1. Environmental Economics
Fall 2017

2. Economic approach Human-Environment relationship
Environmental problems and Economic efficiency
Property rights
Externalities
Persuit of Efficiency

3. 1. Human-Environment relationship
Environment as an asset
Raw materials → consumer
Energy → facilitate the process
Goods & services
Is it a closed or open system?
(closed:no inputs/outputs outside the system)
Figure 2.1 Economic system and Environment

4. 1. Human-Environment relationship
Environment as an asset
Treated our planet and its environs as a closed system
The first law of thermodynamics (mass of materials flowing into the economic system is equal to the mass of waste flowing into the environment)
What would happen when waste flow exceed its absorptive capacity ? (illness, pollution, warming…)

5. 1. Human-Environment relationship
Environment as an asset
The second law of thermodynamics (entropy law, entropy increases)
What would happen to a closed system without new energy flow ? (used up of energy, life ceases…)

6. 1. Human-Environment relationship
Environment as an asset
Our planet is not a closed system. However, solar energy flow has an upper limit.
In the long run, the growth process will be limited by the availability of solar energy and our ability to use it.
What and how can we do ?

7. 1. Human-Environment relationship
Economic approach
Positive Economics : what was, what is and what will be
Normative Economics : what ought to be (value judgment)
Discuss: which one is useful ?

8. 2. Environmental problems & Economic efficiency
Static efficiency (Normative)
Allocation of resources that maximizes the economic surplus is said to satisfy the static efficiency criterion
Economic surplus = consumer’s surplus + producer’s surplus
Consumer’s surplus = the value that consumers receive – the cost to obtain it

9. 2. Environmental problems & Economic efficiency
Static efficiency
Consumer’s surplus
The excess of total willingness to pay over the (lower) actual expenditure.
Quadrilateral 四边形（的）
Figure 2.2 The Consumer’s Choice

10. 2. Environmental problems & Economic efficiency
Static efficiency
Producer’s surplus = the value that producers receive – the cost to provide it
Figure 2.3 The Producer’s Choice

11. Property rights and efficient market allocations
Property rights: a bundle of entitlements defining the owner’s rights, privileges, and limitations for use of the resource.
How can we judge whether the pursuit of profits (for both individuals and government ) is consistent with efficiency or not ?

12. Efficient property rights structures
Exclusivity: all benefits and costs accrued as a result of owning and using the resources should accrue to the owner, and only to the owner
Transferability: all property rights should be transferable voluntarily
Enforceability: property rights should be secure from involuntary seizure or encroachment by others

13. Efficient property rights structures
The exchange of well-defined property rights can facilitate efficiency. (why?)
Consider an allocation between a consumer and a producer. If the producer owns the property rights, is this allocation efficient ?
The answer is …… Yes!

14. Efficient property rights structures
Consider : what will happen if
(1) E0 → E1
(2) E0 → E2
Which allocation is efficient ? E1 E0 E2
Figure 2.4 Market Equilibrium

15. 2. Property rights
Producer’s surplus, scarcity rent, and long-run competitive equilibrium
Total revenue: the area under the price line
Total variable cost: the area under the marginal cost curve
In the short run (some costs are fixed): producer’s surplus = profits + fixed cost
In the long run (all costs are variable): producer’s surplus = profits + rent

16. 2. Property rights
Producer’s surplus, scarcity rent, and long-run competitive equilibrium
With free entry of new firms into profitable industries, long-run profits and rent will equal zero.
Scarcity Rent: producer’s surplus, which persists in long-run competitive equilibrium.
E.g.: land (high quality land earn economic profit)
Most natural resource industries do give rise to rent and, therefore, producer’s surplus is not eliminated by competition, even with free entry.

17. 3. Externalities as a Source of Market Failure
An externality exists whenever
the welfare of some agent, either a firm or household, depends not only on his or her activities, but also on activities under the control of some other agent.
Example : Suppose two firms are located near a river. The upstream firm is a steel company that discharges waste into the river, and the downstream one is a hotel that uses river to carry out recreational activities.

18. 3. Externalities as a Source of Market Failure
The effect of the external cost on the steel industry
Why MCs is higher than MCp ?
Can you find the social net loss (deadweight loss) ?
Figure 2.5 The Market for Steel

19. 3. Externalities as a Source of Market Failure
Consequences of pollution externalities
Excessive production
Excessive pollution
Lower price of potentially polluting products
No incentives to search for ways to yield less pollution are introduced by the market
Recycling and reuse of polluting substances are discouraged because release is so cheap

20. 3. Externalities as a Source of Market Failure
Types of externalities
Positive externality vs Negative externality (a beautiful garden owned by a private individual; pollution emissions discharged by a private producer)
Pecuniary externality: the entry of new firms leads to higher rents on land (Is the market out of order?)
Pollution externality vs Pecuniary externality (identity: negative externality; difference: whether a feedback mechanism of prices signal exists)

21. 3. Externalities as a Source of Market Failure
Tragedy of the commons
Property right structures: state-property regimes (government) (forest), common-property regimes (jointly owned and managed by a group of co-owners) (rural land), res nullius or open-access regimes (no one owns or controls over) (American bison, common-pool)
res nullius: nonexclusivity and divisibility + scarcity

22. 3. Externalities as a Source of Market Failure
Tragedy of the commons
Why the hunters harvest under AR=AC (TC=TR) other than MR=MC ?
Oportunity cost
Consequences: (1) Excessive hunting; (2) Scarcity rent is dissipated. (zero profit)
(1)Total Benefits Curve is a downward parabola.Therefore, the total benefits increases first and then declines after reaching the highest point.
(2)Total Cost Curve slopes up to the right, indicating that the total cost will increase as harvesting increases.
Figure 2.6 Bison Harvesting

23. 3. Externalities as a Source of Market Failure
Tragedy of the commons
Why ?: Unlimited access destroys the incentive to conserve; hence, leads to inefficient allocation.
Another case: open-access for fisheries (discussed in Chapter 12)

24. 3. Externalities as a Source of Market Failure
Public goods
Public goods: both consumption indivisibilities and nonexcludability.
Indivisibilities : one person’s consumption of a good does not diminish the amount available for others.
Nonexcludability : one can enjoy the benefits of a resource whether he/she pay for it or not.

25. 3. Externalities as a Source of Market Failure
Public goods
Examples: charming landscape, clean air, clean water, and biological diversity.
Biological diversity involves: (1) genetic diversity among individuals within a single species (produces new crops and livestock); (2) species diversity within a biological community (keep balance of food chain).

26. 3. Externalities as a Source of Market Failure
Public goods
Problem: the biological diversity is decreasing.
Question: Can efficient biological diversity be supplied only by private sectors ?
Answer: No!
Reason: free rider effect

27. 3. Externalities as a Source of Market Failure
Public goods
Free rider : who derives the value from a commodity without paying efficiently for its supply.
Because of the consumption indivisibility and nonexcludability of public goods, consumers receive the value of any diversity paid by others. Everyone won’t pay more.

28. 3. Externalities as a Source of Market Failure
Imperfect market structures
Environmental problems can also arise when one of the parties in an property right exchange holds inordinate power over the outcome. (monopoly)
Why we say that monopolies violate the definition of efficiency ?

29. 3. Externalities as a Source of Market Failure
Imperfect market
structures
Can you see the loss of social economic surplus ?
Example: Oil Cartel
Figure 2.8 Monopoly and Inefficiency

30. 3. Externalities as a Source of Market Failure
Asymmetric Information
Asymmetric information distribution: One or more parties have more information than the others.
Consequence: inefficient choice of consumers. (insufficient provision of organic foods, lemon market effect)

31. 3. Externalities as a Source of Market Failure
Government Failure
Market failure is not the only source of inefficiency.
The common features of market failure and government failure are: improper incentives.
Rent seeking: the use of resources in lobbying and other activities directed at securing legislation that results in more profitable outcomes for those funding this activity.

32. 3. Externalities as a Source of Market Failure
Government Failure
Consequences of Rent seeking: increase the net benefits for the special interest group, but frequently reduce the surplus of the whole society.
Noting: rent seeking is not the only source of inefficient government policy. Inefficient policies can also occur if the government has not full information. (the new technological strategy was designed to promote cleaner combustion turned out to produce water pollution)

33. 4. The Pursuit of Efficiency
Private Resolution through Negotiation
Property, Liability and the Coase Theorem
Prerequisite: the number of affected parties is small.
Figure Efficient output with pollution damage

34. 4. The Pursuit of Efficiency
Private Resolution through Negotiation
Allocations I: the steel holds the rights to emission
Allocations II: the hotel holds the rights of clean river.
Figure Efficient output with pollution damage

35. 4. The Pursuit of Efficiency
Private Resolution through Negotiation
Question I: what’s the change in the surplus of each party and the social ?
Question II: what’s the impact of rights allocation on the optimal amount and the producer’s surplus ?
Figure Efficient output with pollution damage

36. 4. The Pursuit of Efficiency
Private Resolution through Negotiation
For allocation I
The steel: A+B+D → A+B+(C+D)
The hotel: -B-C-D → -B-(C+D)
The social: A-C → A
Optimal amount: Q*
Figure Efficient output with pollution damage

37. 4. The Pursuit of Efficiency
Private Resolution through Negotiation
For allocation Ⅱ
The steel: A+B+D-(C+D) → A+B
The hotel: -B-C-D+(C+D) →-B
The social: A-C → A
Optimal amount: Q*
Figure Efficient output with pollution damage

38. 4. The Pursuit of Efficiency
Private Resolution through Negotiation
Conclusions
As long as negotiation costs are negligible and affected parties can negotiate freely with each other, then
Figure Efficient output with pollution damage

39. 4. The Pursuit of Efficiency
Private Resolution through Negotiation
Coase theorem
① the efficient allocation would result (Q*) whether the rights were allocated to either party;
② the only effect of the court’s decision would be to change the distribution of surplus among affected parties.

40. 4. The Pursuit of Efficiency
Private Resolution through Negotiation
However,
① The decision to confer the property right on a particular party results in a transfer of wealth to that party. (Wealth effects normally are assumed small)
② Negotiation will become difficult when the number of affected parties is large. (We turn to liability rules)

41. 4. The Pursuit of Efficiency
Private Resolution through Negotiation
Liability rules: The rules award monetary damages, after the fact, to the injured party. The amount of the award is designed to correspond to the amount of damage inflicted.
A liability rule would force the steel to compensate the hotel for all damages incurred. The efficient amount would result as well (Q*).

42. 4. The Pursuit of Efficiency
Private Resolution through Negotiation
The limitations of liability rules: The costs for court’s determination would be very expensive (time, lawyers’ fees, etc.)
Legislative and Executive regulation

43. 4. The Pursuit of Efficiency
Private Resolution through Negotiation
Legislative and Executive regulation
The legislature dictate that no one produce more steel or pollution than Q* (jail sentences or fines); or impose a tax on steel or on pollution; or require the installation of pollution control equipment;
Regulations;
consumer boycotts; labeling for food products, etc.

44. 5. An Efficient Role for Government
The government action could well be used to restore efficiency, but inefficiency is not a sufficient condition to justify government intervention. Why?
Any corrective mechanism involves transaction costs.
If they surpass the benefits from the intervention, then the best choice would be to live with the inefficiency.

45. Summary
① How producers and consumers use the resources making up the environmental asset depends on the nature of the entitlements embodied in the property rights governing resource use.
When property rights systems are exclusive, transferable, and enforceable, the owner has a powerful incentive to use them efficiently.

46. Summary
② The economic system will not always sustain efficient allocations.
Specific circumstances leading to inefficient allocations include: externalities, improperly defined property rights system, imperfect markets for trading the property rights, and asymmetric information.

47. Summary
③ Due to rent-seeking behavior by special interest groups or the less-than-perfect implementation of efficient plans, the political system can produce inefficiencies as well.

48. Summary
④ The efficiency criterion can assist in the identification of circumstances in which our political and economic institutions lead us astray.
It can also assist in search for remedies by facilitating the design of regulatory, judicial, or legislative solutions.

49. Self-Test exercises
Please try to answer the following questions independently, and repeat your answers in the next class if requested:
① , ⑥

50. Answers to question “deadweight loss”

51. Thanks
The end of Chapter 2