Welfare Economics and the Environment (Ch. 5)

Introduction Welfare Economics: Provides framework for analysing many policy questions related to the environment Structure: Conditions for efficiency and optimality Partial equilibrium analysis General equilibrium analysis Market failures related to environment Welfare Economics

1. Conditions for efficiency and optimality Definitions Economic efficiency An allocation of resources is efficient if it is not possible to make one or more persons better off without making at least one other person worse off (= Pareto optimality/efficiency, allocative efficiency) Optimality An allocation of resources is optimal if it maximizes the social welfare that can be obtained from these resources Welfare Economics

1. Conditions for efficiency and optimality Definitions Marginal rate of utility substitution (MRUS) The rate at which one commodity can be substituted at the margin for another without changing a person’s utility NB: equals the slope of the indifference curve Marginal rate of technical substitution (MRTS) The rate at which one production factor can be substituted at the margin for another without changing the output of the commodity NB: equals the slope of the isoquant Welfare Economics

1. Conditions for efficiency and optimality Definitions Marginal rate of transformation (MRT) of a production factor The rate at which the output of one commodity can be transformed into output of another commodity by a marginal shift of a production factor from one production process to another NB: Equals the slope of the production possibility frontier Welfare Economics

1. Conditions for efficiency and optimality Economic efficiency: Efficiency in consumption Efficiency in production Efficiency in product mix Welfare Economics

Figure 5.1 Efficiency in consumption. BY AXb S AXa A0 AX IB1 IB0 IA a BYa . AYa BYb . b AYb IB1 IB0 IA BX B0 BXa BXb T Welfare Economics AY

1. Conditions for efficiency and optimality Consumption efficiency requires that the MRUS is equal for all individuals Welfare Economics

Figure 5.2 Efficiency in production. KY LXa LXb X0 LX IY1 IY0 IX KYa . a KXa KYb . b KXb IY1 IY0 IX LY Y0 LYa LYb Welfare Economics KX

1. Conditions for efficiency and optimality Production efficiency requires that the MRTS is equal for all commodities Welfare Economics

Figure 5.3 Product-mix efficiency. Y YM a Ya b Yb Yc c I XM X Xa Xb XC Welfare Economics

1. Conditions for efficiency and optimality Product-mix efficiency requires that the MRT of all production factors are equal to the MRUS NB: For an economy with given quantities of resources, production functions and utility functions, there are many efficient allocations of resources Welfare Economics

Figure 5.4 The set of allocations for consumption efficiency. BY S A0 AX B A C B A B A B A B B A A . B A B A B A C A B BX B0 T Welfare Economics AY

Figure 5.6 Maximised social welfare. UB W a b c W UA Welfare Economics

1. Conditions for efficiency and optimality Optimality requires that the slope of the social welfare function (social indifference curve) equals the slope of the utility possibility curve Hence: efficiency is a necessary but not sufficient condition for optimality an efficient allocation of resources may have lower social welfare than an inefficient allocation Welfare Economics

Figure 5.7 Welfare and efficiency. UB D E C W2 W1 UA Welfare Economics

1. Conditions for efficiency and optimality Basic Assumptions Institutions Markets exists for all goods and services All markets are perfectly competitive All agents have perfect information Private property rights are assigned to all goods and services There are no externalities All goods and services are private goods (not public goods) All utility and production functions have standard properties Welfare Economics

1. Conditions for efficiency and optimality Basic Assumptions Behaviour Producers are profit maximisers Consumers are utility maximisers Assumptions are very strict & not realistic Serve as a benchmark in welfare analysis of actual economies and for designing appropriate policies Welfare Economics

1. Conditions for efficiency and optimality Approaches: Partial equilibrium analysis (for 1 good/sector) General equilibrium analysis (all economic sectors) Welfare Economics

PARTIAL EQUILIBRIUM: Figure 5 PARTIAL EQUILIBRIUM: Figure 5.11 Partial equilibrium interpretation of economic efficiency. B(X) C(X) d B(X*) NB(X*) C(X*) e a X X* (a) NB(X) NB(X*) NBX X* X (b) g MCX f MBX h (c) X* X g/ SX=MCX f/ Px h/ DX=MBX (d) X* X

1A. Partial equilibrium analysis MB-curve: Demand curve Expresses ‘willingness to pay for a commodity’ MC-curve: Supply curve Shows marginal costs involved in producing an additional unit Welfare Economics

1A. Partial equilibrium analysis Consumer surplus (CS): Triangle g’f’px Shows gains of consumers (who pay a lower price than they are willing to pay) Producer surplus (PS): Triangle h’f’px Shows gains of producers (who receive a higher price than the price for which they are willing to sell) CS+PS = maximised net benefit (=total welfare gain of trading a good in the market) Welfare Economics

1A. Partial equilibrium analysis Advantages and disadvantages: Examines efficiency in consumption and production, but not production-mix efficiency Requires less data and research time than general equilibrium approach Welfare Economics

1B. General equilibrium analysis Can be used to show that if the basic assumptions for institutions and behaviour (see above) are satisfied: A market allocation of resources is an efficient allocation Welfare Economics

Figure 5.8 Utility maximisation. Y b Y* U* c X X* Xmax Welfare Economics

1B. General equilibrium analysis Consumption efficiency: Because all individuals face the same prices, the MRUS is the same for all individuals Welfare Economics

Figure 5.9 Cost minimisation. Y K3 X* K2 b c X* L L1 L2 L3 Welfare Economics

1B. General equilibrium analysis Production efficiency: Because all producers face the same production factor prices, the MRTS is the same for all producers Welfare Economics

1B. General equilibrium analysis Product-mix efficiency: MRUS is equal to the price ratio of products (Fig. 5.8) Because all producers are profit maximisers, the MRT for a production factor is equal to the price ratio of products (see p. 118) Hence: MRUS = MRT for all production factors (5.11) Welfare Economics

2. Market failures related to environment Major result of Part 1: A market allocation of resources is an efficient allocation, if the basic assumptions for institutions and behaviour are satisfied. Market failures: Situations where actual circumstances deviate from the ideal. Analysis of market failures —> policy recommendations to improve economic efficiency Welfare Economics

2. Market failures related to environment Basic assumptions on institutions: Markets exists for all goods and services All markets are perfectly competitive All goods and services are private goods (not public goods) There are no externalities All agents have perfect information Private property rights are assigned to all goods and services All utility and production functions have standard properties Welfare Economics

2A. Market failures: Public goods Private goods: Rivalry: Consumption/use by one person/producer reduces amount available for consumption/use by others Excludability: It is possible to exclude specific persons/ producers from consuming/using the commodity Examples: bread, ice cream, coca cola, cars, car parts Public goods: Exhibit neither rivalry nor excludability Examples: lighthouses, national defence force, clean air Welfare Economics

2A. Market failures: Public goods Open access resources: Exhibit rivalry but not excludability Examples: ocean fish, groundwater, migratory birds Toll goods/congestible resources: Exhibit excludability but not rivalry Examples: wilderness area, city park, cinema, toll roads Welfare Economics

2A. Market failures: Public goods Markets cannot supply public goods due to the non-excludability. Public goods have to be supplied by an entity that can recover production costs from other sources than market sales: Government taxes Welfare Economics

2A. Market failures: Public goods Efficient level of public goods provision: Level where aggregate marginal willingness to pay equals marginal costs of provision Problems: information is difficult to acquire individuals have incentives to provide incorrect information way of taxing has important equity implications Welfare Economics

2B. Market failures: Externalities Externalities / external effects: Consumption or production by one person/producer has unintended impact on utility or profit of other person(s)/producer(s) No compensation/payment is made by the generator to the affected person(s)/producer(s) Can be positive or negative Examples: Radio noise, vaccination, water pollution, bee hives Welfare Economics

2B. Market failures: Externalities Consequences: Due to absence of compensation/payment, the producer/consumer will not take the externality into account in decision making. Private costs (or benefits) therefore deviate from social costs (benefits), and the market will produce either too much (negative externality) or too little (positive externality) of the good. Welfare Economics

2B. Market failures: Externalities Two cases: Externality is private or toll good (e.g. noise pollution, water pollution) Externality is public good (e.g. air pollution) Welfare Economics

1. Externality is private or toll good Figure 5.13 The bargaining solution to an externality. £ MB MEC a c b d Hours of music M* M0 Welfare Economics

2B. Market failures: Externalities Affected person/producer does not have a property right in an unpolluted environment. Hence, no compensation is paid and pollution will continue until the marginal benefit is zero. Solution: Establish private property right in non-polluted environment (for affected person/producer) This will cause a bargaining process until MB=MEC, and reduce environmental pollution to M* NB: Pollution is not zero in M*; this level, however, is the efficient level of pollution. Welfare Economics

2B. Market failures: Externalities Alternative solution: Establish private property right in environmental pollution (for pollution generator) Consequences: Causes similar bargaining process until MB=MEC Now the pollution victim(s) should pay the generator Hence: Both solutions lead to the same efficient outcome Welfare/equity implications are different = Coase theorem Welfare Economics

2B. Market failures: Externalities Assignment of property rights is not often used to correct externalities: Legislators also have non-economic objectives Bargaining is costly (espec. with many generators & victims) Many externalities have public good characteristics Welfare Economics

2B. Market failures: Externalities 2. Externality is public good (‘public bad’) Assignment of property rights and private bargaining will not deal with the problem; public intervention is required, e.g. taxation of pollution generator Optimal tax level: Makes output price equal to social marginal costs SMC (= private marginal costs PMC + marginal environmental costs MEC) Welfare Economics

Figure 5.14 Taxation for externality correction. £ SMC PMCT PMC PY t Y Y* Y0 Welfare Economics

2B. Market failures: Externalities Taxing agency will have to identify the optimal production level Y* , and then calculate the tax rate t*. To do so, it will need information on the willingness to pay of the affected persons at different production/pollution levels. Problems (see above): information is difficult to acquire individuals have incentives to provide incorrect information way of taxing has important equity implications Welfare Economics

2C. Market failures: Imperfect information Condition for efficiency: All agents have perfect information. Reality: Some agents (victims, generators) may be unaware (e.g. smoking); result; no bargaining process; solution: information provision (= public good) by government No accurate or unambiguous information (e.g. global warming); implications: see Ch. 8 Welfare Economics