Natural Resources, the Environment and Agriculture Chapter 10

Topics of Discussion Agriculture and the environment Economics of the environment Economics of resources in agriculture Soil quality and quantity Economics of soil conservation Government policies for agriculture, natural resources, and the environment 2

Agriculture and the Environment Water pollution  Non-point source  Point source Air pollution  Dispersed agricultural industry requiring extension transportion system to get goods to market Global climate change  Impact on rainfall totals  Impacts of temperature changes Other environmental impacts Pages

Economics of the Environment From Ch. 9 we saw that if an economy is fully efficient then  Private actions of consumers and producers will maximize total surplus  Referred to as being Pareto Efficient Can the same be said for environmental impacts of economic activity?  Is the efficient level of environmental impacts being generated? Pages 177 4

Economics of the Environment Does the environment have value?  Example of the impacts of water pollution  Users of waterway would be willing to pay something to reduce (abate) the level of pollution  →Implicit demand for environmental improvements  Similar to market commodities Page 177 5

Economics of the Environment Are there costs associated with reducing the level of environmental pollution?  Install scrubbers on power plant smokestacks  Use more expensive lower sulphur coal  The above implies that there is a supply curve (MC curve) for pollution abatement What would be the socially optimal level of pollution abatement? Page 177 6

WTP MC Pollution Abatement (Reduction) $ P1P1 C1C1 A1A1 A3A3 At A 1, ↑ abatement (↓pollution) would cost C 1 but public would be willing to pay P 1  If WTP>MC then society’s net benefit will be increased by increasing abatement Economics of the Environment Socially efficient abatement level A2A2 C2C2 P2P2 C3C3 P3P3 A4A4 At A 4 too much abatement, Why? 7

Page 177 Unlike typical market goods such as food, clothes, etc.  We cannot use market information to determine value of pollution abatement  WTP is obtained using a variety of procedures generally referred to as non-market valuation techniques Will a market develop for environmental improvement and socially optimal outcome?  Usually not because the characteristics of efficient property rights are not satisfied for environmental goods Economics of the Environment 8

Efficient Property Rights Efficient property rights are characteristics that ensure a socially optimal provision of goods and services will be provided  Property rights  Property rights: Privileges and limitations that are associated with the ownership of a resource  Enforceability  Enforceability: Can enforce individual property rights  Transferability  Transferability: One is able to transfer property rights from one individual to another  Exclusivity: All associated benefits and costs are received by only one individual at a time Pages

Efficient Property Rights Enforceability: security of individual rights  If not present then there is nothing to stop someone from taking the good from its owner  No one would produce the good as not assured will get paid  No one would purchase because they could take without paying Pages

Efficient Property Rights Transferability: Property can be transferred from one individual to another  Example is laws prohibiting the sale of certain goods  No markets will arise because sale is not allowed  Efficient transfer from one individual to another cannot occur Pages

Efficient Property Rights Exclusivity: All associated benefits and costs are received by only one individual at a time  Example is some costs are not borne by the producer of the good but by the public at large  Example of agricultural production  Farmer pays for labor, capital and material inputs  Producer does not pay for the negative impacts downstream when runoff causes a degradation in water quality such as reduced fishing quality  This downstream impact passed onto the public is referred to as an externality as the producer of the impact does not pay for its cost Pages

Concept of Externality Externality  There exists positive as well as negative externalities  Example of positive externality: Honey producer’s impact on neighbors' crop yield  Example of negative externality: Playing loud music in your apartment to the point that it wakes your neighbors Pages

Page 179 Concept of Externality Q $ D C B A 6 15 PmPm QmQm Below represents aggregate market demand and supply for good, Q S m =MC m DmDm Producer surplus = B Total willingness to pay = A + B + C + D Consumer surplus = C + D Total (societal) surplus is B + C + D 14

Page 179 Concept of Externality Suppose the production of Q causes pollution  Assume this pollution imposes costs on others due to degradation of water resources  Neither producers nor consumers of this good takes these costs into account  i.e. are external to the market  For simplicity lets assume these external costs (E x ) are constant at $9/unit The social marginal cost (MC S ) per unit of production is: MC S = MC m + E x 15

Page 179 Concept of Externality Q $ C B 6 15 PmPm QmQm E x = $9 S m =MC m MC S =MC m +E x DmDm The social marginal cost (MC S ) is: MC S = MC m + E x  With Q m units produced there is additional cost = Q m *E x = area (B + C + E) below E 16 D A

Page 179 Concept of Externality Q $ D E C B A 6 15 PmPm QmQm E x = $9 S m =MC m MC S =MC m +E x DmDm From the market equilibrium the social net benefits (SNB) = CS + PS – External Costs SNB = (B + C + D) – (B + C + E) = D – E CS+PS External Costs

Page 179 Concept of Externality Q $ D E 6 15 QmQm S m =MC m MC S =MC m +E x DmDm How can we increase the SNB = (CS + PS – Externality)?  What happens if we increase production to Q m *?  What happens if we decrease production to Q m **? F G Q m *→ SNB* = D – E –F – G → SNB* < SNB Q m ** → SNB** = D → SNB** > SNB At Q m and Q m * production is inefficiently high relative to socially optimal, Q m ** Qm*Qm* Q m ** From above: SNB = D - E

Page 179 Concept of Externality Q $ QmQm S m =MC m MC S =MC m +E x DmDm We can also look at the above inefficiency relative the marginal (last) unit  What are the marginal net benefits and marginal costs of the last unit of Q purchased? At the market level of production, Q m  Consumers willing to pay P m  The cost to producers is P m  →the SNB for the m th (last) unit purchased is 0 PmPm

Page 179 Concept of Externality Q $ QmQm S m =MC m MC S =MC m +E x DmDm We can also look at the above inefficiency relative the marginal (last) unit  What are the marginal net benefits and marginal costs of the last unit of Q purchased? There are additional social costs (area E) →the marginal SNB for the last unit purchased is (WTP – MC m – E x ) where we assumed E x =$9 per unit of Q PmPm E

Page 179 Concept of Externality From the above we can conclude the following:  In the presence of externalities the free market will not reach socially optimal production level  Referred to as an example of market failure  Although production of Q results in an externality this does not mean that production should be set to 0  Reducing production to 0 is socially inefficient  At social optimal production level, SNB may be positive even after subtracting external costs, E x

Environmental Policies As noted above, an externality results in a market failure as too much production occurs  If responsibility for damages could be established and enforced then a market would arise  Lets look an example of a farmer and fisherman  Coase market based approach to solving the negative externality problem Pages

Environmental Policies Lets look at farmer/fishing association example Pages Q $ QmQm S m =MC m MC S =MC m +E x Qm*Qm* Q m * is socially optimal pollution for farm C is the externality (cost) of producing Q m Fishing assoication offers a bribe of C+D PS w/o payment = A + B + D w/payment = A+B+C+D Social Net benefits Q m = A – C Q* = A A B D C

Environmental Policies Coase’s approach has not been widely adopted due to the free-rider problem  Suppose a fisherman’s association forms to pay upstream polluters not to pollute  Although only association members pay into the fund, all fishermen whether a member of not benefits from cleaner water  →A strong incentive not to pay the cost of association membership while enjoying the benefits (i.e. to be a free-rider) Pages

Environmental Policies Given the difficulty of obtaining an economic efficient level of environmental resources there are a number of types of public policies used to move toward this target  Command-and-Control policies  Taxes and subsidies  Transferable rights Pages

Environmental Policies Command and Control: Environmental policy consisting of regulations on technology or restrictions on practices  All economic agents treated equally  All firms required to abate to the same level  All must install same equipment  Problem is that it does not recognize the diversity in the economy and the differential impact of a regulation Pages

Environmental Policies Example: Two farmers and a requirement to reduce non-point pollution  Producer John uses older technology → reducing pollution could be costly  Producer Sue uses newer technology → reducing pollution achieved relatively cheaply  If they are neighbors  Same level of total environmental improvement achieved at a lower total societal cost if Producer Sue reduced more and Producer John reduces less Pages

Environmental Policies Pages Fig. A & B represent the MC of abatement for Firms 1 and 2  MC ↑ with abatement level Fig. C combines these two figures $ $ $ A1A1 A2A2 A1A1 A2A2 MC 1 MC 2 MC A B C $

Environmental Policies Pages Movement to the right (left) would ↑ (↓) abatement for Firm 1 and ↓ (↑) that of Firm 2 Total abatement will always equal 10 units $ A1A1 A2A2 MC 2 MC $

Environmental Policies Pages If each firm abates 5 units the total abatement cost (TAC) is: TAC = A + B + C Firm 1’s last unit of abatement cost much higher than the last unit of Firm 2’s abatement  Difference = MC 1 *- MC 2 * → that TAC could be reduced if Firm 2 abates more, Firm 1 less  TAC is minimized when MC 1 = MC 2 The gov’t could make such an allocation but would have to know the MC curves $ A1A1 A2A2 MC 2 MC A B C Firm 1 Firm 2 MC 1 * MC 2 *

Environmental Policies Taxes and Subsidies: An incentive-based approach to environmental policy  Subsidy for abatement  Tax on pollution Subsidy of S dollars on pollution abatement to minimize TAC Firm 1 will abate 3 units, Firm 2 will abate 7 units  A 1 7→MC 2 > S  A 1 >3→MC 1 > S, A 2 <7→MC 2 < S  A 1 = 3 & A 2 =7 →MC 1 =MC 2 =S Pages $ A1A1 A2A2 MC 2 MC S 7

Environmental Policies A tax on pollution would work just like a subsidy on pollution abatement  A tax of $T per unit of pollution, for each unit of abatement the firm saves $T  The firm will continue to abate as long as the tax savings are greater than or equal the MC of abating Pages

Environmental Policies Advantage of tax/subsidy: Whatever level of abatement is achieved it will be done at the lowest total cost (across all agents) Disadvantage of tax/subsidy: Unless MC curves known, the gov’t will not know with certainty the abatement level achieved  T too low, too little abatement  T too high, too much abatement Pages

Environmental Policies Transferable Rights: When applied to pollution known as transferable discharge permits (TDP) Under a TDP program rights to pollute can be bought and sold by polluters  Moves the permits to those polluters with relatively high abatement costs  As long as aggregate pollution level stays below the target, the gov’t does not worry who is polluting Pages

Environmental Policies TDP Example: Firm 1 and Firm 2 are required to do 5 units of abatement MC 1 > MC 2 at this level A trade could work out where Firm 1 could pay Firm 2 for a permit  Firm 1 ↑ pollution  Firm 2 ↓ pollution Permits could continue until MC 1 = MC 2 Pages $ A1A1 A2A2 MC 2 MC

Environmental Policies Advantage of a Transferable Rights program:  Are cost effective given the least cost of TCP could be achieved  Gov’t can control level of pollution and leave the allocation up to the marketplace Pages

Natural Resources and Agriculture Distinction between environmental issues and natural resource issues: The extent to which externalities exist  Environmental issues: Important externalities present  Natural Resource issues: Costs and Benefits of natural resource use falls mainly on the user  Lets look at the example of soil quantity and quality Pages

Economics of Soil Use Farmer undertakes efforts to prevent soil erosion this protects its quality  Soil quality a fundamental issue in agriculture  An asset with potentially long productive lifetime Major source of decline in soil quality is soil erosion resulting from rain or wind  Erosion can wash away productive soil  Can also degrade features of the soil that are essential for crop productivity  Soil nutrients Pages

Economics of Soil Use Soil quality is a complex function of physical (i.e., depth), chemical (i.e., acidity) and biological (i.e., microbial activity)  What is the value of this resource?  How much should be spent on preserving it? A farmer values soil because it has the potential to generate a positive income stream over time  Important question: What is the value of this future income worth? Pages

Discounting and Present Value Example of 5 years of $100/year income from an acre of land each year→total income of $500  Not accurate that this $500 of future income is worth $500 today, need to wait to receive it  Would you prefer to wait for 3 years for $100 or receive $75 today?  General principle: The further in the future income is generated, the less it is worth today Pages

To compare $ values over time economists use discounting to convert all $ to present values  Present value: Amount of money an individual could be given today that would make him/her indifferent to a greater amount of income in the future  What is the opportunity cost today of that future income Pages Discounting and Present Value

Suppose you purchase a certificate of deposit today for $6 with an interest rate of 5% annually  In 5 years that $6 would have grown due to compound interest to $8.04  $8.04 = $6 x (1.05) 5  You would be indifferent between $ years from now and $6 today  The present value (PV) of $ years from now given the 5% interest rate is $6.00 Pages Discounting and Present Value Initial deposit Number of years Interest rate

What is the present value of $10 5-years from now with a 6% interest rate? From the above we know that: $10=$X x (1.06) 5 → $X = $10 ÷ [(1.06) 5 ] = $7.47  →$7.47 is the PV of $10 5-years from now and given a 6% interest rate  Present value should always be < future value with a positive interest rate  →Opportunity cost of $10 5 years from now is $7.47 given the above interest rate Pages Discounting and Present Value

Returning to our farm example: You have an acre of land that generates a stream of income over time  The PV of this stream would be the amount of money the farmer would have to be paid now that would be equivalent to this stream of future income  The total PV of the stream would equal the sum of the PV’s of the individual elements of this future stream Pages Discounting and Present Value

Lets represent some unknown interest rate by the symbol ρ If we have a level of income in year t represented by Y t, the PV of the stream of income (V) is: Pages Discounting and Present Value PV of yr 1 income PV of yr 2 income PV of yr 3 income

Given the above assume:  The farmer receives the same level of income each year (Y*)  This income is generated for a very large number of years  There is a mathematical result that the PV of this sum over a large number of years (V*) will be approximately equal to:   V* is referred to as the capitalized value of the constant income stream, $Y* given interest rate ρ Pages Discounting and Present Value

Going back to our soil example  Y* earned each year from an acre of land  Capitalized value of this stream of income needs to be shared with all inputs used to generate this income  Fertilizer, seed, tractor time, management, etc.  How can we determine the marginal value of the soil?  What is the value of the last unit of soil added to the generation of the above income?  Page 186 in the text shows how to undertake such an evaluation Pages Economics of Soil Use

Going back to our soil example  Suppose the yearly profits is $10/year/acre and ρ = 5%  Capitalized Value = $10/(5/100)=$200  What is the marginal value of his soil given other inputs used? The next year, there was a change in tillage practices that resulted in unanticipated and significant erosion events  → loss of $1/acre in return Pages Economics of Soil Use

The capitilized value of the now $9/acre return is 9/(5/100)=$180  →The value of soil conservation efforts is $20 ($200 - $180)  How does this value compare to conservation effort costs? Pages Economics of Soil Use

A characteristic of surface water (i.e., lakes, rivers) are that they are typically renewed over time via rainfall and runoff Important question for economists: How are these water resources to be allocated among competing uses?  i.e., agricultural irrigation, residential use, industrial use, recreation, etc. Pages Water as an Asset

We have two farmers who are competing for the use of a river’s water for irrigation  Assume that a total of 100 acre-feet are allowed to be extracted  Applying irrigation water increases crop yield  The marginal revenue of water and marginal cost of pumping are such that both farmers would like to use 80 acre ft of water Pages

Water as an Asset One farmer is upstream of the other  Will use 80 acre-ft of water  Leave only 20 acre-ft for downstream farmer Pages Irrigation Marginal Revenue and Marginal Cost Both farmers have the same revenue and cost curve Upstream farmer Downstream farmer

Water as an Asset The 80/20 allocation is economically inefficient  Marginal Value of water = 0 for upstream farmer as MR=MC  Marginal Value of water for downstream farmer > 0 = a – c →Total net benefits could be ↑ by allocating water from upstream to downstream farmer Pages

Water as an Asset If the water rights are transferable Downstream farmer would be willing to pay more for an additional unit of water than upstream farmer values the marginal unit of water → A deal could be made such that both are better off Ideally, the farmers would bargain back and forth until each had 50 acre-ft of water Purely the result of assumed cost and revenue structures Pages

Water as an Asset Given the assumption of equal cost and revenue structures for both farmers  Total net benefits would be maximized where the net benefits of an additional water unit would be the same for both farmers →A system in which upstream users have preference over downstream users can result in an inefficient water allocation Pages

Summary Economists play a role in designing policies that affect the environment and natural resources Incentives matter when designing policies to achieve desired objectives For agricultural production, water and soil are assets that have value and net benefits associated with their use

Chapter 11 is used to discuss forms of governmental intervention, including price and income supports that impact agricultural markets…