ENVIRONMENTAL ECONOMICS

BASIC THEORY OF ENVIRONMENTAL ECONOMICS

ASSIGNMENT
By A.NILOFER (11- PEC-006) ARTHI (11-PEC-007)

DEPARTMENT OF ECONOMICS LOYOLA COLLEGE

BASIC THEORY OF ENVIRONMENTAL ECONOMICS

Introduction Market Failure Externalities Kinds Of Externalities Solutions For Externalities Pollution Externalities And Economic Efficiency Concept Of Social Welfare Economics Efficiency And Perfect Competition Perfect Competition And Externalities Pareto Efficiency Maximum Social Welfare And Perfect Competition The Problem Of Second Best

SYNOPSIS
Environmental economics is the part of economics which deals with the interface between the mans environment and his development.It mainly builds its theoretical foundations on welfare economics.Economists have considered environmental degradation as a market failure because of market failure it imposes external costs on the society. There are costs associated with an economic activity that are borne by the population at large but do not appear on in the calculations of the producer. Similarly, there might be benefits accruing to the society that the producer fails to capture. These are the cases of externalities. In the presence of the externality, there is a divergence between private cost and social cost and benefits. The private cost underestimate (overestimate) social cost if the externality is negative (positive). We would interpret the environment as a common property (free access) resource used by everyone. Earths water, air, forests and meadows,plants and bio diversities all together constitute the environment and it is used as a dump for waste products of economic activities. The damage thus caused to it in the form of pollution of air, water and destruction of plants and biological species that are important costs that the society as a whole has to bear. These costs do not appear in the calculations of the individual producers and thus remains uncovered. Our task is to trace the implications of market failure and its impact on the economy. The study thus consists of analyzing externalities and market failure under various market conditions.

BASIC THEORY OF ENVIRONMENT ECONOMICS INTRODUCTION Environmental economics is the part of economics which deals with the interface between the mans environment and his development. The environmental problems are mainly due to imperfect working of the market mechanism. Environmental economics mainly builds its theoretical foundations on welfare economics. Environmental values are economic values; it is in principle just important in the interest of economic efficiency and therefore ,economics welfare, to conserve our limited natural resources , to make wise and sparing use of our limited clean air, water and living space, as it is to economize the use of labor and capital and using some of our limited economic resources to preserve or restore an acceptable environmental welfare is as much as contribution to economic welfare as devoting them to travel, shelter or national defense.1

Kahn, Alfred E. (1966) "The tyranny of small decisions: market failures, imperfections, and the limits of economics"

MARKET FAILURE AND EXTERNALITIES Economists have considered environmental degradation as a market failure because of market failure it imposes external costs on the society. This means externalities like pollution disrupt the smooth functioning of the market system. There are costs associated with an economic activity that are borne by the population at large but do not appear on in the calculations of the producer. Similarly, there might be benefits accruing to the society that the producer fails to capture. These are the cases of externalities. MARKET FAILURE In the context of environmental economics, the most important source of market failure is the divergence between the producers valuation of the costs of his activities and the valuation by society as a whole.2 This divergence typically arises because of the presence of what are variously called EXTERNAL EFEECT, SPILLOVERS, NEIGHBOURHOOD EFFECTS AND THIRD PARTY EFFECTS arising from the production or consumption of goods and services of which no appropriate compensation is paid.

RabindraN.Bhattacharya, Environmental Economics An Indian Perspective , Oxford India Paperbacks

SOCIAL COSTS on the other hand, measure the opportunity cost to society as a whole of the resource used by firm. The opportunity cost is evaluated on the basis of the alternative uses which might have been made of resources. Whenever a producer uses a resource for which society has an alternative use, the social cost of this resource is not zero, even if no price is charged for its use. The use of rivers to carry away industrial wastes is a conspicuous example of this. External effects thus involve the non-recognition and misdistribution of costs. EXTERNALITY

An externality exists when consumption and production choices of one person or firm enter the utility or production function of another entity without that entitys permission or compensation.

An externality is an effect that one economic agent has on another over which the effected agent does not fully consent.3

NEGATIVE EXTERNALITY it imposes an external cost on the society. Eg:pollution POSITIVE EXTERNALITY- it gives external benefit to the society. Eg: afforestation 3

Baumol,W.J. (1972), On Taxation And Control Of Externalities, American Economic Review .

In the presence of externalities, the private cost underestimate (overestimate) social cost if the externality is negative (positive) 4

Example: BergstromsSmoking Box. There are 2 goods, beans and smoke. Ed likes beans and smoking, Fiona also likes beans but suffers a negative externality from Eds smoking. The initial allocation of beans is given by W0.In the absence of restrictions on smoking the outcome would be at X.

A shift away from X to any point on the line Y T would be a pareto improvement.

Baumol,W.J. And W.E. Oates (1988), The Theory of Environmental Policy 2 Edition, Cambridge: Cambridge University Press.

nd

VARIOUS KINDS OF EXTERNALITIES An externality occurs when an economic activity causes external cost or external benefits to third party stakeholders who cannot directly affect an economic transaction. There are various kinds of externalities. They are as follows: Externalities can be unidirectional or reciprocal which means simply that if A imposed an externality on B and B has not imposed an externality on A, the externality is unidirectional. If B imposed an externality on A as well then the externalities are reciprocal. Further classification of externalities is whether they are marginal or intra marginal. If they are marginal and unidirectional then As behavior at the margin effects Bs utility or profit. If they are intra marginal, then A can marginally adjust his behavior without any change in the external effect on B.5 (1) A marginal, unidirectional externality. An important example is the disutility to pedestrians caused by the emission of exhaust fumes by motor cars.

S.Varadarajan, S.Elangovan ,Environmental Economics , A Speed Publication.

(2) Marginal reciprocal externalities. An example of this is when people who enjoy smoking but do not enjoy inhaling smoke that has been exhaled by other smokers respond to others smoking by smoking themselves. (3) An intra-marginal, unidirectional externality. A lake may be unsuitable for swimming if too much of certain types of effluents are discharged into it but it may be able to accommodate a large inflow of additional effluents and hence the marginal adjustments in the outflow over a certain range do not alter the extent of the damage. (4) Intra marginal reciprocal externalities. When two radio listener people are in close proximity to each other on the beach one may be disturbed if the other operates a radio. If each attempts to raise the volume of his radio to overcome the others volume then it is possible that, over a range of volumes, their welfare is changed. In this situation the externalities are infra marginal. The absence of the existence of the above mentioned externality is the precondition in the determining the efficiency of perfect competitive market. This has led to the evolution of the concept of market failure.

(5) Market failure in accounting external economics The monetary values of externalities are difficult to quantify, as they may reflect the ethical views and preferences of the entire population. An example would be SMOKING, which can cost or benefit society depending on situation and the preference.6

In environmental matters there are many examples of the divergence between private and social costs. (1) The atmosphere may be polluted in zero private cost, while the social costs are potentially extremelarge, from extra cleaning bills through chest disease and unknown implifications of any damage to the ozone layer. (2) The use of chemical fertilizers gives the farmer the private advantage of improved crop yields; the costs resulting from the accumulation of chemical compounds will be borne by other, possibly far apart in distance and even generations apart in time.

Cornes ,R, And T.Sandler (1986), The Theory Of Externalities ,Public Goods, And ClubGoods , Cambridge :

Cambridge University Press

(3) Externalities may of course also be beneficial. The planting of forests may reduce soil erosion over a wide area and good architecture or, effective landscaping gives pleasure, at no charge, to the passerby.

(6) Public goods We would interpret the environment as a common property (free access) resource used by everyone. Earths water, air, forests and meadows , plants and bio diversities all together constitute the environment and it is used as a dump for waste products of economic activities.7 A further area of major relevance to environmental economics, where even a perfect market system would not secure the socially optimal level of provision, concerns what are called collective consumption goods or public goods. Economics has defined two fundamental characteristics of public goods. EXCLUDABILITY RIVALRY.

Cropper, M.L. And W.E. Oates (1992), Environmental Economics :A Survey, Journal Of Economic Literature

Excludability has to do with whether it is possible to use prices to ration individual use of commodities. Rivalry has to do with whether it is desirable to ration individual use through prices or any other means.8 SOLUTIONS FOR EXTERNALITY (1) Solution by prohibition This suggests total prohibition of the action giving rise to pollution.

(2) Solution by direct controls It requires setting a ceiling level of the quantity effluent/emission discharged into water or air, for example in the case of air pollution.

(3) Solution by taxes and subsidies Here the idea is to encourage activities that contribute to common goods and discharge those that deviate from common goods.

(4) Solution through direct action Solution through direct action by the government in the form of direct investment on sewage investment plans etc.

Nick Hanley, Jason.F.Shogren and Ben White, Environmental Economics in Theoryand Practise. Case Macmillan India Ltd.

(5) Solution by the sale of pollution permits This requires the establishment of a system of marketable licenses. Each license would give its owner the right to pollute up to a specified amount in a given place during a particular period of time. Their licenses could be bought and sold in an organized market.

(6) Solution through restoration of property rights It is also suggested by many, who strongly believe that common property nature of the resources is responsible of the damage imposed on them. The advocates of this measure believe that restoration of private property ownership will sever as an incentive for preservation and conservation of resources. Coase argued that many types of externalities can be optimally controlled by creating property rights to relevant resources.9 Each solution has its own cost and benefits. The relative merit and demerit of each will have to be evaluated through the appropriate cost benefit technique and one that maximizes net benefit should be chosen.10

Coase ,R.H.(1960), The Problem Of Social Cost ,Journal Of Law And Economics Charles D.KolstadEnvironmental Economics, New York Oxford University Press 2000.

10

POLLUTION EXTERNALITIES AND ECONOMIC EFFICIENCY There are three important functions performed by the environment that are relevant for an examination concept of pollution as an externality .They are (1) The environment acts as supplier of natural goods such as beautiful landscape. (2) It acts as supplier of natural resources which are used to create economic goods. (3) The environment acts as a sink into which the inevitable byproducts of pollution and consumption activities can be discarded. It is otherwise called as waste assimilative function of the environment.11 The term external implies that some costs do not accrue to the firm that produces the goods but are imposed on the society. Of the many kind of externalities, we identify only two types; Technological or non-pecuniary externalities Pecuniary externalities.

11

Sankaran .S , Environmental Economics ,Margham Publications

PECUNIARY EXTERNALITIES They are reflected in market prices and do not cause a divergence between marginal private cost and marginal cost. The chance in price caused by the individual decisions which increase the demand and theory of an increase in the cost of production is termed as pecuniary externality. This raise of price is a pecuniary externality. REAL OR TECHNOLOGICAL ECONOMIES This on the other hand, prevents the market mechanism from functioning efficiently by laying deviating marginal private cost and marginal social cost on each other. Pollination of water and air are examples of technological economies thatimpose an additional cost to the society. If the externalities are not there the society optimal output is reached when price is exactly such that the marginal private cost = marginal cost. Thus optimal output, whenexternalities exist is determined when price is equal to marginal social cost.12 MARGINAL SOCIAL COST (MSC) =MARGINAL PRIVATE COST (MPC) +MARGINAL EXTERNAL COST (MEC).

12

Eugine.t ,Environmental Economics , Vrindha publications

In the above diagram, the private optimal level of production is Q1. But social optimum level of production is Q2. The difference between the levels of production represents over production by the firm. Society would be better off with Q2 than with the Q1 units because the resources used to produce Q2 units have greater net productive value in other employments. . The same logic may be applied that in some other goods, production may be below the socially optimum level. Thus, we come to the conclusion that external diseconomy distorts the optimal allocation of resources, some goods may be over produced and some in lesser quantities, or they may not be produced at all. Montgomery states that a quality based instrument has to be implemented to achieve a specified environmental target at minimum cost .he states that a competitive bidding

for permits by different sources of pollution will result in least cost solution for achieving the pre-specified levels of environmental quality .13 CONCEPT OF SOCIAL WELFARE ECONOMICS Welfare economics studies the ways, means and the methods of ensuring and increasing economic wellbeing of the individuals as well as the society. The main tool of welfare economics therefore is to bring the actual economy closer to ideal economy. The concept of social welfare in welfare economics and also its measurements are much complicated affairs. Individual welfare is a subjective concept and we can arrive as it very easily, as it is only additive of utilities. So the only way of deciding approach to define social welfare is to set down the aggregate utilities or satisfaction of all the individuals in the society.
A PERFECTLY COMPETITIVE MARKET ECONOMY ACHIEVES A PARETO EFFICIENT ALLOCATION:

This powerful theorem tells us that a competitive economy does not waste any resources, the minimum requirement we might want satisfied by any system of resource allocation. It does not tell us that a competitive equilibrium will

13

Montogomery,W.E(1972), Markets In Licenses And Efficient Pollution ControlPrograms, Journal Of Economic Theory .

be a social welfare optimum. To demonstrate that the theorem is true and understand why we need to show that a market system satisfies the three Pareto conditions:

The marginal rate of substitution between two good is equal to the slope of the indifference curves, thus the condition for Pareto Efficiency in consumption tells us that the indifference curves for the two individuals must have equal slope at a Pareto efficient allocation.

MRSAXY = MRSBXY (Pareto Efficiency in Consumption.)

The marginal rate of technical substitution between two inputs is equal to the slope of the isoquant, thus the condition for Pareto Efficiency in production tells us that the isoquants for the two goods must have equal slope at a Pareto efficient allocation.

MRTSXKL = MRTSYKL (Pareto Efficiency in Production.)

MRSAXY = MRSBXY = MRTSABXY(Pareto Efficiency in Production and Consumption.)14

14

Murty, M.N. And P.B. Nayak (1982), Externality Abatement Technologies, PigouvianTaxes and Property Rights

, Indian Economic Review.

EFFICIENCY AND PERFECT COMPETITION In a perfectly competitive private market economy every operator in the market, whether consume or supplier is only a price taker and not price maker. The general equilibrium price in such a market is determined by impersonal forces of market supply and demand. We assume that the level of technology, tastes, preference and other factors remain constant without affecting the state of general equilibrium.

In a perfectly competitive market, a firm will maximize its profit at a level of output where P=MC. Every firm will produce where P=MC. Here the seller group gets maximum benefit by making P=MC . the total market SS is equal to total market demand and in this since all consumers are satisfied as they get the quantity what they demand.

PERFECT COMPETITION AND EXTERNALITIES The goal of profit maximization leads perfectly competitive firms in equilibrium to produce at a level of output at which price equals marginal cost. This equality between price and marginal cost is a crucial link in the chain of logic that concludes with the identification of maximum social welfare with the outcome of a system of competitive private markets. DEFINITION AND MEANING OF PARETO EFFICIENCY Paretoefficiency is defined as a situation in which everyone is so well off it is impossible to make anybody better off without simultaneously making at least one person worse off. It is a situation in which all possibilities for voluntary more efficiently, have been exhausted. There are no more opportunities to improve the efficiency of economic system.15 According to our analysis all profit maximizing firms will produce at the level of output in which the cost of last unit produced (marginal cost or MC) will be just equal to the prevailing market price of its output. Suppose for illustrations, MC is not equal to price for some reason or the other and it is greater than price (MC>P). This means the cost of the last unit of the commodity produced is greater than the market price of the last unit offered for sale. Evidently, the producer has to use more productive input of greater
15

Chaudhary M.A. And Tripathi .S.M. Global Encyclopedia of EnvironmentalEconomics, Global Vision Publishing House.

value than the price paid by the household. Price paid by the household is less than that of input. This in essence reveals that the economy is producing more than price what is actually required by the household. This suggests that the production can be reduced and thereby productive input resources could be released for using the same for more socially valuable commodity. This type of cost benefit tests determines the optimum levels of production in the economy. Further, in such a situation where MC not equals P the profit maximization behavior of the firm will be upset. Thus we come to the conclusion that MC=P is a necessary condition for MXSW in a perfectly competitive system, and the market becomes more efficient with allocation of resources.

MAXIMUM SOCIAL WELFARE AND PERFECT COMPETITION Indifference curve technique can be used for analyzing the concept of maximum social welfare with available resources to indicate that perfect competition is a necessary condition for achieving Paretos efficiency of optimum welfare.16

16

Sankaran .S , Environmental Economics ,Margham Publications

In the diagram, I2,I3 , I4 indicates levels of welfare. The assumption is that consumer behaves rationally. Hence, higher indifference curve indicates higher level of satisfaction. In the indifference curve analysis, the slope of the budget line AB represents the ratio of prices of two commodities. Ie, X and Y. Hence at equilibrium point, the marginal rate of substitution between the two goods is equal to the ratio of their price. That is at equilibrium, MRSxy = Px / Py The price of every commodity measures the benefit of the last unit consumed. That is, the marginal welfare for any household in the economy is equilibrium

THE PROBLEM OF SECOND BEST (MONOPOLY AND EXTERNALITIES) The first one selating to perfect competition in which the external costs cause price to fall below the true marginal social cost of production and the resulting level of output is too high compared to the level where all costs are paid by the firm. That is, under perfect competition, the firms produce more at a lesser price. On the other hand in case of monopoly, the firm produces less and prices at a higher level, i.e., more than the marginal cost. These two effects work in opposite directions and will tend to offset each other. Any one of these two effects may dominate. It will be very difficult to determine theoretically which effect is stronger, as it is an empirical problem. 17 Now we can take up the consideration of externality in a monopolistic firm .suppose, the monopoly firm generates pollution and imposes external cost on the society. Based on maximizing behavior without considering the externality, the monopolist will produce OM units of output at OPm price as shown in the diagram. When the firm internalizes the external cost, the level of output will be OL as shown in the diagram. Now the situation presents two distortions: The existence of monopoly The existence of external cost

17

Karpagam .M, Environmental Economics: A Textbook (1993), Sterling Publishers Pvt.Ltd.

Correction of both problems is necessary to obtain the socially efficient outcome. Economists, call such a situation as the problem of second best.

Suppose if the government imposes a tax on the monopolist to curb his production activities to neutralize the pollution or external cost, in that case the monopolist will behave as if the MSC is his MPC, as the tax paid will be brought into cost of production. . The monopolist will find his equilibrium by equating MSC with MR and reduce the output to the level of OJ at a price Pj. By the imposition of the tax, the level of production has decreased very much from the socially optimum level of OL with a conspicuous increase in the price PJ, which is higher than the monopoly price OPm.

This level of output is decidedly less efficient socially than the output of OM level, since this level is too far less than the socially optimum level OL.

The conclusion that trade increases national income depends on the assumption that the economies are undistorted. Anything that causes the economy to be at an inefficient equilibrium can be viewed as a distortion, including imperfect competition, missing markets (e.g. absence of insurance markets) or government policies that restrict trade (e.g. tariffs). The Theory of the Second Best states that if there are two or more market imperfections (distortions), correcting one of them may either increase or decrease welfare. For example, if there are two tariffs, eliminating one may not increase welfare. A pessimistic interpretation of this theory is that it implies that economic theory allows us to reach no conclusion about real world markets, since we know that these are subject to many imperfections/distortions. A more moderate interpretation is that we cannot uncritically use economic theory to conclude that a particular reform, such as trade liberalization, necessarily improves efficiency.

BIBLOGRAPHY

1. Baumol,W.J. (1972), On Taxation And Control Of Externalities, American Economic Review . 2. Baumol,W.J. And W.E. Oates (1988), The Theory of Environmental Policy 2nd Edition, Cambridge: Cambridge University Press. 3. Chaudhary M.A. And Tripathi .S.M. Global Encyclopedia of EnvironmentalEconomics, Global Vision Publishing House. 4. Charles D.KolstadEnvironmental Economics, New York Oxford University Press 2000. 5. Coase ,R.H.(1960), The Problem Of Social Cost ,Journal Of Law And Economics 6. Cornes ,R, And T.Sandler (1986), The Theory Of Externalities ,Public Goods, And ClubGoods , Cambridge : Cambridge University Press 7. Cropper, M.L. And W.E. Oates (1992), Environmental Economics :A Survey, Journal Of Economic Literature 8. Eugine.t ,Environmental Economics , Vrindha publications. 9. Karpagam .M, Environmental Economics: A Textbook (1993), Sterling Publishers Pvt.Ltd. 10. Montogomery,W.E(1972), Markets In Licenses And Efficient Pollution ControlPrograms, Journal Of Economic Theory .

11. Murty, M.N. And P.B. Nayak (1982), Externality Abatement Technologies, PigouvianTaxes and Property Rights , Indian Economic Review. 12. Nick Hanley, Jason.F.Shogren and Ben White, Environmental Economics in Theoryand Practise. Case Macmillan India Ltd. 13. RabindraN.Bhattacharya, Environmental Economics An Indian Perspective , Oxford India Paperbacks 14. Sankaran .S , Environmental Economics ,Margham Publications 15. S.Varadarajan, S.Elangovan ,Environmental Economics , A Speed Publication.