1. Natural Resources, the Environment and Agriculture Chapter 10

2. Topics of Discussion Agriculture and the environment Valuation of non-market goods Economics of soil conservation Government policies for agriculture, natural resources, and the environment 2

3. Agriculture and the Environment Water pollution  Non-point source  Fertilizer run-off from cropland  Point source  Manure pit overflow/leak Air pollution  Dispersed agricultural industry  Markets have become more distant  Dairy industry increased reliance on foreign markets  Distant markets require extension transportation system to obtain goods Pages 171-176 3

4. 4 Agriculture and the Environment Above Ground Manure Pit Manure Runoff and Soil Loss Hog Manure Spill, Clay Cty, KY

5. Agriculture and the Environment Global climate change  Impacts of changes in rainfall patterns  Impacts of temperature changes Other environmental impacts Odor from CAFO (Concentrated Animal Feeding Operations) Pages 171-176 5

6. Agriculture and the Environment 6

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8. Economics of the Environment From Ch. 8 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 8

9. Economics of the Environment Does the environment have value?  Example of the impacts of water pollution  Users of a particular water resource would be willing to pay (WTP) something to reduce (abate) the level of pollution  → Implicit demand for environmental improvements  Demand curve for pollution abatement?  Similar to market commodities Page 177 9

10. Economics of the Environment Are there costs associated with reducing the level of environmental pollution?  Install scrubbers on power plant smokestacks (i.e. Charter St. power plant)  Use more expensive lower sulphar coal  The above implies that there is a supply curve (MC curve) for pollution abatement What is the socially optimal level of pollution abatement?  Should pollution be reduced to 0? Page 177 10

11. Page 177 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 Socially efficient abatement level A2A2 C2C2 P2P2 C3C3 P3P3 A4A4 At A 4 too much abatement, Why? At A 4 too much abatement, Why? 11 WTP → Demand curve for pollution abatement WTP → Demand curve for pollution abatement

12. 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 12

13. 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  Exclusivity: All associated benefits and costs are received by only one individual at a time Pages 178-179 13

14. 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 or it could be taken without permission Pages 178-179 14

15. Efficient Property Rights Transferability: Property can be transferred from one individual to another  Example is laws prohibiting the sale of certain goods  Sale of goods made of ivory from endangered species  No markets will arise because sale is not allowed  Efficient transfer from one individual to another cannot occur Pages 178-179 15

16. Efficient Property Rights Exclusivity: All associated benefits and costs are received by only one individual at a time  One example of this not existing when some costs are not borne by the producer of the good but by the public at large Pages 178-179 16

17. Efficient Property Rights Exclusivity: All associated benefits and costs are received by only one individual at a time  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 178-179 17

18. Concept of Externality Externality  There exists positive as well as negative externalities  Example of positive externality: Honey producer’s impact on neighbors' apple crop  Example of negative externality: Playing loud music in your apartment to the point that it wakes your neighbors Pages 178-179 18

19. 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 Total willingness to pay = A + B + C + D Producer surplus = B Consumer surplus = C + D Total (societal) surplus is B + C + D 19

20. Page 179 Concept of Externality Suppose the production of Q causes pollution  Assume 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 of Q The social marginal cost (MC S ) per unit of production is: MC S = MC m + E x 20

21. Page 179 Concept of Externality Q $ C B 6 15 PmPm QmQm E x = $9/unit of output 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) E 21 D A

22. Page 179 Concept of Externality Q $ D E C B A 6 15 PmPm QmQm 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 E x = $9/unit of output

23. 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 ** 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 From above: SNB = D - E

24. 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 (i.e., last) unit purchased is 0  MC M =P m 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 (i.e., last) unit purchased is 0  MC M =P m PmPm

25. 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 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

26. Page 179 Concept of Externality From the above we can conclude the following:  In the presence of externalities the free market will not produce socially optimal level of output  Referred to as an example of market failure  Negative externality → produce too much of the good  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

27. 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 for damage abatement would arise Example:  A dairy farmer who has a pasture that borders a Class I trout stream and generates some non-point manure run-off into the stream  Local Trout Unlimited club wants the loadings to be reduced to ensure a self-reproducing trout population  The following is an example of a “Coase” market-based approach to solving the negative externality problem Pages 180-183

28. Environmental Policies Pages 180-183 TU : “We are 140,000 conservation minded anglers united behind a simple philosophy: take care of the fish, and the fishing will take care of itself.”

29. Environmental Policies The Coase Theorem  Attributed to British economist Ronald Coase  Describes the economic efficiency of an economic outcome in presence of externalities  → When trade in an externality is possible, bargaining (without transaction costs) will lead to efficient outcome  In practice, obstacles to bargaining or poorly defined property rights can prevent Coasian bargaining Pages 180-183 29

30. Environmental Policies Dairy farmer/Trout Unlimited example Pages 180-183 Q $ QmQm S m =MC m MC S =MC m +E x Qm*Qm* Q m * is socially optimal pollution for farm Area C is the externality (cost) of producing Q m Trout Unlimited offers a bribe of C + D to produce Q m * 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

31. Environmental Policies Coase’s approach has not been widely adopted due to the free-rider problem  Suppose Trout Unlimited decides to pay upstream polluters not to pollute  Although only Trout Unlimited 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 180-183

32. 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 180-183

33. 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 differential impacts of regulation  Example: In WI, not allowed to spread liquid manure on fields in winter due to frozen soil  Example: In Dane County cannot use phosphorous in fertilizer Pages 180-183 33

34. Introduction to Agricultural Economics, 5 th ed Penson, Capps, Rosson, and Woodward © 2010 Pearson Higher Education, Upper Saddle River, NJ 07458. All Rights Reserved. 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 w/lower abatement cost reduces more  Producer John w/higher abatement cost reduces less by the additional abatement of Producer Sue Pages 180-183 34

35. Environmental Policies Pages 180-183 Figures A & B represent the abatement MC for Firms 1 and 2  MC ↑ with abatement level Fig. C combines these two figures  D 2 < D 1 where each firm has 5 abatement units $ $ $ A1A1 A2A2 A1A1 A2A2 MC 1 MC 2 MC 1 5105 5 0 0 0 0 5 $ 35 D2D2 D1D1 A B C

36. Environmental Policies Pages 180-183 Movement to the right (left) would ↑ (↓) abatement for Firm 1 and ↓ (↑) abatement of Firm 2 Assume we want total abatement to equal 10 units  Firm 1: 10 → Firm 2: 0  Firm 1: 0 → Firm 2: 10  Firm 1: 5 → Firm 2: 5  Firm 1: 4 → Firm 2: 6 36 D 1,4 : MC of firm 1 for 4 units of abatement D 2,6 : MC of firm 2 for 6 units of abatement $ A1A1 A2A2 MC 2 MC 1 4 10 0 0 6 $ 5 5 D 1,4 D 2,6

37. If A 1 = A 2 = 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  A 1 =3, A 2 =7  TAC reduced by area F The gov’t could make such an allocation but would have to know the MC curves B Environmental Policies Pages 180-183 $ A1A1 A2A2 MC 2 MC 1 510 0 0 5 A C Firm 1 Firm 2 MC 1 * MC 2 * 3 7 F

38. Introduction to Agricultural Economics, 5 th ed Penson, Capps, Rosson, and Woodward © 2010 Pearson Higher Education, Upper Saddle River, NJ 07458. All Rights Reserved. TAC reduced if Firm 2 abates more, Firm 1 less  TAC is minimized when MC 1 = MC 2 (i.e., TAC*)  TAC* = D + E  TAC - TAC* = B = amount cost reduced for same total economy abatement (10) Each firm could be assigned firm-specific targets  Would have to know the MC curves of each firm Environmental Policies Pages 180-183 $ A1A1 A2A2 MC 2 MC 1 510 0 0 5 A B C MC 1 * MC 2 * 38 $ A1A1 A2A2 MC 2 MC 1 510 0 0 5 MC* TAC=A+C+B DE TAC*= D+E How do I know that A + C = D + E?

39. Environmental Policies Taxes and Subsidies: An incentive- based approach to environmental policy  Subsidy: Promote abatement  Tax: Penalize for pollution Assume we have a 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 180-183 $ A1A1 A2A2 MC 2 MC 1 510 0 0 5 3 S 7 39

40. Environmental Policies A tax on pollution would work just like a subsidy on pollution abatement  A tax of $T per unit of pollution → each unit of abatement saves the firm $T  The firm will continue to abate as long as the tax savings are ≥ MC of abating  One could also tax the output whose production generates the pollution  $T*/unit of output  Shifts up the firm’s (industry’s) marginal cost curve Pages 180-183 40

41. Introduction to Agricultural Economics, 5 th ed Penson, Capps, Rosson, and Woodward © 2010 Pearson Higher Education, Upper Saddle River, NJ 07458. All Rights Reserved. Environmental Policies A tax on output (Pigovian Tax)would shift up the marginal cost curve Pages 180-183 41 $ QmQm SmSm MC S =MC m + T* DmDm T* Qm*Qm* Pm*Pm* PmPm A B C D E F Price increase ≠ T* Impact on producers vs. consumers?  PS ↓ from A+F to C  CS ↓ from B+C+D+E to D  Amount of tax collected = A + B Deadweight loss to society of Pogovian tax = E+F Tax collected = A + B

42. Introduction to Agricultural Economics, 5 th ed Penson, Capps, Rosson, and Woodward © 2010 Pearson Higher Education, Upper Saddle River, NJ 07458. All Rights Reserved. Environmental Policies Difficulty with Pigovian tax is setting tax rate to counterbalance negative externality effects  $T* = $E x ?  Tax revenue used to pay damages of the externality Lobbying of gov’t by polluters  ↓ of tax rate  ↓ mitigating effect of the tax  Sub-optimal solution from society’s perspective Pages 180-183 42

43. Environmental Policies Advantage of tax/subsidy: Whatever abatement level is achieved it will be done at the lowest total cost across all agents (for society as a whole) Disadvantage of tax/subsidy: Unless firm specific MC curves known, will not know with certainty the abatement level achieved  T too low, too little abatement  T too high, too much abatement Pages 180-183 43

44. 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 180-183

45. 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 180-183 $ A1A1 A2A2 MC 2 MC 1 510 0 0 5

46. 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 180-183

47. 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 183-187

48. Economics of Soil Use Farmer undertakes efforts to prevent soil erosion so as to protect 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 183-187

49. 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 183-187

50. Discounting and Present Value Example of 5 years of $100/year net income from an acre of land each year → total net 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 183-187

51. 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 183-187 Discounting and Present Value

52. 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 $8.04 5- years from now and $6 today  The present value (PV) of $8.04 5-years from now given the 5% interest rate is $6.00 Pages 183-187 Discounting and Present Value Initial deposit Number of years Interest rate

53. 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 183-187 Discounting and Present Value

54. 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 183-187 Discounting and Present Value

55. 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 183-187 Discounting and Present Value PV of yr 1 income PV of yr 2 income PV of yr 3 income

56. 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 183-187 Discounting and Present Value

57. 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 183-187 Economics of Soil Use

58. 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 183-187 Economics of Soil Use

59. 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 183-187 Economics of Soil Use

60. 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 187-189 Water as an Asset

61. “The State Water Board’s mission is to preserve, enhance and restore the quality of California’s water resources, and ensure their proper allocation and efficient use for the benefit of present and future generations.” …Mission Statement, CA State Water Resources Control Board, CA Environmental Protection Agency Pages 187-189 Water as an Asset

62. We have two farmers who are competing for the use of a river’s water for irrigation total of 100 acre-feet  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 both farmers such that both farmers would like to use 80 acre feet of water  But there is only 100 acre-feet Pages 187-189

63. Water as an Asset One farmer is upstream of the other  Will use 80 acre-feet of water  → Only 20 acre-feet for downstream farmer Pages 187-189 Irrigation Marginal Revenue and Marginal Cost Irrigation Marginal Revenue and Marginal Cost Both farmers have the same revenue and cost curves Both farmers have the same revenue and cost curves Upstream farmer Downstream farmer 80 20 MC MR MR = Implied value of one more unit of water MC = Cost of producing one more unit of water MR = Implied value of one more unit of water MC = Cost of producing one more unit of water 100 $

64. Water as an Asset The 80/20 allocation is economically inefficient  Marginal Value of another unit of water = 0 for upstream farmer as MR=MC  Marginal Value of another unit of water for downstream farmer > 0 = ($A – $C) per unit → Total excess value =ABDC →Total net benefits could be ↑ by allocating water from upstream to downstream farmer Pages 187-189 Downstream farmer 80 20 MC MR 100 Upstream farmer A C $ B D

65. 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 This result is due to the assumed cost and revenue structures being the same across farmers Pages 187-189

66. 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 187-189

67. 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

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