The Economy and the Environment

THE ECONOMY AND THE ENVIRONMENT

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•Environmental Economics is concerned with the impact of the economy on the environment, significance of the environment to the economy, and the appropriate way of regulating economic activity for achieving balance among environmental, economic and other social goals •Essence of environmental problem is the economyproducer behaviour and consumer desires

The Economy and the Environment

• It is one of the fastest growing branches in economics • Many environmental goods have become scarce resources • For many decision making problems in environmental problems an economic approach is needed to obtain the money value of the damages • There has been a shift in emphasis from command and control policy to economic/market based instruments to achieve environmental policy goals

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• Government faces budget constraints

• In reaching binding international agreements on global environmental issues, economic analysis is needed to assess the likely impact of different policy options on distribution of benefits and costs among the member nations and in devising mechanisms for sharing the costs and benefits in equitable manner

The Economy and the Environment

• Consumer behaviour, firm behaviour, market structure, economics of information and uncertainty (Microeconomics) • Externalities, public goods, efficiency and equity concepts (Welfare Economics) • Design of taxes and subsidies, public goods (Public Economics) • Optimal control theory, input-output model, game theory and econometrics (Quantitative Economics)

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The Economy and the Environment • Economy: All the firms that make up industry • Environment: All natural resources, including land, land cover and ecosystems • The economy operates from inside the environmental system, with conditions in the two systems being simultaneously determined • Many links between the two systems

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Environmental System Global Life Support Impact on bio diversity

Economic System

Resource Inputs

Amenity Values

Wastes (Global, regional And local pollution)

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Linkage between the Economy and the Environment • Environment provides inputs of raw materials and energy sources • Waste sink for the economy • Direct source of amenity to the environment • Basic life support services ▫ Climate regulation, operation of water cycle, regulation of atmospheric composition and nutrient cycling

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Impact on the Environment • An increase in the use of environment as a waste sink may reduce the ability to supply basic life support

• Reduction in amenity flows ▫ developed in national parks, logging reducing Quarries the area of rainforest

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Impact on the Environment • Effect on natural diversity (by taking over habitats) • Co-evolution ▫ The way in which economic subsystem evolves over time depends on the changing conditions of the environmental subsystem, and vice versa

• Case of Neolithic Scotland

The Economy and the Environment

Insights from Economics Environmental Studies

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required

in

• Simultaneously determined • Behavioral underpinnings of economics ▫ Incentives ▫ Decisions at margins ▫ To expect firms and households to act in their best interests

• Scarcity • Market Failure

The Economy and the Environment

The First Law of Thermodynamics: Materials Balance Principle

“Matter, like energy, can neither be created nor be destroyed” • Implications: ▫ As more matter is extracted by the production process, more waste is generated ▫ Puts limits on the degree to which resources can be substituted

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The Second Law of Thermodynamics: Entropy Law “In a closed system, the use of matter-energy causes a one way flow from low entropy resources to high entropy resources; from order to disorder” • Implications: ▫ Energy can not be recycled in such a way that we get back all the capacity of the original energy source ▫ Helps in understanding the limits of matter-energy recycling, but is not harbinger of doom

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The Market System is considered failure when a set of competitive markets fail to generate an efficient allocation of resources between and within economies. Efficiency is defined as ‘Pareto Optimality’ which states the impossibility of reallocating resources to make one person in the economy better off without making someone else worse off. Efficiency defined in terms of ‘Pareto Optimality’ is achieved when private decision leads to a social Optimum.

The Economy and the Environment

Six Cases of Market Failure:
Incomplete Markets
Externalities
Non-exclusion
Non-rival and Public Goods
Non-convexities
Asymmetric information

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Markets are complete when enough markets exist to cover each and every possible transaction or contingency so that resources can move to their highest valued use. A complete market requires a set of well-defined property rights system This well defined property rights system represents a set of entitlements that define the owner’s privileges and obligations for use of a resources or asset

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A well-defined property Rights system has the following key characteristics: Comprehensively assigned: all resources or assets should either be privately or collectively owned Exclusive: all benefits should accrue to the owner only either directly or through sale Transferable: from one owner to another in a voluntary exchange Secure: from involuntary seizure or encroachment by other individuals, firms or the government

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One of the prominent reasons for market failure Normally actions or decisions by one individual agent does not directly affect anybody else. For example: purchase of shoes Some other actions affect others directly. For example: driving near hospital (harmful effects inoculation of children (beneficial effects)

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Two Types Externality: Positive and Negative Positive: when action of individual agent has beneficial effects. Examples: 1. Flowers garden providing enjoyment, 2. Vaccination, 3. Production of Honey Negative: when action has negative effects on the agents Examples: 1. if neighbor plays loud music at 4 a.m. in the morning, 2. Riding on a noisy motor cycle, 3. Smoking in a public place.

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Externality the Problem: A.C. Pigou in his book titled Wealth and Welfare (1912) dealt with the problem of Externality systematically for the first time. Overall economic efficiency requires that: MSB = MSC MSB = Marginal Social Benefit MSC = Marginal Social Cost where, MPB = Marginal Private Benefit MSB = MPB + MEB MPC = Marginal Private Cost MEB = Marginal External Benefit MSC = MPC + MEC MEC= Marginal External Cost If, MSB>MSC, Output can be expanded because additional output adds more benefits to the society than the cost. In a situation when MSB≠MSC, the optimal condition of efficiency can be obtained through imposition of Tax and Subsidy

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Externality in Production: Negative and Positive Figure 1: Negative Externality in Production Price, MC

Fig 1 illustrates negative externality in Production (MSC>MPC)

MSC D

MPC

Po P1 C0

Assuming no externalities in consumption, DD shows MSB and MPB (MSB=MPB)

D

Q0

Q1

Quantity

With MSC the optimal output produced is Q0 corresponding to Price P0 (where MSC=MSB)

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The Competitive Market (when left alone) produces Q1 with a price P1 - There is a tendency to overproduce. At Q0 the Price is P0 but the MPC is C0 Therefore the Govt. can levy a per unit tax of (P0 - C0 ) which in turn will increase MPC by (P0 -C0) and reduce output from Q1 to Q0 At Q0 the consumers would pay P0 the full marginal social cost of Production.

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The extra revenue earned from taxation can be used for external damage from production of this product. The tax revenue could be more or less than the external damage The tax revenue is equal to (P0 - C0)×Q0 whereas the total external cost would be equal to area between MSC and MPC The Net Gain to the Society is equal to ∑(MSC-MSB) over Q0 to Q1 (the shaded area) which is eliminated by tax.

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Figure 2: Positive Externality in Production Price, MC

Fig 2 illustrates positive externality in Production (MSCMSC)

MSB

D MPC=MSC

Po P1 C0

Assuming no externalities in production (MSC=MPC)

D=MPB

Q0

Q1

Quantity

The optimal quantity is given by Q0 (the point where MSB=MSC)

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In the absence of any intervention, the quantity supplied and produced is Q1 with a price P1 At Q1 there is overproduction of the commodity compared to social optimality To restrict the output to Q0 , the price has to be increased to P0 But the supply price for Q0 is C0 Hence a tax equal to (P0 - C0 ) needs to be levied

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The price consumers pay is P0 (=MPC + Cost of Externality in Consumption) The revenue generated from the consumption of the tax could be used to compensate those who are hurt by the external cost arising from the consumption of the product The shaded area measures net benefit of the tax policy.

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Externality in Consumption: Negative and Positive Figure 4: Negative Externality in Consumption Price, MC

Fig. 4 illustrates positive externality in Consumption (MPBMPC

Tax Producers

MSC – MPC

MSCACE so that gain to the fishers is larger than the loss to the consumers and producers, there is the possibility for the fishers to bribe the producers and consumers to cut production to Q0 Thus, this proves that socially optimal level of output could be achieved without government taxing or subsidizing.

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If the number of people involved is large, the bargaining costs will be high Assignment of property rights to any party also does not make any difference to the allocation of resources In our example, if Property rights to the river were assigned to the fishers, the paper mill would have to pay the fishers compensation for dumping the waste in the river equal to (MSC-MPC) per each unit in fig. 5 The paper mill, thus, would have to take the costs of compensation in to account when calculating its costs. Thus the externality has been internalized

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Caose Theorem: Under Perfect Competition, if income effects and transaction costs are ignored, voluntary agreements among the different parties concerned will lead to a socially optimal output even in the presence of externalities, an the result will be the same regardless of which party is assigned the property rights to the contestable resource.

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Another reason for Market Failure Non-exclusion implies a situation when it is impossible or at least very costly to deny access to an environmental asset. In the presence of non-exclusion, but with rivalry in consumption user finds incentive to capture the goods as soon as possible before anyone else captures them It, in turn, results in over-use as the market fails to signal true scarcity value of the asset The problems associated with non-exclusion implied by such open access property rights have long been recognized, but it has been popularized by Hardin (1968) through his celebrated article “The Tragedy of the Commons”.

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Concepts: Commons: Refers to the environmental resources itself Common Property Resources: refers to a property right regime that allows members of a group or collective body to use the asset and devise rules to exclude non-members from using the resource. Open Access Resources: Implies there is no ownership of the asset in the sense that “everybody’s property is nobody’s property”.

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An environmental asset is considered a pure public good if its consumption is non-rival and nonConcepts: Commons: Refers to the environmental resources itself excludable. Common Property refers to a property Non-rival means Resources: good is available to all right and one regime that allows members of a group or collective body person’s consumption does not reduce another to use the asset and devise rules to exclude non-members person’s from usingconsumption the resource. – it implies that the marginal cost of supplying the good to an additional individual isOpen zero.Access Resources: Implies there is no ownership of the asset in the sense that “everybody’s property is property”. Itsnobody’s is not Pareto efficient to set prices that will exclude

anyone who derives positive marginal benefits from the public, hence, market failure occurs.

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InConcepts: addition, with the provision of pure public goods Commons: to the environmental resources itself there is alsoRefers the problem of free riding. Common Property Resources: refers to a property right A regime free that rider is one who conceals his or her allows members of a group or collective body preferences for and thedevise goodrules in order to enjoy benefits to use the asset to exclude non-members without paying for them from using the resource. Resources: Impliesmarket there is no InOpen the Access presence of free-ride, willownership provide of less asset in the sense propertyresulting is ofthe public good thanthat is “everybody’s socially desired in nobody’s property”. misallocation of resources

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Convexities associated with environmental bads (e.g. pollution): Concepts: 1. results from assumption that marginal benefits Commons: Refers to the environmental resources itself and cost functions are well behaved: i.e. marginal benefits are decreasing while marginal costsright are Common Property Resources: refers to a property increasing. regime that allows members of a group or collective body to use the asset and devise rules to exclude non-members implies that if an equilibrium level of pollution exists, from 2. using the resource. it is unique 3. therefore, if a set of complete markets exist for clean water or pollution control, the market will send the correct signal about the socially optimal level of pollution.

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Concepts: In real situation, for many physical systems the Commons: Refers to the environmental resources itself marginal benefit or cost curve need not be so well behaved assumed by convexities Common as Property Resources: refers to a property right regime that allows members of a group or collective body Marginal costs and may at first increased to use the asset devise rulesincrease to excludewith non-members from using but the resource. pollution then may actually decrease or go to

zero as the physical system so badly damaged that there are simply no more costs as pollution costs as pollution increases.

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Concepts: Commons: Refers to the environmental resources itself

Thus Non-convexities implies that there may be Common Property Resources: refers to a property right more than one locally optimal level of pollution

regime that allows members of a group or collective body to use the asset and devise rules to exclude non-members Infrom theusing presence of non-convexities, market fails to the resource.

send correct signal about the socially optimal level of pollution.

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Asymmetric Information arises when there exists Concepts: differences amongitself the Commons: Refersofto the information environmental resources agents/parties involved in a transaction. Common Property Resources: refers to a property right regime that allows members of a group or collective body For example: to use the asset and devise rules to exclude non-members from using the resource.

1. when an insuree knows more about his precautionary behaviour thanthere the isinsurer Open Access Resources: Implies no ownership of the asset in the sense that “everybody’s property is 2.nobody’s Seller property”. knows more about the quality of a product

than a buyer

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Two types of Asymmetric Information: Moral Hazard and Adverse Selection Moral Hazards: the moral hazards or incentive problem arises when the actions of one person unobservable to a second person. Adverse Selection: the adverse selection problem exists when one person can not identify the type or character of the second problem.