The Economic Approach to

Environmental and Natural

Resources, 3e
By James R. Kahn
2005 South-Western, part of the Thomson Corporation
Theory and Tools of
Environmental and Resource
Economics
3e
Part I
Economic Efficiency and
Markets: How the nvisi!le
Hand "orks
Chapter 2
2004 Thomson Learning/South-Western
4
The "orkin# of the nvisi!le Hand

Adam Smiths The "ealth of Nations argues that

markets lead to socially eicient allocation o
resources. People acting in their o!n "est interests
tend to promote the social interest.

Anti#glo"ali$ation protestors counter that ree

markets are the root o all social e%ils.

&he truth pro"a"ly lies some!here in "et!een.

5
Market $undamentals

Begin "y looking at an e%ery day pri%ate

good.

&he goal is to understand the diering

components o a market.

Ater !e understand ho! a market !orks' !e

can add the comple(ity associated !ith the
impact o market acti%ity on the en%ironment'
and the impact o the en%ironment on market
acti%ity and society in general.
6
$i#ure %&' ( Market for )lue *eans
7
The Market for )lue *eans

&he marginal costs o "lue )eans are relected in the

up!ard sloping supply unction. &hese costs
include*

Production costs such as la"or' energy' capital' and

materials.

&he do!n!ard sloping unction is the demand cur%e

!hich represents ho! much people are !illing to
pay or an additional pair o )eans.

Consumer demand is inluenced "y tastes and

preerences' prices o su"stitutes and complements'
income' num"ers o consumers and consumer
e(pectations.
8
The Market for )lue *eans

E+uili!rium is the price at which +uantity

demanded e+uals to +uantity supplied&

+hat happens !hen price is not at e,uili"rium-

&here is an automatic ad)ustment "ack to
e,uili"rium.

I price is less than e,uili"rium .P/0' then ,uantity

demanded !ill "e greater than ,uantity supplied and
there !ill "e pressure on price to rise .up to e,uili"rium0.

I price is greater than e,uili"rium .P/0' then ,uantity

supplied !ill "e greater than ,uantity demand and there
!ill "e pressure on price to all .do!n to e,uili"rium0.

Measurin# Net )enefits

I !e make t!o simple assumptions*

All costs associated !ith "lue )eans are

incorporated into the supply cur%e.

All the "eneits associated !ith "lue )eans are in the

demand cur%e.

&hen e,uili"rium in this market also e,uates

marginal "eneits !ith marginal costs.

&he market ma(imi$es total net "eneits.

!0
Measurin# Net )enefits

&he demand cur%e can %ie!ed as a marginal

%alue unction "ased on !illingness to pay.

&he market demand cur%e is the sum o all

indi%idual demand cur%es.

1%ery indi%idual demand cur%e relects a

!illingness to pay "ased on a percei%ed %alue .or
"eneit0 o the good.

As a result' the market demand cur%e

relects pri%ate "eneits.
!!
Measurin# Net )enefits

&he supply cur%e relects the costs o

producing the good or ser%ice.

&hese costs are incurred in production and

can "e %ie!ed as pri%ate' since all these
costs are "orne "y the suppliers.

As such' the supply cur%e em"odies pri%ate

costs.
!2
Ma,imi-in# .rivate and /ocial )enefits

Pri%ate net "eneits are ma(imi$ed at

e,uili"rium.

In order or social net "eneits to "e

ma(imi$ed' it is necessary that pri%ate
marginal "eneits !e identical to social
marginal "eneits and pri%ate marginal costs
!e identical to social marginal costs.

I this condition holds' then market orces

!ill e,uate "oth marginal pri%ate costs and
"eneits and marginal social costs and
"eneits.
!"
Market $ailure: "hen the nvisi!le Hand
0oesn1t "ork

2arket 3ailure occurs !hen the market does

not allocate resources eiciently.

4ne possi"le cause o market ailure is a

di%ergence "et!een pri%ate and social costs.

Consider a production process !hich

relects all the pri%ate costs o production
"ut does not relect all the social costs
associated !ith production .or e(ample' i
the process generates air pollution0.
!4
$i#ure %&3& /teel .roduction E,ample
!5
Market $ailure

2arket orces generate an e,uili"rium

production le%el and price associated !ith
pri%ate costs .56 and P60.

&his output le%el is greater than the socially

optimal le%el o 5/ .!hich considers
additional cost rom pollution0.

&he shaded area in 3igure 2.7 represents the

costs to society o ha%ing this higher than
optimal le%el o output.
!6
Market $ailure

&here are 8 categories o market ailure*

Imperect competition.

Imperect inormation.

Pu"lic goods.

Inappropriate go%ernment inter%ention.

1(ternalities.
!7
mperfect 2ompetition

Imperect competition occurs !hen the indi%idual

actions o particular "uyers or sellers ha%e an
impact on market price.

In imperectly competiti%e markets' marginal

re%enue di%erges rom price and marginal social
cost is not e,ual to marginal social "eneit at
e,uili"rium.

2arket ailure due to imperect competition has an

impact on the study o en%ironmental and natural
resources "ecause o the monopoly po!er in
e(tracti%e industries such as oil and coal.
!8
$i#ure %&3& mperfect 2ompetition
!
mperfect nformation

Imperect inormation means that some segment o

the market .either consumers' producers' or "oth0
does not kno! the true costs or "eneits associated
!ith the good or acti%ity.

3or e(ample*

9igh risk occupations !here !orkers do not ha%e

complete inormation a"out risks.

9a$ards o using chemicals in your home !here you may

not "e ully a!are o dangers and potential side#eects.

Potential that armers in de%eloping countries are not

a!are o en%ironmentally riendly alternati%es to clear
cutting.
20
.u!lic 4oods

Pu"lic goods are distinguished rom pri%ate goods

"y t!o primary characteristics* nonri%alry and
none(cluda"ility.

:onri%alry means that one indi%iduals consumption

does not diminish the amount o the pu"lic good
a%aila"le or others to consume.

:one(cluda"ility means that i one person has the

a"ility to consume the pu"lic good' then others cant
"e e(cluded rom consuming it.
2!
.u!lic 4ood

:ational deense is an e(ample o a pure

pu"lic good.

:one(cluda"ility holds "ecause in protecting

one citi$en in a region rom missile attack'
e%ery citi$en is protected.

:onri%alry holds "ecause one citi$ens

consumption o protection does not reduce
the le%el o protection a%aila"le to other
citi$ens.
22
.u!lic 4ood

:ot all pu"lic goods are pure pu"lic goods.

It is possi"le to "uild a long ence around the

;rand Canyon to e(clude people.

It is also true that "eyond some point' more

people at the ;rand Canyon reduces the
,uality o the e(perience or e%eryone.
2"
$i#ure %&5 /pectrum of pu!lic #oods
24
nappropriate 4overnment ntervention

;o%ernment inter%ention is a potential

source o disparity "et!een pri%ate and
social %alues.

4ten go%ernment action to address an

alternati%e issue creates this di%ergence.

As 3igure 2.< illustrates' go%ernment policy

regarding leasing o tim"ering has created a
greater than socially optimal le%el o tim"er
har%est.
25
$i#ure %&6 ( nappropriate 4overnment
ntervention
26
E,ternalities

1(ternalities are "est descri"ed as =spillo%er

costs or "eneits>' unintended conse,uences
or side eects' associated !ith market
transactions.

&hese unintended costs or "eneits !ill

result in a di%ergence "et!een pri%ate and
social "eneits and costs .as illustrated in
3igure 2.70.

1(ternalities are perhaps the most important

class o market ailures or the ield o
en%ironmental and resource economics.
27
E,ternalities

A more complete deinition is pro%ided "y

Baumol and 4ates .6?@@' p.6A0

7An e,ternality is present whenever some

individual1s 8say A1s9 utility or production
relationships include real 8that is
nonmonetary9 varia!les, whose values are
chosen !y others 8persons, corporations,
#overnments9 without particular attention to
the effects on A1s welfare&:
28
E,ternalities

Key points rom this deinition*

Production and Btility

Real %aria"les

Bnintended eects
2
;nintended Effects

I you !ere intentionally "lo!ing cigar smoke

in someones ace' that is not an e(ternality.

I your cigar smoke drits rom your ta"le to

someone elses' then this is an e(ternality.

Intent is important.
"0
Real <aria!les

Real %aria"les are not prices.

Bnintended price change is not an

e(ternality.

Price changes are %ie!ed as =pecuniary

e(ternalities>' not real.
"!
.roduction and ;tility Relationships

Air pollution has the potential to impact "oth

production and utility relationships.

Air pollution may create a less ideal gro!ing

condition and impact yields.

Air pollution may also make outdoor

acti%ities less en)oya"le .reduce utility0.

&hese are e(amples o technological

e(ternalities.
"2
Technolo#ical vs& .ecuniary E,ternalities

Consider 3igure 2.@ !hich represents a production

possi"ilities rontier or t!o goods* cotton and steel.

&he production possi"ilities rontier sho!s all

easi"le production points.

Consumer preerences determine the actual

com"ination o cotton and steel produced.

A change in consumer preerences !ill result in a

change in demand' !hich changes prices and proit
potential' !hich' in turn' !ill cause a change in
production le%els o "oth goods .along the same
production possi"ilities rontier0. &his is a pecuniary
e(ternality.
""
$i#ure %&=> .roduction .ossi!ilities
$rontier
"4
Technical vs& .ecuniary E,ternalities

:otice the second lo!er cur%e in 3igure 2.@.

&his represents a situation !here the

production o steel generates pollution .an
e(ternality0.

Pollution reduces the yield per acre o cotton

!ith the e(isting resource "ase.

A ne! lo!er production possi"ilities cur%e

results rom this e(ternality.

&his is a technical e(ternality.

"5
E,ternalities as .u!lic 4oods

Reerred to as nondepleta"le e(ternalities'

these are characteri$ed "y the pu"lic good
property o nonri%alry.

&he pollution o drinking !ater is a good

e(ample !here one persons consumption o
the !ater pollution does not reduce the
amount o !ater pollution to !hich others are
e(posed.
"6
Market $ailure and .roperty Ri#hts

A special class o e(ternality that is

generated "y the lack o property rights .or
the ina"ility to enorce property rights0 is the
open#access e(ternality.

In this case property rights are insuicient to

pre%ent general use o a resource and
uncontrolled use leads to destruction or
damage o the resource.

1%en !hen property rights e(ist' an ina"ility

to enorce them !ill lead to open#access
e(ternalities.
"7
The nvisi!le Hand and E+uity

2arket allocation o resources' a"sent o

market ailure' is eicient.

An eicient allocation ma(imi$es the

dierence "et!een social "eneits and social
costs.

An eicient allocation' ho!e%er' does not

imply e,uita"le allocation.

&he ="est> distri"ution depends on !hat

%ie! o e,uity or airness is held.
"8
The nvisi!le Hand and 0ynamic
Efficiency

A static analysis is only concerned !ith one

time period.

I the optimal allocation o resources in one

period depends on the optimi$ing decisions
o the past or uture periods' then a dynamic
analysis must "e employed.
"
The nvisi!le Hand and 0ynamic
Efficiency

Static e(ample C a armer has 6DD acres o

cropland and decides to plant one type o
crop this year and a dierent crop ne(t year'
in response to changes in market orces.

Eynamic e(ample C a armer has 6DD acres o

orest land and 6DD acres o cropland. A
choice to cut trees this year means that in
the ne(t time period the trees !ill "e gone.
40
0ynamic Efficiency and E,hausti!le
Resources

Since decisions made today can inluence

the ,uality and stock o resources ar into the
uture' one !ould e(pect dynamic
considerations to "e important in the study
o en%ironmental and resource economics.

3or e(ample' the decision o ho! much oil to

take out the ground today eects our a"ility
to take oil out o the ground in the uture.

&his !ill "e "ased on ho! much people !ill

"e !illing to pay or oil in the uture.
4!
0ynamic Efficiency and E,hausti!le
Resources

1iciency re,uires that you continue to sell

oil today until the point at !hich marginal
cost e,uals marginal re%enue.

&he !ay in !hich the uture is represented in

this decision is to incorporate an opportunity
cost .user cost or rent0 into the decision
making process.

&he interest rate "ecomes important also.

42
0ynamic Efficiency and E,hausti!le
Resources

&he indi%idual oil o!ner has t!o choices or

producing income in the uture*

Sell oil today and in%est money and earn interest

income.

9old on to oil' sell in the uture.

Intertemporal eiciency re,uires that the

producer make a choice that !ill ma(imi$e
the sum o the present %alues o the earnings
potentially recei%ed in each period.
4"
0ynamic Efficiency and E,hausti!le
Resources

Assume that oil producers "elie%e that the uture

price !ill "e too lo!' and they !ill "e "etter o
selling oil no!.

Sales o oil no! mean less oil a%aila"le in the uture

.this !ill cause uture oil prices to rise0.

Sales o oil no! !ill also depress current price o oil.

&his com"ination o prices changes in the uture and

no! !ill make holding oil or sale in the uture more
attracti%e.
44
0ynamic Efficiency and E,hausti!le
Resources

As long as one option .selling in the present

%ersus selling in the uture0 appears to "e a
more attracti%e option than the other' prices
!ill ad)ust.

&he process o price ad)ustment !ill

continue until o!ners o oil are indierent
"et!een the options o selling in the present
and selling in the uture.
45
0ynamic Efficiency and E,hausti!le
Resources

Since the present price is dependent on the

uture price' and the uture price is
dependent on the present price' there is an
opportunity cost or using a "arrel o oil at
any particular point in time.

&his opportunity cost is associated !ith :4&

ha%ing the "arrel o oil a%aila"le in another
time period.

&his opportunity cost is "oth a social cost

and a pri%ate cost and is reerred to as a user
cost.
46
0ynamic Efficiency and E,hausti!le
Resources

&he price o oil' at any particular time can "e

represented "y the ollo!ing e,uation*
P
6
F 2BC
6
G 21C
6

+here

2BC reers to 2arginal Bser Cost' and

21C reers to 2arginal 1(traction Cost

47
Mar#inal ;ser 2ost and Mar#inal
E,traction 2ost

&he most important thing to understand a"out this

e,uation is that it is possi"le to predict the changes
in the price o oil "y predicting changes in the
marginal e(traction cost and the marginal user cost.

Hour te(t illustrates this point "y considering the

rise in 2BC !hen Ira,i orces in%aded Ku!ait in
early August 6??D. 3ear a"out potential changes in
production le%els in Ku!ait dro%e up the opportunity
cost .2BC0 o using a "arrel o oil. Prices rose
dramatically "ut ell again !hen BS orces
esta"lished dominance and remo%ed concerns a"out
alling production.
48
Mar#inal ;ser 2ost and Mar#inal
E,traction 2ost

&!o important points*

&he e(istence o 2BC means that price !ill al!ays

"e dierent rom 21C. 2BC is a orm o scarcity
rent .not monopoly proit0.

In order or an o!ner o oil to "e indierent as to the

period in !hich he or she sells' the present %alue o
the 2BC must "e the same in all periods. &his
means that 2BC o an e(hausti"le resource !ill
increase !ith the discount rate.
4
?ther E,amples of 0ynamic .ro!lems

Persistent pollutants' chronic pollutants' or

stock pollutants that accumulate in the
en%ironment.

&odays decision to generate a stock pollutant has

an eect on en%ironmental ,uality ar into the
uture.

Changes in land use patterns can change

en%ironmental resources that can ne%er "e
restored.

4%er#gra$ing o grasslands has allo!ed the Sahara

desert to mo%e south at an alarming rate.
50
2onclusion

&he "ulk o this chapter ocuses on markets

and ho! markets eiciently allocate goods
and ser%ices.

+hen market ailure occurs' marginal pri%ate

"eneits di%erge rom marginal social
"eneits and marginal pri%ate costs di%erge
rom marginal social costs.

2arket ailure results rom e(ternalities'

pu"lic goods' imperect inormation'
imperect competition' and inappropriate
go%ernment inter%ention.