EXAM I: MARCH 27, ALL MATERIAL COVERED 1

2 Chapter 4. Property Rights, Externalities, and Environmental Problems

3 Review From the text, which is NOT a recognized potential source of bias while using contingent valuation surveys? a. starting point bias b. strategic bias c. information bias d. hypothetical bias e. vehicle bias

4 Review The value of an ecosystem can be adequately established by figuring out how much it would cost to build man-made systems to replace the functions of that ecosystem. a. True b. False (from Dr. Trudy Cameron, UCLA)

5 Introduction Resource allocations are not always efficient. When would the breaches of efficiency occur? What would cause individual/group interests diverge from society’s? This chapter focuses on the inefficiencies caused by the lack of well-defined property rights.

6 Property Rights Property rights—An entitlement defining owner’s rights, privileges, and limitations for use of resource. Property rights can be held by an individual or a state. “Corporations are more interested in profits than in the needs of people.” Can centrally planned economies prevent environmental problems? Property Rights and Efficient Market Allocations

7 Property Rights (cont.) Exclusivity—All the benefits and costs should only accrue to the owner. Transferability—Property rights should be transferred to others. Enforceability—Property rights should be secure from seizure or encroachment. Efficient (Well-defined) Property Rights Structure

8 Property Rights (cont.) Well-defined property rights are exchangeable. Consumer will decide how much to purchase by maximizing his or her own individual net benefit. Consumer surplus (Consumer’s net benefit) is willingness to pay minus the actual payment or the area under the demand curve and above the price line. Consumer Surplus

9 Figure 4.1 The Consumer’s Choice For a given price P*, consumer net benefit is maximized by choosing to purchase Q d units.

10 Property Rights (cont.) Sellers face a similar choice. They want to maximize their net benefits. Producer surplus (seller’s net benefit) is the area above the marginal cost (supply) curve and below the price line. Producer Surplus

11 Figure 4.2 The Producer’s Choice Given price P*, the seller maximizes his or her own net benefit by choosing to sell Q s units.

12 Figure 4.3 Market Equilibrium

13 Max Net benefits = consumer surplus+ producer surplus. In a market system, both self-interested parties will achieve efficient allocation. (remember “invisible hand?”) If net benefits are not maximized, the allocation is inefficient. Property Rights (cont.) Net Benefits

14 Property Rights (cont.) In the short run, producer surplus is equal to profits plus fixed cost. This is because the area under the marginal cost curve is total variable cost. In the long run, producer surplus is equal to profits plus rent. Rent is the return to scarce inputs owned by the producer. Under perfect competitions, long-run profits equal zero and producer surplus equals rent. Scarcity rents are the returns that persist in the long run competitive equilibrium. David Ricardo first recognized scarcity rent of land. Producer Surplus, Scarcity Rent

15 Externalities as a Source of Market Failure Market failure can be caused by property rights that fail to achieve exclusivity, transferability or enforceability. Exclusivity is one of the chief characteristics of an efficient property rights structure. If an agent making a decision does not bear all of the consequences (costs and benefits) of that decision, then the characteristic of exclusivity is violated.

16 Externalities as a Source of Market Failure Externalities exist whenever an agent’s activities affect another agent’s welfare. For example, suppose two firms are located by a river, a steel firm upstream and a brewery downstream. The steel firm produces both steel as well as pollution, and it dumped its waste to the river, and the brewery draw the water for its beer-making. And this is the cost that the steel firm did not take into account.

17 Externalities as a Source of Market Failure We can draw several conclusions: –The output of the commodity is too large. –Too much pollution is produced with the increased output. –Prices of product are too low. –Because costs are external (release waste to the environment is so cheap), there is no incentives to reduce pollution as well as developing technologies for recycling and reuse,

18 Improperly Designed Property Rights Systems –Private property regimes: individuals hold entitlements. –State-property regimes: governments own and control property (some parks and forests). –Common-property regimes: property is jointly owned and managed by a specific group. Common property regimes are quite variable, but many result in overexploitation of the resource. Over fishing in local fisheries or over hunting are good examples(a small fishing village in Sri Lanka). A few successful examples exist (the system of allocating grazing rights in Switzerland). –Res nullius or open access regimes, no one owns or exercises control over the resources. This type of regime leads to the “tragedy of the commons” because they can be exploited by whoever can get them first.

19 Improperly Designed Property Rights Systems (cont.) Common pool resources are characterized by non- exclusivity and divisibility. These characteristics allow the resource to be exploited by anyone. Access cannot be denied, and the amount captured will be eliminated from the original amount available (divisibility). Examples also include unregulated groundwater withdrawal and high seas fisheries. Common mentalities: “get it while the getting is good” and “if I don’t get it, someone else will.” and “first come, first serve”

20 Public Goods Public goods are both indivisible and non-excludable. –Indivisibility (non-rivalry) means that one person’s consumption does not affect another’s. –Non-excludability means that persons cannot be kept from enjoying the benefits of a good even if they do not pay for it. –Examples? –Clean air, national defense and biological diversity are all examples of public goods.

21 Biological diversity includes the amount of genetic variation among individuals within in a single species and the number of species in a community. Species have value beyond intrinsic value by providing ecological stability, and potentially providing sources of food, raw materials and medicines.

22 Imperfect Market Structures Markets that are not competitive will exhibit inefficiencies. Monopolies will supply too little of a good at too high a price. A cartel is a group of producers who form a collusive agreement to gain monopoly power. OPEC, for example, colludes in order to gain monopoly power. Restricting output, raises the price of oil. At the monopoly output, marginal benefits are greater than marginal costs. Net benefits are not maximized and there is a deadweight loss.

23 Government Failures Governments as well as markets can also be sources of inefficiency. 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. Agricultural producers seeking price supports. Increased Net Benefit might go to the special interest group.

24 Government Failure Why don’t losers rise up to protest their losing net benefits? –High cost of information –Low probability that any single vote will matter –Difficult to organize unified opposition (Is successful opposition a private good?) –Normally underfunded. (It is known as voter ignorance)

25 The Pursuit of Efficiency Private resolution through negotiation is the simplest means of restoring efficiency. –“Victim pays” For example, a downstream firm hurt by an upstream polluter could negotiate or bribe the upstream to reduce pollution. Other options include consumer boycotts or other means of imposing costs on the polluters. Property rights that are not well-defined and lead to inefficiencies can be corrected by a court system which imposes either property rules or liability rules. Remedies

26 The Coase Theorem says that when negotiation costs are negligible and affected parties can freely negotiate, the entitlement can be allocated by the courts to either party and an efficient allocation will result. Only the distribution of costs and benefits among the effective parties is changed. Regardless of which party the property right is assigned to, an efficient level of production will result. The Pursuit of Efficiency

27 The Pursuit of Efficiency The Coase Theorem is not without problems. If the property right is assigned to the polluter, pollution could become a profitable activity. Also, the Coase Theorem relies on some very restrictive assumptions such as the number of polluters being small. If the number of polluters is large, negotiation is difficult and free-riders more prevalent. Transactions costs is assumed to be small. The courts can use liability rules if negotiation is not practical, however transactions costs such as lawyers fees and administrative costs could be large.

28 The Pursuit of Efficiency Remedies Legislative and executive regulation are remedies that can take several forms including taxes and regulatory laws.

Homework… Game ( Plus chapter 4 online quiz 29

Chapter 5 Sustainable Development: Defining the Concept “We usually see only the things we are looking for – so much so that we sometimes see them where they are not.” -- Eric Hoffer, The Passionate State of Mind

Introduction 2 criteria for decision-making regarding allocation of resources among generations –Static efficiency: time is not an important factor (example – solar energy) –Dynamic efficiency: time is a crucial factor (example – depletable energy) Efficiency is not the sole decision factor Other criteria? –Fairness –Justice Important issue to be examined in this chapter: treatment of future generations 31

5-32 A Two-Period Model Assumptions –Fixed supply of certain depletable resource –Consider two time periods only –Total supply is 20 units –Demand (marginal WTP) is constant:

Allocation of an Abundant Depletable Resource. If supply is sufficient to meet demand, then a static efficient solution will provide the optimal allocations over time, regardless of the discount rate. For example, if the total supply of a depletable resource were 30 or more, what will the efficient quantities for each period? 5-33

5-34 As shown by demand curve, 15 units of resources would be used in period 1 and 5 units in period 2.

Defining intertemporal fairness No generally acceptable standards of fairness However, certain standards are more acceptable than others One prominent fairness concern is the treatment of future generations Why? Because future generations cannot express their preferences 35

One solution to intergenerational equity problems provided by John Rawls – the Theory of Justice -> people are placed behind a veil of ignorance (they don’t know their position in society) -> behind this hypothetical veil, they decide on rules to govern society and then are forced to play by these rules  Behind the veil of ignorance, people do not know to which they generation they belong thus, leads them to be not too exploitative, not too conservative  Resulting rule = sustainability criterion. At a minimum, future generations should not be left worse off than current generations 36

Sustainability criterion One of the implications is that it is possible to use resources (even depletable resources) as long as the interests of future generations could be protected Do our institutions provide adequate protection for future generations? Let’s examine the conditions under which efficient allocations satisfy the sustainability criterion Are all efficient allocations sustainable? 37

5-38 Are Efficient Allocations Fair? A dynamic efficient allocation will not automatically satisfy the sustainability criterion, but can be consistent with sustainability. – With a discount rate greater than zero, an economically efficient allocation will allocate more of a resource to the first period than the second. Net benefits will be greater in the first period than the second. – The sustainability criterion can still be met if the first period sets aside sufficient net benefits for the second period.

5-39 Example 5.1

5-40 Example 5.1

5-41 Applying the Sustainability Criterion It is very difficult to implement because it requires to know the preferences of the future generation. Total capital is defined as physical capital plus natural capital. A more operational criterion is Hartwick’s Rule. – If all scarcity rent is invested in capital, the value of the total capital stock will not decline. –If the principal or the value of total capital is declining, the allocation is not sustainable. But complete substitutability between physical and natural capital is an extremely strong assumption.

Hartwick Rule Current generation has been given an endowment of –Natural capital –Physical capital In this context, sustainability = making sure that total capital stock is maintained and not depleted Example: if technological progress makes it possible to make production processes less resource intensive, then the current generation can afford to leave less natural resources to future generations since physical capital has been improved 42

What is sustainability? What kind? Weak sustainability — the maintenance of total capital Strong sustainability— the maintenance of the value of the stock of natural capital Environmental sustainability—to maintain certain physical flows of certain individual resources 5-43

5-44 Example 5.2

5-45 Example 5.2

5-46 Implications for Environmental Policy Not all efficient allocations are sustainable and not all sustainable allocations are efficient. Policy implication –Efficiency is useless when choosing among a certain number of sustainable allocations –Sometimes, unsustainable allocations are the result of inefficient behavior Win-win situations are possible because removing an inefficiency increases net benefits; it is then possible to allocate these benefits among generations If compensation is possible, then change is more likely to happen because of weaker resistance