EC383 ENVIRONMENTAL ECONOMICS

1
EC383 ENVIRONMENTAL ECONOMICS

• WEEK 2

Main Reference Perman, Chapter 5
2
Outline

• Conditions for Efficiency of Free Markets to
  Fail
• Externalities
• Result The Coase Theorem and
  Property Rights
• Limitations of
  the Coase Theorem
• Public Goods
• Result Underprovision by
  free market
• Information Incompleteness
• Result Preference Revelation
  needs to be induced

3
When are Markets (for Environmental Services)
Likely to Fail?

• Externalities
• Some environmental services are Public Goods
• Imperfect information

All three of these are likely to be present in
the sort of problem we study in this course.
Think of the global warming problem externalities
are present in agents actions, the climate is a
public good in a sense well define shortly, and
information is very imperfect on this issue at
the moment Well now consider each in turn and
possible responses to the issues raised in each
category
4
EXTERNALITIES
Definition There is a positive/negative
externality when the action of an economic agent
benefits/harms another economic agent and the
agent taking the action is not herself affected
by the fortune of the other agent. Examples
Smoking in restaurant Access roads and scenic
beauty Noise pollution
5
THE PROBLEM WITH EXTERNALITIES
If the activity of agent A generates a positive
externality for a agent B, then self-interested
agent A will expend too little effort on this
activity compared to what would be socially
optimal. Conversely, for a negative externality,
self-interested agent A will expend too much
effort on the activity compared to what would be
socially optimal. This principle holds
regardless of whether the activities involved are
consumption or production activities
6
Example 1 Consumption to Consumption Externality
YA, YB Composite good consumed by agent A,
B. SA Barbecue smoke generated by A and drifting
over Bs garden UA(YA,SA), UB(YB,SA)
- MB IS THE MARGINAL
BENEFIT OF BARBECUING TO A MEC IS THE MARGINAL
EXTERNAL COST BORNE BY B.
7
EFFICIENT BARBECUING

MEC
MB
S
0
S0
SA
8
Efficient Level of the Externality

• IF THE WELFARE OF A AND B ARE WEIGHTED
  EQUALLY,THEN EFFICIENCY REQUIRES THAT MB MEC,
  WHICH OCCURS AT SA S.
• NOTICE THAT, GENERALLY, THE SOCIALLY EFFICIENT
  LEVEL OF THE EXTERNALITY IS NOT ZERO.

9
PROPERTY RIGHTS
Assume that A has the legal right to pollute as
she wishes. Acting unilaterally, she would then
choose SA S0 Assume now that B has the legal
right to clean air. Acting unilaterally, he
would choose SA 0 Hence property rights do not
by themselves ensure that the efficient outcome
arises
10
PROPERTY RIGHTS AND BARGAINING
Assume that A has the legal right to pollute but
that A and B can also bargain efficiently. Defini
tion Efficient bargaining means that bargaining
will take place and will reach an outcome that
maximises the total surplus to be split between
the two parties.This presumes that bargaining
does not involve significant transaction costs
and that the bargaining is not characterised by
asymmetric information
11
Property Rights and Bargaining (2)

• Say A has the right to pollute
• MEC is Bs willingness to pay to obtain a unit
  reduction in SA. MB is As enjoyment from one
  more unit of barbecuing ? as long as MEC gt MB, A
  would rather take a payment from B to reduce S
  than enjoy this marginal unit of barbecuing ? A
  and B agree on SA S, with B paying something
  between c and c d to A.

12
EFFICIENT BARBECUING

MEC
MB
d
c
S
0
S0
SA
13
PROPERTY RIGHTS AND BARGAINING (3)
Suppose now that there is efficient bargaining
but that B has an absolute legal right to clean
air in his garden. MB is As willingness to pay
to be allowed one more unit of barbecuing. As
long as MB gt MEC, the parties can find
payments(between MEC and MB) so that extra
barbecuing is allowed and both parties are
better off ? they will agree on SA S, and B
will receive payments between b and a b.
14
EFFICIENT BARBECUING

MEC
MB
a
b
S
0
S0
SA
15
End of lecture
12/1 Below are two slides of review to start
lecture 19/1
16
(U XY)Move from No Runway to Runway
No Third Runway Third
Runway X Y U
X Y U
A 10 5 50
20 5 100 B
5 20 100 5
10 50
KALDOR A can compensate B (by giving 5 units of
X) ? Runway HICKS B can compensate A (by giving
5 units of Y) ?? No Runway
Utility? Uncertain benefits? Affected parties far
afield with large compensation costs? Unaffected
parties performing compensation? Framing ie,
depending on policy options get different answers?
17
Negative Externality

MEC
MB
overproduction
S
0
S0
SA
Failure of free market solution under
externalities.
18
COASE THEOREM
Definition The Coase Theorem says that, in the
presence of externalities, allocating property
rights to either party will lead to an efficient
outcome if efficient bargaining is
possible. CAVEAT WE HAVE IMPLICITLY ASSUMED
THAT A AND BS TASTES (REFLECTED IN MB AND MEC)
ARE INDEPENDENT OF THEIR WEALTH. IF THEY ARE
NOT THEN, SINCE DIFFERENT ALLOCATIONS OF
PROPERTY RIGHTS RESULT IN DIFFERENT LEVELS OF
WEALTH. THEY WOULD ALSO CORRESPOND TO DIFFERENT
MB AND MEC SCHEDULES AND THUS TO DIFFERENT
EFFICIENT ALLOCATIONS.
19
LIMITS TO THE APPLICABILITY OF THE COASE THEOREM

• TRANSACTION COSTS ? LESS LIKELY TO APPLY AS
• NUMBER OF PARTIES GETS LARGE
• ASYMMETRIC INFORMATION ? BARGAINING DOES
• NOT NECESSARILY PRODUCE THE EFFICIENT
• OUTCOME
• THE EXTERNALITY MIGHT AFFECT SEVERAL
• PARTIES AND HAVE A PUBLIC GOOD ASPECT
• ASSIGNING AND DEFENDING PROPERTY RIGHTS
• ON EVERYTHING MIGHT BE PROHIBITIVELY
• COSTLY

20
Example 2 Production to Production Externality
Firm A produces X according to the production
function X F(LX,KX,S) and firm B produces Y
according to the production function Y
G(LY,KY,S), where S is the amount of pollutant
generated by A. Polluting helps A produce X but
hurts B, i.e. ?X/?S gt 0 and ?Y/?S lt 0. Define
the profits of firm A and firm B as ?A and ?B
respectively. Then the MEC is just ??B/?S and the
MB is just ??A/?S. From then on, the analysis is
identical to the consumption to consumption case.
21
EFFICIENT POLLUTING

MEC of pollution to the receiving firm
MB of pollution to polluting firm
S
0
S0
SA
22
EFFICIENT POLLUTING

MEC of pollution to the receiving firm
MB of pollution to polluting firm
S
S
0
S0
SA
23
Externalities and Total SurplusEmissions from
Production

• In the presence of a negative externality, the
  marginal social cost (MSC) exceeds the marginal
  private social cost (MPC) by the extent of the
  marginal external cost (MEC)
• In a competitive economy, production occurs where
  price (as given by the demand curve) is equal to
  MPC.

24
Market-Based Approach
Price
MSC
MPC
Ps
Pc
demand
MEC
Output
0
Qc
Qs
25
Externalities and Total Surplus

• In the presence of a negative externality, the
  marginal social cost (MSC) exceeds the marginal
  private social cost (MPC) by the extent of the
  marginal external cost (MEC)
• In a competitive economy, production occurs where
  price (as given by the demand curve) is equal to
  MPC.
• This is higher than the socially optimal level of
  production, determined at the intersection of
  demand and MSC.

26
Market-Based Approach
Price
MSC
Total surplus at Qs
MPC
Ps
Decrease in total surplus Going from Qs to Qc
Pc
MEC
0
Qc
Qs
Output
27
Example 1 Emissions and Emission Fees

• Consider the case where the MEC reflects the
  pollution associated with the production process.
• One possible approach to the problem is to tax
  the production of the polluting good in a manner
  that reflects the marginal cost imposed on
  others.
• In other words, taxes can be used to force the
  polluters to internalise all of the costs
  associated with its production.

28
Socially Optimal Level of Pollution Through Taxes

• The trick is to impose just enough of a tax so
  that the MPC plus that tax goes through the point
  where MSC intersects demand.
• In that manner, the private producers will, on
  their own accord, choose the socially optimal
  level of output

29
Optimal Unit Tax
Price
MSC
MPC t
MPC
Ps
t
MEC
t
Output
0
Qs
30
Example 2 Common Property Resource and Congestion

• Pollution was an example of negative externality
  arising as a by-product of productive activity.
• Negative externalities can also arise in markets
  that do not generate such by-products.
• This occurs with common property, i.e. property
  that a number of agents can access for free and
  such that the value of the property to an
  individual decreases with the number of other
  individuals using it.

31
Tragedy of the Commons

• The Commons were often common grazing land.
• If the land is over-grazed, its quality will
  deteriorate.
• Common agricultural land will tend to be overused
  because each user only because each individual
  determines his/her use without any regard for the
  consequences of land degradation for other users.

32
Other Examples

• Road Congestion
• Internet Congestion
• Fishing grounds

33
Common Property and Congestion

• The source of the externality is not production
  of a by-product but use/participation.
• Hence use/participation is what should be
  penalised.
• The most straightforward manner of doing this is
  to have a user fee.
• Examples London congestion charge, or other
  road-pricing schemes.

34
Common Property and Congestion (2)

• Another approach would be to privatise the common
  property and let the private owner(s) choose the
  access fee.

35
Congestion Pricing Example

• One Road
• Two times of day peak (high demand) and off-Peak
  (low demand)
• MPC is the drivers Private cost from driving
  given the level of traffic. MEC is the
  externality imposed on other drivers.
• The optimal pricing structure imposes a toll of
  to off peak and a toll of tp during peak times

36
Congestion Pricing

MSC MPC MEC
MPC
tp
MEC
to
Peak Demand
Off-Peak Demand
0
Vehicles per Hour
37
Example 3 Environmentally Friendly Production

• Undertaking environmentally friendly
• production creates positive externalities.
• The private benefit is any benefit it confers
• on the source.
• The external benefit is the benefits reaped by
  others.
• Social benefit is the sum of these two benefits.

38
Example Environmentally Friendly Production

MC supply
S
MSB
Optimal Subsidy
MPB market demand
MEB
Qs
Qp
0
units
39
PUBLIC GOODS
A good is described as Rival if its consumption
by one agent precludes its consumption by another
agent. Hence, an apple is a rival good, but an
idea is not. Air is usually considered
non-rival. A good is described as Excludable if
it is possible to select agents who can consume
it. In practice, one can think of ways to make
most goods excludable so the criterion is
whether such exclusion is not too costly. In
that sense, national defense is clearly not
excludable but access to a public park might or
might not be. Pure Private Goods are both
rival and excludable, while pure Public Goods are
neither. Well focus on pure public good case
40
Efficiency with Public Good
There are two goods, a public good X and a
private good Y, and two agents A and
BRecall With two private goods economic
efficiency required that
MRUSA MRUSB MRT With Y private and X
public, the corresponding condition is
MRUSA MRUSB MRT
41
Explaining the Efficiency Condition
Assume that MRT 1, so that giving up one unit
of X allows the economy to produce one more unit
of Y, and conversely. To have economic
efficiency, such a marginal change in the output
mix must leave A and B indifferent. Suppose then
that society does give up one unit of X for one
more unit of Y. Let X be a public good. Start
from MRUSA MRUSB MRT. As X is a public good,
each agent suffers the loss of a full unit
of consumption. On the other hand, as Y is a
private good, each agent only gains ½ extra unit
of Y. The MRUS tells us how many extra units of
Y are needed to make the agent just willing to
give up one unit of X. Hence to leave both A and
B indifferent when Y is split between A and B,
it must be the case that A and B are willing to
accept less Y in exchange for one unit of X, or
MRUSA MRUSB 1 MRT.
42
Figure 5.12 The efficient level of supply for a
public good. (MWTP stands for
marginal willingness to pay)

MRUSA MRUSB MWTPA MWTPB MB
MC MRT
MRUSB
MWTPB
MRUSA MWTPA
X
0
X
Recall that aggregate demand usually is the
horizontal sum of individual demands. Here, it
is the vertical sum!
43
Public Goods and Market Economy
We have seen that, under some stringent
conditions, a market economy can ensure that
MRUSA MRUSB MRT. If all goods are private,
this is one of the conditions for economic
efficiency.but it is not as soon as one of the
two goods is a public good. Why? Because trade
usually ensures efficiency. If X is a public
good, and A has it to trade, then B surely
has access to the same amount. So why should B
trade away any of the private good to get X? Why
not just be a free rider? A market economy
cannot generally ensure the efficient
provision of public goods. If information is
full, however, we can rely on public provision
combined with taxation.
44
Figure 5.12 The efficient level of supply for a
public good. (MWTP stands for
marginal willingness to pay)

MRUSA MRUSB MWTPA MWTPB MB
MC MRT
MRUSB
MWTPB
MRUSA MWTPA
X
0
X
Recall that aggregate demand usually is the
horizontal sum of individual demands. Here, it
is the vertical sum!
45
The Preference Revelation Problem
The agents preferences with respect to public
and private goods are not public knowledge. In
an economy with private goods only, this is not a
problem as the market mechanism only requires
that each agent knows his or her own preferences.
Trading behaviour reveals and reflects these
preferences, as do prices. To achieve efficiency
with public goods, one needs some other mechanism
leading agents to truthfully reveal their
preferences
46
An Example
Should one build a foot-bridge between Wivenhoe
and Rowhedge? Total Cost 1,000,000 Two
agents, Rowhedge (R) and Wivenhoe (W). Each
would enjoy benefits of 750,000 from the bridge.
Since 750,000 750,000 gt 1,000,000, the bridge
should be built.but will it be? Procedure
without central government each party votes
independently for or against the bridge. With
two positive votes, the bridge is built and the
cost is shared equally. With two negative
votes, the bridge is not built. With only one
positive vote, the bridge is built and the
community that voted for it shoulders the entire
expense.

47

W
FOR AGAINST FOR
250,000 250,000 -250,000,
750,000 R AGAINST 750,000, -250,000
0 0
payoffs are written (R, W)
Both, in essence, understate their willingness to
pay. Any mechanism to reveal preferences
truthfully will have to take such strategic
behaviour into account.
48
IMPERFECT INFORMATION
Agents might not be aware of the externalities
from which they benefit or suffer. The
government might therefore have a role as
provider of credible information
This is explicit in the Stern Review
49
GOVERNMENT FAILURE
The government can itself be inefficient,
however. Reasons for governmental inefficiency
include Lack of information
Incompetence Organizational inefficiencies
(bureaucracy) Governments are not necessarily
benevolent (political economy)
? In case of market failure the
choice is between two imperfect solutions.
50
Summary

• As we saw in Week 1, the free market can be a
  good
• instrument for achieving efficiency under
  some rather
• strict conditions.
• If these conditions fail, we may be able to
  re-establish
• efficiency.
• The Coase Theorem indicates that, under certain
  conditions,
• by establishing clear property rights,
  decentralised
• interactions among agents can allocate a
  resource
• efficiently, despite externalities.
• These conditions may not be fulfilled, however.
  Other
• instruments such as taxes/fees are
  available.

51

• When public goods must be allocated, the market
  will tend
• to be inefficient, with the public good
  underprovided due
• to free riding.
• When information about valuations of public goods
  is
• incomplete, strategic behaviour can hamper
  efforts to
• reveal the information that governments
  could use to
• correct market failures. Furthermore,
  government
• incompetence or strategic behaviour can
  make both
• resolution of informational problems and
  attainment
• of socially efficient outcomes difficult.