1. Session 3: Market Efficiency and Sustainability

2. 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

3. 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

4. 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)

5. Willingness to Pay Fig 1: The Concept of Willingness to Pay P
Total Willingness to pay can be measured by the area under the demand curve. 60 50 40 30 20 10 1 2 3 4 5 6 Q

6. 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?

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

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

9. Willingness to Pay and Benefits
Demand curves can be used to determine the benefit that individuals get from consumption
Fig 4: Measuring Benefits P
What is the total benefit of increasing
Output of this good from q1 to q2
for individual 1 and individual 2? a I1 I2 b q1 q2 Q

10. 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

11. 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

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

13. 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

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

15. 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

16. 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

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

18. 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

19. 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)

20. 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?

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

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

23. 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

24. 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

25. 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

26. 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

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