental risks be handled when prior negotiation is clearly impractical?



• The Courts: Property Rules and Liability Rules–Property rules specify the initial allocation

of the entitlement or property right.– Liability rules award monetary

compensation from an injurer to an injured party after damage has occurred.



• Property rights that are not well-defined can be corrected by courts.– In the absence of court, the entitlement is

seized by the party that can most easily seize it (e.g., Steel Firm).

• How can the courts decide whom to give the property rights to?

•The Coase theorem


• The Coase Theorem (Ronald Coase, 1960)– If negotiation costs are negligible and affected

parties can freely negotiate, then entitlement can be allocated by the courts to either party and an efficient allocation will result. • Coase implies that once property rights are

established, no government intervention is necessary.

• The problem is not the polluter polluting. The problem is both parties think their position is justified (polluter v/s victim).



• The Coase Theorem (Ronald Coase, 1960)– If the steel company had the property right, it

is in the resort’s interest to offer a payment that results in the desired level of output.

– If the resort had the property right, the steel company must pay the resort to pollute the river. (It must compensate all the damages to the resort).



• Problems with Coase Theorem– Willingness to Pay and Willingness to Accept

are different• You may not be willing to pay as much to avoid

damage as you would require in compensation to accept it.

– Costs of bargaining and transaction costs• Negotiation does not work when large numbers of

people are involved, or when the victims aren’t well defined (e.g., endangered species).



• When negotiation is not practical the court can turn to liability rule.– Here, the steel company could produce as

much as it wanted, but must compensate the resort for all the damage it incurred.

• Appropriately designed liability rules can also correct inefficiencies by forcing those who cause damage to bear the cost of that damage.



The Pursuit of Efficiency (cont.)

• Legislative and Executive Regulation• Several forms taken including taxes and

regulatory laws • Set quota on the amount of good to be

produced. • Put a cap on the amount of pollution emitted

– Carbon Permit• Zoning laws could establish separate areas

for steel plants and resort• Other options: consumer boycotts / strike by

employers or other means of imposing costs on the polluters.


Summary

• Efficient allocation• Inefficient allocation and externalities• Property rights• Improperly defined property rights system• Imperfect markets• Divergence of social and private discount

rate• Rent seeking

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