Topic 2: Market Efficiency and Sustainability 1

Learning Outcomes After this session you should be able to ◦ Apply some microeconomics concepts to the analysis of environmental issues ◦ Explain the equi-marginal principle and how this applies to finding the optimum level of output at the firm and sectoral levels and well as for society in general ◦ Explain the notion of social efficiency and how it differs from market efficiency ◦ Understand the issues around external benefits, especially the notion of public goods and why the market will under-produce public goods 2

Benefit-Cost Approach to Environmental Issues Economic and environmental actions have two sides: benefits and costs Benefits (or value) are measured by willingness to pay Costs can be measured via private, external and marginal costs 3

Benefit- Cost Analysis: Clean Air US EPAS Acid Rain Program 4

US EPAS acid rain program The annual benefits of Title IV of the Acid Rain Program in 2010 are $122 billion. 91% of the benefits are in the lives saved category (i.e., mortality) when lives are valued at $6 million. Using alternative, more conservative, estimates of lives saved would reduce this benefit by about half. Other important benefits are for reductions in illnesses (i.e., morbidity) and visibility. The annual costs of Title IV in 2010 are $3 billion, $2 billion for SO2 and $1 billion for NOx. The average cost of each ton reduction is about $250 for SO2 and and $125 for NOx. The annual net benefits are $119 billion, which is a big number. And this is for just one year. Aggregating the net benefits into perpetuity at a 10% discount rate gives us $1.19 trillion in net benefits (about 10% of annual GDP). 5

Analysing Benefits: Willingness to Pay The fundamental idea of benefit (or value) is tied to willingness to pay The total willingness to pay for a given consumption level refers to the total amount a person would be willing to pay to attain consumption at that level rather than go without the good entirely A Persons willingness to pay is determined by ◦ Individual values ◦ Ability to pay ◦ The number of units already consumed The Marginal Willingness to Pay describes the additional willingness to pay by an individual for one more unit of a good (Marginal Benefit) 6

Willingness to Pay Fig 1: The Concept of Willingness to Pay P Q Total Willingness to pay can be measured by the area under the demand curve.

The Demand Curve and Willingness to Pay An individuals willingness to pay curve coincides with the demand curve It provides a way of summarising personal consumption attitudes and capabilities of a particular individual for a particular good. What does a steep/flat demand curve say about MWP? Higher v lower demand curves? 8

The Slope of the Demand Curve Fig 2: Steep V Flat demand curves 9 P Q D1 D2

Higher V Lower Demand Curves Fig 3: High V Low Demand Curves 10 P Q D1 D2 What can this tell us about the demand for environmental quality? Environmental Quality is a normal good Individual tastes preferences? Income?

Willingness to Pay and Benefits Demand curves can be used to determine the benefit that individuals get from consumption Fig 4: Measuring Benefits 11 P Qq1q2 a b I1I1 I2I2 What is the total benefit of increasing Output of this good from q1 to q2 for individual 1 and individual 2?

Marginal Benefit/ Willingness to Pay People with higher demand curves place a higher value on the item. They are willing to pay more for it than the people whose demand is lower This idea is not perfect ◦ Willingness to pay and benefits are often hard to measure when it concerns environmental issues ◦ Demand curves/WTP are affected by ability to pay ◦ Individuals demand/WTP is affected by how much they know about the good Hence the of MB/Demand/WTP must be used with caution when applied to environmental issues 12

How much on average are US citizens willing to pay for higher water quality The average annual amounts per household (2000 dollars) for respondents were: ◦ Boatable $152 ◦ Fishable $ 194 ◦ Swimmable $ 225 There are about 80 million households in the United States. Assume that the sample results imply an annual willingness to pay of $200 per household to have high quality recreation waters throughout the country. This would imply a total willingness to pay of $16 billion. 13

Cost The production of goods and services require the expenditure of productive resources, or inputs in the process. Concept of opportunity cost: defined as the next best alternative foregone. It is the maximum value of the alternative output that could have been obtained had we used the resources differently Private V social costs ◦ Private costs are the costs experienced by the party making the decision leading to the action ◦ Social costs are all the costs of an action, no matter who experiences them 14

Now Back to Cost Curves Marginal cost is the increase in total cost when output increases by one unit Fig 5: Marginal Cost 15 Q Cost MC

Marginal Cost The key determinant of the location of the MC curve is technology (both human and technical capital) A technological improvement will lower the MC curve and total costs Technical change requires significant investment in R & D generally And is very significant for reducing environmental problems 16

Technical Improvement, MC and TC Fig 6: Calculating TC 17 Costs Output MC2 MC1 a b What are the total costs of producing q* at MC1? What are the total costs of producing q* at MC2? q*

Putting MB and MC together… The equi-marginal principle says the optimal level of production is where MB = MC, this is the point where net benefits are maximised This criterion helps minimise wasted resources This is an exceptionally important principle in natural resource and environmental economics 18

Economic Efficiency Economic efficiency means that there should be a balance between the value of what is produced and the value of what is being used up (MB=MC) Output is at a socially efficient level when MSB=MSC When a rate of output is at the socially efficient level, the net value, defined as total willingness to pay minus total costs, is as large as possible qe (see fig) is efficient because the marginal worth of a good (indicated by WTP) and what it costs to produce it (indicated by MC) are equated However, an outcome that is efficient may not be equitable 19

The Socially Efficient Rate of Output Fig 7: Measuring New Value 20 MSB MSC Pe qe Price Quantity a b c TWP at qe = a + b + c TC at qe =c Surplus = (a+b+c) –c= a + b

Do markets give socially efficient outcomes? Should we rely on markets to solve environmental problems? The case for relying on markets ◦ Already committed to a market based economy ◦ We do not have to accept the results that the market yields ◦ The market system contains incentive structures that can be harnessed to improve environmental quality 21

Market and Social Efficiency In a market equilibrium, the intersection of demand and supply, shows the rate of output and the market price for a particular product In a socially efficient equilibrium, MSB = MSC There is likely to be a very substantial difference between market values and social value with respect to environmental issues This is a market failure and requires government intervention Environmental effects create a difference between market demands and true social marginal willingness to pay (External Benefit problem) Environmental effects also create a difference between market supply and marginal social cost curves (External Cost Problem) 22

External Costs Firms generally take account of ‘private costs’ but not ‘external costs when making decisions about production Social Costs = Private Costs + External Costs Environmental destruction is generally related to external costs How do you assess whether there are external costs (externalities) or not? 23

External Costs and Market Outcome Fig 8: External Costs 24 P Q D MPC MSC qm Pm P* q* Em ES qm> q* Pm < P*

Costs of Freight Transportation List as many private costs associated with a freight transportation business List as many external costs associated with freight transportation 25

Private and Social Costs of Freight Transportation Private Costs ◦ Capital, labour, maintenance, fuel, depreciation, repairs, insurance, administration etc.. External Costs ◦ Accidents (fatalities, injuries, property damage) ◦ Emissions (air pollution & GHGs) ◦ Noise ◦ Congestion ◦ Provision, operation and maintenance of roads and bridges 26

Open Access Resources An open access resource is a resource or facility that is open to uncontrolled access by individuals who wish to use this resource Problem with defining property rights With open access resources, it is difficult to keep its rate of use to the level that will maximise its overall value 27

Social Benefit (SB) and Private Benefit (PB) SB = PB + EB External Benefit is a benefit that accrues to somebody who is outside or external to the decision about consuming or using the good or resource that causes the externality The market reflects only the private benefit The market willingness to pay for the item will understate the social willingness to pay The market undersupplies goods that provide external benefits 28

Summary We reviewed some basic tools in micro-economics that can be used to analyse environmental issues To assess the appropriate course of action we must consider the benefits and costs of this action On the benefit side the marginal willingness to pay (MWP) is very useful in measuring the benefit of a commodity to the individual but must be used with caution The marginal cost concept is a useful measure of costs associated with a particular action. The equi-marginal principle states that the ‘best’ output for a firm/society is where MB = MC 29

Summary We used the concept of economic efficiency in a wider sense to determine the socially efficient outcome (MSB=MSC) The market system does not always produce the output that is socially efficient This is because firms and consumers generally do not take account of external costs and external benefits Environmental quality is one type of good that requires non-market institutions to ensure its adequate provision 30

Required Reading Field & Field, Environmental Economics: An Introduction, ch.3 & ch. 4 31