Download module iv- natural resource economics

Module IV
ENVIRONMENT AND ECONOMICS
As an extrusions of ‘environmental crisis’ this module group out the causes of such cases
and methods to control it.
First of all there is need to identify the natural endowments / resources of a nation and
categories them into renewable and non-renewable resources the rate of use of these
resources makes up the total social cost to any nation. If the rate of usage is greater then
the ‘social cost’ or ‘royalty’ is very high. This then leads to depletion of a resources as
well as pollution.
Therefore each nation needs to carry out a social cost benefit analysis to weigh the pros
and cons of over- utilization of resources for faster rate of growing and development. An
equilibrium level of resource utilization keeps pollution under control.
Various methods of pollution control have been discussed in this module. All these
measures would lead to sustainable development or ‘growth with stability’.
Environmental Crisis
Environmental crisis is global phenomenon. More recently there has been major over the
environment protection and environmental development.
The rapid economic
development, Technological and scientific advancements have increased their impact on
the natural environment.
They have added to the environmental degradation and
ecological imbalances. Increasing damage to the environment and ecological imbalance
has created a fear in the mind of developing and developed countries. In this direction
the Stockholm Conference in 1972 is significant which emphasized to deal with the
aspects of environment. After the conference all the countries made environmental
protection enactments on various aspects form time to time.

Protection of Environment (Link to be created, Dogra, 1998)
State of environment in developed and developing countries
National and International Initiatives, Global Network, Issues at UNCED, Ways of
Cutting Bio-diversity Losses, Wildlife Conservation and Eco-Development of
Sanctuaries, Local Sharing of some of the issues in the Non-use Values of Biodiversity,
Sustainable Use of Bio-diversity, Situ Conservation relates to Research and Training,
Free Exchange of Germplasm, Initiatives on the follow-up of the Convention on
Biological Diversity, Identification of Action Points, and Transfer of Genetic Resources,
Ratification of the Convention.
The Genetic Revolution is related to, The Colonization of Human Regeneration, The
Colonization of Plant Regeneration, Food Crises, Biotechnology and the Third World,
United Nations Efforts, Fewer Varieties, Narrowing the Genetic Base, Intense Farming,
Access to Seeds, Gene Bank, What are Genetically Engineered Foods ?, Breeding
Uniformity, Jurassic Park is Science Fiction, BST : Biotech and Cows, Soybean Drought
Resistant Crop, Corn Fever, The Seed, Corporate Control of the Seed Industry, Who
Controls the Seeds ?, Women, Ecology and Biotechnology, Genesis, Fewer Crops, A
Roulette-Wheel for Farmers, Third World Strategies to Reverse the Trends, Program
Areas : Increasing the Availability of Food, Feed and Renewable Raw Materials, Basis
for Action, Objective, Data and Information, International and Regional Co-operation
and Co-ordination, Means of Implementation, Financing and Cost Evaluation, Improving
Human Health, Basis for Action, Objectives, Activities, Management-Related Activities,
Data and Information, International and Regional Cooperation and Co-ordination.

Economic and Political Dimensions (if Pollution Need far Political Action
for Environment Protection (make link)
NATURAL RESOURCE ECONOMICS
Natural resources are generally divided into different parts depending on the time scale
related to their use.
They are i.
Expandable or constant flow resources.
ii.
Renewable resources.
iii.
Depletable or exhaustible resources.
1) Expandable (Continuous flow) Resources: - The main feature is that use at
one particular point of time will not affect the amount that can be used in
the future and exhibit continuous flows, through time. Agricultural
products, solar radiation and the waves in the tides, the ability of the
environment to absorb non-persistent pollution etc may be assumed as
examples.
2) Renewable Resources: - The essential feature of renewable resources is
that they can be increased as well as decreased. It will increase if the stock
is allowed to regenerate. However, there is a maximum stock: no
renewable resource can regenerate to the levels above the carrying
capacity of the ecosystem in which it exists. An obvious example of this
kind of resources is a forest or a single species of fish. Use of such
resources today usually affects future utilization possibilities.
This means that the rational utilization policy must take into account the time dimension
during which the resources are regenerated. Biologically regenerating resources are often
characterized by emphasizing that they are ‘renewable but exhaustible’. This refers to
minimum variable population size. Harvesting a population smaller in size or harvesting
over and above its potential only cause ‘extinction’ (i.e. if the rate of harvest exceeds the
natural growth of the resources).
3) Non-renewable Resources: - In this case the inter-temporal sum of the
services provided by a given stock of exhaustible resources is finite. This
definition highlights the importance of the long term perspective.
The resource will be depleted so long as the use rate and the harvest rate is positive.
The central economic problem of these resources is thus how to allocate their fixed
amount inter temporally that is between different points over time or between different
generations.
Table 1 shows example of all these three kinds of natural resources. Among these three
kinds of natural resources we will now concentrate over optimal use of renewal
resources.
TABLE 1:- EXAMPLES OF NATURAL RESOURCES.
Among these three kinds of natural resources we will now concentrate on the optimal use
of renewable and non-renewable resources.
Renewable Resources: To obtain an optimal solution let us consider a single fish
species and assume that its stock (or biomass) exhibit logistic growth through time shown
in fig 1. The curve shown is logistic function: at low level of stock the fish multiply, but
as they begin to complete for food supplies their rate of growth slows down and
eventually the stock converge on some maximum level X max, the ecosystem is carrying
capacity for the species.
Table 1: Examples of natural Resources
Physical Properties
Availability
Biological
Non-Energy
Energy
Expendable
Most
Salt
Solar radiation Noise pollution
agricultural
products
Hydro
for
example corn,
grains
ethanol
Environment
power Non-persistent
air
pollution
water
Renewable
Forest product
Wood
for Groundwater
fish live stock
burning
air
harvested wild
Hydropower
Air and water
wood
animal
geothermal
pollution
wood
whales
power
forests.
persistent
flowers insects
Depletable
Endangered
Most minerals Petroleum
species
for
example natural
gold, iron ore, coal
Virgin
gas wilderness
uranium ozone
bauxite top soil oil shall
water in some
aquifers.
Stock (x)
X max
X min
X zero
Time
layer
Fig 1: Logistic growth curve of a renewable resource.
Rate of growth of
resorces (x)
MSY
F(X)
X max
Stock (x)
Fig 2: Pure compensation growth curve
MSY = Maximum sustainable yield
The curve begins at X min, which is the critical minimum level of population. If the
members go below this level the species is driven to extinction (X zero). Now if we
assume that there is no critical minimum population ignore the segment of the curve in
fig 1 between X min and X zero, then fig 2 plot the same information as in (1), with
X = the rate of change in X with respect to the time the growth of the resources on the
vertical axis and
X = the level of stock on the horizontal axis.
Fig. 2 shows that the rate of growth of the resource stock is positive at the first, reaching
a maximum and then declines as the stock gets bigger.
Thus if we leave the resources alone it will grow continuously in size in terms of its total
biomass until it reaches the carrying capacity of its environment at X max, where the
growth rate of the resources reaches a maximum. This point (X max) represents the
‘maximum’ sustainable yield (MSY) of the resource.
This concept is important because if we harvest the renewable resources in such a way
that it is equal to the MSY: the resources will regenerate itself and reviews for ever. The
level of exploitation or harvest (or yield) of the resources is expressed as. The effort
expended in harvesting and is equal to the ratio of the actual harvest H, to the sock X.
That is, E 
H
X
(1)
The larger the effort, the greater the proportion of the stock that would be harvested. We
can rewrite this equation as
H = EX
(2)
The rate of harvest is shown in fig 3, which shows how the choice of the effort level will
determine the harvest (H) and the stock level (X) i.e. where ‘EX’ is equal to the rate of
growth of the resources.
Any harvest level along the line EX to the right or left of X* will mean that the harvest is
greater (lesser) than the sustainable field through natural regeneration and the stock will
fall (grow). (It should be noted here that H* is not the maximum sustainable yield but we
could easily introduce a management policy which says that effort should be changed so
as to take the MSY. Here E becomes the instrument of management and the harvest rate
is set equal to E ‘x as in fig: (3).
Thus introducing the effort level helps us to determine the harvest and stock level but
tells us nothing about the desirable level of exploitation. To get this we need to introduce
the concepts of costs and revenues.
Growth of resorces (x)
Harvest
E 'x
Ex
H*
X0
X*
Fig 3: Effort growth equilibrium
X max
Stock (x)
In order to do this we transform fig: (3) into fig: (4) showing the relationship between the
harvest or yield and the level of effort. In fig: (4 a) we find various equilibrium for
various degrees of effort where E4>E3>E2>E0 (E is the slope of the line E x). Now
plotting the levels of the effort in the horizontal axis of fig 4 b and the associated harvest
levels in the vertical axis, we get the effort harvest (or effort yield curve).
This curve looks very much like growth harvest curve and the yields are read off from
fig: (4 a) in such a way that they appear mirror image of the lower half. Thus, X max
corresponds to zero effort and Xo to E in fig 4.
X
H
E 4x
E 2x
E 2x
E 1x
H1
E0x
H3
H2
H1
H0
X0
4a
x
H
E0 E1
E2
E3
E4
E
Effort
4b
Fig 4: From growth effort to the effort harvest function.
Now, if we assume that effort is the only factors of production involved then total cost,
TC, will be equal to the level of effort multiplied by the prices of effort (W). If the wage
rate (W) is assumed to be constant then TC = WE 3. Also if the price of the harvested
product is constant at P, then total revenue (TR) from the harvest will be TR = PH 4.
Since P and W are assumed constant the total revenue curve will have the same shape as
the effort harvest function in fig: (4) the total cost function with a constant slope equal to
the wage rate or “price per unit effort” is shown in fig: (5).
Revenue cost
R^
A
C^
TR = PH
Effort
E^
Fig: 5(a) profit maximum
MR/ COST
M.R Cost
A^ MR = MC
MC = W
Effort
E^
M.R
5 (b)
Fig: 5(b) marginal conditions
Now, for profit maximization producer requires 1) maximum to the difference between
TR and TC or 2) slope equate marginal revenue (MR) with marginal cost (MC) and the
MC must have a steeper slope than MR curve or MC must cut MR from below (shown in
fig 5b). Under the profit maximization hypothesis two possible equilibrium are possible
(shown fig 6).
1. Common property equilibrium.
2. Open access equilibrium.
A common property equilibrium or resource is one that is owned by some defined group
of people a community or a nation. It is possible that within this group of people there
will be open access and it is harvested.
An open access equilibrium or property means that no one owns the resources and access
is open to all. There are no limit on new entrants (e.g. sea fisheries).
Revenue Cost
A
HPROF = H 
TC = WE
B
HP of = H^
H H on
OA
TR = PH
0
E pr of
EPROF
E on
EOA
(6)
Fig: 6 Profit maximization and open access equilibrium
If the renewable resources can be placed under single ownership or joint ownership in
such a way that the owners’ act collectively, we can assume that the resources will be
managed to maximise profit. In the fig: (5a) and (6); A is the point of maximum profit
with
HPROF = Hπ = as the harvest rate.
Eπ = as the effort rate.
However private ownership is not typical or applicable for all the resources e.g. major
forest or sea fishes. Instead we may have either territorial ownership or no territorial
ownership (Internationally common property). In either case we get the ‘Open access
solution’.
Here, if less than normal profit are being made (TR<TC) some resource exploiters will go
out of business and if abnormal profit (TR>TC) are being earned new entrants will come
in. At equilibrium profits point are dissipated (TR =TC) and each resources exploiter
recurs normal profit only. In fig: (6) equilibrium is at point B with a harvest rate HOA and
effort rate EOA equal.
From the two-equilibrium solution it can be said that the profit maximization solution can
only be optimal in the social sense if the preference of conservation imply zero
‘preservation value’ for the resource. In order to get socially optimal solution we try to
accommodate externalities in our analysis. For example, if conservationists prefer larger
to smaller stocks their utility loss will be a function the difference between the maximum
possible stock (the natural equilibrium or carrying capacity stock) and the actual stock
that results from the amount resources use.
UC = f (X max – XE)
Where UC = the loss of utility of the conservationists.
XE = the various equilibrium levels of stock.
The valuation function consistent with this function is shown in fig: 7. How ever we
should remember that depending upon the ‘reference point’ (here X max) the valuation
function may differ (e.g. if we take X MSY the reference point or most desired point).
Now it is most likely that at very low levels of stock the preservation value function will
be discontinuous.
From the above discussion we can conclude that the addition of externalities in the
normal situation following things happens.
1. When the aim is to maximise net benefit in contrast to simple profit maximization
the optimal stock of the resource will be higher.
2. If the external costs are very large the resources will be ‘optimally’ managed if it
is left alone to reach its natural equilibrium.
3. Introduction of social cost also does not confer any particular emphasis on the
social desirability of the stock levels corresponding to MSY.
Non-Renewable Resources
In order to get the optimal solution economics principles underlying the analysis of nonrenewable resource scarcity we will use the model by Hotelling. According to the classic
article published in 1931 by Hotelling, for non-renewable resources our main objective
should be the allocation of a given amount of resources stock over different moments of
time in order to maximize the utility or benefit from consuming the resource. Even
though during the last several years the economic analysis become much more
complicated but the basic insight remains the same.
Since the size of non-renewable resources is fixed, consuming and extracting a unit of the
resources implies that there is less of the stock of resources for future consumption. Thus,
in addition to extraction costs, there is another kind of cost associated with it i.e. the
reduced level of future benefit due to fewer resources being available called ‘royalty’ or
‘users cost’. Hotelling assumed that.
1. The marginal utility of consuming the resources is decreasing.
2. Marginal extraction cost constant.
This means that along an economically optimal expansion path the marginal utility of
consuming the resources must be equal to the sum of constant unit of extraction costs and
the royalty. Thus marginal utility of using the resources is greater than the marginal cost
of extracting the resources and difference is royalty. It reflects the value of an un
extracted marginal resources unit with respect to future consumption possibilities. This
‘Royalty’ cost implies the fact that the society must be much more conservative in
consuming non-renewable resources compared to other ordinary goods the production
cost of which do not include royalty.
The concept of royalty and optimum utilization decision is explained in fig C1.
On the vertical axis we measure marginal utility from consuming the resources marginal
cost of extracting the resources whereas the horizontal axis we measure the level of
resources utilization over one year.
Here, MU curve shows the marginal utility of consuming the resources, which is
diminishing. For normal commodities (whose stock is not prefixed) the optimal
production occurs at Q** where marginal utility of the resources equal marginal cost.
How ever for non-renewable resources this will not be the case since today’s
consumption of the resources involves opportunity costs, Royalty. At the level of royalty
(AB) the optimal level of resources extraction and consumption is Q*.
We need to analyse the question that how the level of royalty evolves over time.
According to ‘the Hotelling rule’ royalty must increase wit h time at rate equal to the rate
of discount. This means that the net marginal utility of consuming the resources must also
increase at a rate equal to the rate of discount. This implies the fact that from the current
point of view the net benefits from the marginal units consumed in every period (the
discounted value of net utility) are equal/same. Again the equality emphasizes the fact
that it is not possible to increase the total level of discounted net utility from resources
consumption via changing the extraction of the resources over time. Thus ‘the Hotelling
rule’ established that royalty increases exponentially and the level of resources utilization
decrease over the time. The higher (lower) the rate of discounts the higher (lower) the
rate at which the level of resource consumption falls over time.
Fig C1: Optimum Resource Utilization
Up to now we have discussed optimal renewable resource utilization only when the rate
of resources utilization can be directly controlled by the government or society.
But in a market economy profit maximizing private firms usually utilize resources. Now
the question is how the level of resource utilization will be affected by this owner ship?
In contrast to our general idea, Hotelling shows that private ownership will not accelerate
resources utilization. The reason behind this is as follows since the marginal utility curve
shows the maximum amount that consumers (or firms who use the resources as input) are
willing to pay for consumption of another unit of the resources it is also the demand
curve of the industry in the market. To maximise the present value of profit the industry
must apply such a rate of extraction that royalty increase exponentially over time. This
means that the industry will also follow a resources extraction policy that maximises the
profit for the industry “the socially optimal resource utilization policy”.
The higher the level of royalty the higher will be the market price of the resources which
implies that market price of non-renewable resources must increase over time.
A project will be profitable if the benefits of the project exceed the costs. The
concept of profitability requires calculation of the stream of a project is future benefits
and costs period by period and conversation of this stream of benefits and costs into some
simple measure expressed as a number. The commonly used measures are the net present
value (NPV) and the internal rate of return (IRR). The net present value may be define as:
n
NPV  
t 0
Bt  Ct
(1  r )t
Where Bt are benefits in year t
C t are costs, including investment in year t
r is the rate at which future benefits and costs are discounted
n is the life of the project
Discounting reduces the value of future benefits and costs. Why future benefits and costs
are discounted and how is this rate of discount determined? The answer to the first part of
the question is that cash received in the future is less valuable than the same amount of
cash received immediately because in the interim the firm could invest these funds and
earn interest on them. For a private individual or firm the correct rate of discount is the
market rate of interest. If a firm can lend at 10 percent it would have no reason to choose
a project that costs Rs. 1000 today and yields only Rs. 1080 next year because by lending
this amount it would get Rs. 1100 next year. Similarly if it barrows at 10 percent it would
not invest in such a project which fields only 8 percent return. On the other hand a firm
would have no reason to reject a project that costs Rs. 1000 today and yields Rs. 1110
next year. Even if it does not have the money it can borrow it at 10 percent and make net
profit of Rs. 10. As long as a project has a positive NPV it is considered desirable. If
funds are available a firm should select those entire project which have positive NPV. If
however because of resource constraints a firm has to choose one project out of several
competing projects the one with the highest NPV should be selected. A positive NPV
means that benefits of a project are higher than costs. This ratio of benefits to costs in that
case would be greater than 1.
The benefit cost ratio (BCR) is defined as
n
BCR 
 B 1  r 
t 0
n
t
t
 C 1  r 
t 0
t
t
Thus serves the same purpose as the NPV a measure of project desirability. An interest
rate for which the net present value of a project is zero is called the “internal rate of
retrieve (IRR)” of the project. The IRR is an alternative measure of project desirability. A
project with an IRR higher than the market rate of interest is considered desirable project.
If NPV of project at alternative discounts rates is plotted as shown in Fig. 1 point A
gives the IRR for the project.
NPV
A
Discount Rate
Fig 1: NPV at alternative discount Rates
One difficulty with the IRR criteria is that it is quite possible that the NPV of a project
may become zero at more than one rates of interest i.e. a project may have several
internal rates of return. However, if a project incurred negative net cash glows up to a
certain point in time (when initial investments are made) and there after yielded positive
net cash flows, its IRR would be unique. For this reason the problem of multiple internal
rates of return is not considered very serious.
Which one of the two measures NPV or IRR is a better measure of project desirability?
If choice of one project does not rule out another, we can use either of the two selection
rules they both will give same answer so long as NPV always goes down as the discount
rate is raised. If the market rate of interest is lower than the IRR, the NPV of a project
will be positive. Such a project should be selected.
The problem arises when all desirable projects cannot be undertaken. In such a situation
the two decision criteria may provide conflicting choices. This is illustrated in fig.2: -
NPV
B
A
A
10
15
Discount Rate
20
Fig. 2: NPV and IRR Criteria
Project A has 20% IRR whereas for project B, the IRR is 15%. Thus by the IRR criteria
project A is better. However at 10% rate of discount, Project B is preferable to Project A
by the NPV criteria.
If the market rate of interest at which the firm borrows is known with certainty, it is better
to use the NPV criteria than the IRR. The NPV criteria are better than the IRR for one
more reason: the former provides a measure of total gains which the latter does not.
When cost- benefit analysis is employed by a private firm to assess a project, market
prices of inputs and outputs are used in calculations of costs and benefits of the project.
This commercial profitability criteria is however not suitable for assessing public sector
projects, because for various reasons elaborated below the market prices of inputs and
outputs do not necessarily reflect their social costs and social value respectively. In order
to allocate resources in a way most profitable to society, social cost benefit analysis in
recommended for the appraisal of public sector projects.
Market prices of goods, labour, foreign exchange and capital may be distorted through
taxes, subsides, tariffs and import quota and government control of various kinds such as
minimum wages, interest rate controls and price controls. Prices set by monopolists and
public utilities are also distorted, as they are different from competitive market prices.
Because of the presence of externalities market prices of goods do not reflect their true
social value. The externalities could be positive or negative. Externalities refer to the
effects that work outside the market. Positive externalities occur when it is not possible to
charge the beneficiaries for the benefits they receive. It may be for several reasons:
access to the facilities may be difficult and costly to control; An example of such a
situation is when a firm trains the labour force in the region. This may not enhance the
firm’s profits since after training the workers are free to leave. Large infrastructure
projects such as dams, roads and railroads have important positive externalities. For
example in case of a hydroelectric dam many people not connected with the project also
derive substantial benefits. The downstream farmers may witness increased production
become the dam prevents floods. May other cases of positive externalities could be cited
however it is the negative externalities, which are concern because they are more
prevalent, and have very severe adverse social impacts. Negative externalities occur
when firms or individual do not pay for damages their actions cause to other industrial
firms for example give rise to negative externalities in polluting air and water. It is a
serious problem not only in the industrial world but also in the developing countries since
the firms do not bear the cost inflicted on the society by pollution, their profits do not
decrease. Externalities are very important in social decision-making. Their presence
provides a sufficient reason why commercial profitability should not be used as a guide in
public policy.
Market prices may diverge from their social values because of the fact that the prices of
factors of production may not reflect the opportunity costs of using these factors. Take
the case of labour in developing countries; unskilled workers in modern sectors often get
wages which are much higher than what the opportunity cost criteria would suggest. In
these developing countries there is widespread under employment of labour in rural
sector. When modern industrial sector or government draws labour from the rural sector
its opportunity cost if the loss of output in the rural areas i.e. labour’s marginal
contribution to production, which is quite low. The wages paid to these unskilled workers
are much higher. The domestic market price of the other primary factor, capital also tends
to be distorted in developing countries. The capital market intermediates between those
making saving and investment decisions. In a perfect capital market the social return
from one unit of current drawings is equal to the social values of one unit of current
consumption at the margin. In the absences of market distortions this equality between
the two sides is established through market rate of interest. The distortions are caused by
the presence of monopolistic elements and government intervention (fiscal distortions).
Further more in many developing countries export earnings and foreign investment are
not adequate to meet import requirements. Scarcity of foreign exchange in a serious
problem in many developing countries with chronic balance of payment problems. It is
observed that in these counties, quite often official exchanges rates over value local
currency. It does not reflect the real scarcity of foreign exchange. There are several
interest rates prevailing in the market at the same time. The differences in interest rate are
two enormous to be justified as the basis of differential risks. These are caused by capital
market rigidities.
Price distortions can possibility is removed by suitable fiscal methods of lump sum taxes
and subsidy. But for various reasons it is very difficult to implement such policies and
they are usually not undertaken. If price distortions in the economy cannot be removed
then project appraisal method should be such that corrects for price distortions. Instead of
using market prices, which are distorted, it is recommended to use imputed values, which
reflect real opportunity costs to the society in cost-benefit analysis of the projects. This is
referred to as shadow pricing.
Shadow prices are determined by the interaction of national objective of the resource
constraints facing the economy. Shadow price, i.e. opportunity costs of a resource, which
using scarce tends to be high. The reason for high opportunity costs is that such resource
have many competing uses and the forgone benefit in the best alternate that must be
given up is high. On the other hand, shadow price of a resource available in abundance
will tend to be low. Shadow prices usually differ significantly from market prices in
developing countries because for various reasons noted above, market prices are distorted
and thus do not correctly reflect scarcity of resources.
As discussed earlier, the opportunity cost of labour in a labour surplus economy is very
low. Labour in modern sector is, however paid considerably more than its opportunity
cost. The shadow wage, lies somewhere between the opportunity costs of labour (equal to
its marginal productivity) and the industrial wage. To settle on a particular figure
however, requires a great deal of judgement. It is a common practice to use a specific
conversion factor (or the standard conversion factor) to convert market rate into shadow
wage.
As discussed above, official foreign exchanges rate in many developing countries
overvalues local currency. In social cost benefit analysis a corrected exchange rate,
referred to as shadow exchange rate which reflects the true opportunity costs of foreign
exchange is used. One method of calculating shadow exchange rate involve comparison
of the domestic prices of imported commodities with the official foreign exchange prices
of there commodities. For example, if an import item can be sold in the domestic market
at a price which is 50% higher than the price calculated on the basis of official exchange
rate, it means that the domestic currency if overvalued by 50%. It should be devalued by
50% to reflect its true value.
In the conventional approach the social cost-benefit analysis all traded and nontraded goods are measured in one currency either foreign or local. Traded goods in
foreign prices are converted into domestic prices or alternatively non-traded goods in
domestic price are converted into foreign prices using shadow exchange rate.
An alternate approach recommended by Little and Mirrlus1 requires that all goods should
be valued at world prices because these represent a country’s actual trading opportunities.
It is argued that is a better measure of the social valuation of goods than the other nontraded goods at domestic price and traded goods at their international price. In the latter
method domestic and foreign goods are made comparable using a shadow exchange rate,
which may itself be distorted.
There is no need to calculate shadow exchange rate if all goods traded and non-traded are
measured at world prices. The values of goods can be expressed in any currency local or
foreign. Since all values will retain a constant relationship to each other it does not matter
what currency they are measured. The values can be converted form one currency to
other using any exchange rate.
Non-traded goods are those, which normally cannot be imported. For example,
electricity, construction, local transport and labour are non-traded goods or inputs. Since
these goods are not traded internationally their valuation at ‘world prices’ poses a
problem. The way out is to take each non-traded input and break it down into traded and
non-traded components. The latter are in turn broken down into traded and non-traded
components. This way it is possible, at least theoretically, to reduce all non-traded inputs
and goods into traded items. Land is not considered very important in industrial projects.
Regarding labour it is argued that it can be valued in terms of its own inputs (i.e. into
consumption) which consist of traded items. A detailed input output table for the
economy, as a whole is required to conduct these exercises. Such a table will however be
available only in a few developing countries. Some critics have pointed out that all this
trouble of conversion of non-traded items into traded items in order to avoid using a
foreign exchange rate official or shadow, is not worth it. The cure, it is alleged is worse
than the disease. It may be just as accurate to use properly adjusted shadow exchange rate
to convert values in domestic currency into foreign currency.
METHODS OF POLLUTION CONTROL
Market Mechanism does not allocate resources efficiently if production involves
pollution externalities. Produces of a particular product may emit pollutants into the
atmosphere, which result in damage to others. The pollutants may adversely affect health
of people exposed to pollution, pollutants released into air or water may cause property
damage or may have adverse impact on incomes of people in the area.
The affected individuals are not compensated for damages. This causes divergence
between private and social, costs of production resulting in inefficiency in resources
allocation. This happens because the affected individuals are not a party in the market
decision-making process.
In a free market economy in which companies seek to maximize their profit, if private
costs of production do not reflect social costs, there is excessive production of the
commodity as well of the associated pollution. Figure 1 illustrates this very clearly.
A
E
Rs
C
Q1
Q2
Quantity of Output
Figure 1
This industry also produces pollution as by-product, which is not compensated. BC
represents the marginal private costs of production.
There are costs borne by the producers and they do not involve externalities.
BE represents the original social costs of production. In addition to marginal
private costs, these costs include marginal costs to the society caused by pollution.
AD represents the demand curve for the commodity. It shows the price which
buyers are prepared to pay for the various quantities of the commodity.
As discussed earlier, the demand curve is equivalent to the marginal benefit
curve: it shows the marginal benefit to the society of extra production of the commodity.
This form of the market is assumed to be perfectly competitive here. It is socially
optimal to produce Q1 amount of the commodity. At this level of output, the product’s
marginal social benefit is just equal to its marginal social cost of production.
In a unregulated market, the producers do not take into consideration the environmental
costs. In such a situation the firms would produce Q2 output. At this level of output, the
product’s marginal benefit (or the price of the product) is just equal to its marginal
(private) costs of production. An unregulated market thus, produces output which is in
excess of socially desirable level of output. The associated pollution level is also higher
than the socially desirable level.
Pigou (1932)1 suggests that the excess production of the commodity can be reduced to the
socially desirable level by imposing a suitable tax on the commodity (see Fig. 2). If Rs.
KL per unit tax is imposed on the commodity, the marginal (private) costs curve will shift
upwards by a vertical distance of Rs. KL. The marginal (private) cost curve with tax will
be GH. The output produced in the industry will now be Q1, which is the socially
desirable level of output as discussed earlier.
H
Rs
Quantity of Output
Figure 2:
If the market is not competitive, the Pigou taxation method may not be relied upon to
achieve the desirable objective. If the industry in question has only one producer (a
monopoly situation), then the firm would produce an output lower then the competitive
market level and charge higher price from the consumers as shown in figure 3.
As the monopolist equates the products marginal (private) costs with the marginal
revenue AM showing marginal revenue associated with various levels of output, Q3
output would be produced. It is lower than the competitive market output Q2 it may, in
fact be even lower then Q1, the socially desirable level of output. If tax on output is
imposed, the monopolist will produce output less then Q3, thus moving further away
(lower from Q1, in case Q3 is less than Q1).
In Pigovian approach, the pollution is control is achieved through reduction in output. In
this sense, it is an indirect method of pollution control.
P3
P1
P2
Figure 3
It is argued that a direct method involving taxation of the particular input in the
production process, which is the main source of pollution, may be more efficient method.
This method is discussed a little later. The Pigovian method, despite being indirect and
relatively crude, is liked by some economists because it is relatively easy to implement.
Since output is the tax base in this method, it may be easier to monitor and enforce the
regulations. To arrive at the desired level of output and pollution, a few trials would be
required. This method does not require very precise of measurement of effluents since
effluent discharge is not the tax bare hire.
A simple model used by economists for discussing the efficient level of environmental
quality is based on benefit/cost analysis of control of emission of pollutants. Small
reduction in emission of pollutants can be achieved easily using inexpensive method of
pollution control. Higher levels of emission control are, however, more expansive to
obtain than lower levels. More sophisticated and complex techniques must be used to
achieve emission control after certain level. The total costs of pollution abatement
increase at an increasing rate. In Figure 4 the curve TC shows the relationship between
the total costs of pollution abatement and the environmental quality.
Figure 4
The slope of TC curve at any given level of environmental quality gives the marginal cost
of pollution abatement (shown by MC curve). The marginal costs of pollution abatement
rises with improvement in environmental quality because as discussed above, higher
levels of emission control can be achieved only at higher costs.
Emission of pollutants causes damage to people, plants, animals and physical assets.
Control of emissions leads to improvement in environmental quality which increases
social welfare.
The benefits to society of emission control can be quantitatively
measured in monetary terms. Although their actual measurement in practice poses a
great many problems, conceptually The TB curve in Figure 5.
Figure 5
the total benefits of pollution abatement. In the beginning small reductions in emission
of pollutants gives rise to substantial benefits. However, after the first improvements, the
total benefits increase at decreasing rates. The slope of TB curve gives the marginal
benefit (MB) curve. As shown in the figure marginal benefit of pollution abatement
declines as the environmental quality improves.
The efficient level of environmental quality is given by the part of intersection of the MB
and MC curves. It is desirable to reduce emissions as long as the marginal benefits of
doing so are higher than the marginal costs.
Figure 6
In Figure 6 the socially optimal level is shown by E. At this level, marginal benefit and
marginal costs of pollution abatement are equal to each other. Further reduction in
emissions would result in costs higher than benefits.
The desirable level of environmental quality (E) can be achieved by regulatory approach,
Government can specify the allowed limits of emission of pollutants for all polluting
firms. This approach which calls for direct government involvement and control in the
sphere of economic activity is criticized on the ground that it is wasteful and leads to suboptimal outcomes.
There are several alternative methods based on ‘economic
incentives’, which can reduce the inefficiencies inherent in a regulatory approach. These
methods are discussed below.
The efficient level of environment quality (E) could be achieved by imposing a tax of Rs.
T per unit of pollutant emitted. If it is cheaper to reduce emission of pollutants than
paying taxes, the polluters would choose the former. In other words as long as the
marginal cost of pollution abatement is less than the tax (per unit) on the emission of
pollutants, it would be advantageous for polluters to reduce their emissions. On the other
hand, if the marginal cost of pollution abatement is higher than the per unit tax on the
emission of pollutants, polluters would prefer to pay taxes. The equilibrium would be
reached at E* which is the socially optimal level of emission of pollutants.
Coase (1960)2 has suggested another method, which could be used to achieve the desired
objective. In this method, the sufferers (i.e., the parties damaged by pollution) pay
(bribe) polluters to reduce their level of pollution. This is, however, not only difficult to
put in practice but is also ethically unjustifiable.
A method equivalent method to Coase’s method would be a subsidy system where by
pollutants is paid subsidy for not releasing pollution. MC curve in Figure 7 represent the
marginal amounts when polluters would require compensating them for their cost of
abating pollution. If subsidy is fixed at Rs. 5 per unit on reduction of emission of
pollutants than profit maximising polluting fins would undertake reduction of emissions
upto level E1. If S is fixed equal to T (as in figure 6), then E1 would be equal to E*, the
efficient level of environmental quality.
3. coase, R (1960) “The Problem of Social Waste”, the journal of law and Economics, 3 pp 1-44.
Figure 7
Dales has suggested another method of reducing emission of pollutants.
This method requires fixing of a target for reduction of pollution. Once the acceptable
amount of emission of pollutants is decided, the polluting firms could be sold pollution
rights.
Dales method of controlling pollution can be illustrated by means of figure 8.
D-R
Emission of Pollutant
Figure 8
Point D on the horizontal axis represents the existing level of emission of pollutants. If
the target of reduction of emission is R, the socially desirable levels of emission of
pollutants are D-R. The number of pollution rights made available to the firms is D-R,
gives the vertical line S in the figure showing fixed supply of pollution rights. Polluters’
demand for pollution rights is shown by AD. As usual it is negatively sloped curve. It is
equal to the marginal cost of pollution abatement curve, MC in Figure 7. As discussed
earlier, some reduction in emission of pollutants can be done at very low cost, but further
reductions are very costly. If the aim is to reduce emission of pollutants only marginally
than the number of pollution rights supplied to the firms would be very close to the
existing level of emissions. In that case, the firms would not be willing to purchase
pollution rights at a very high price. Point C on the demand curve reflects such a
situation. On the other hand, if the target of pollution reduction is very ambitions, than
the number of pollution rights made available to the firms would be very low. The firms
the would have to cut emission of pollutants drastically, thereby incurring heavy costs.
They will be willing to pay high price for pollution rights. Point B on the demand curve
reflects such a situation.
The intersection point of the demand and supply curves would give the equilibrium
market price of pollution rights. As shows in Figure 8, the polluters would purchase the
D-R amount of pollution rights at price P. If the target of reduction of emission of
pollutants R is chosen in such a way that D-R corresponds to E*, then the market price P
would be equal to Rs. T per unit tax discussed in connection with Figure 6. Dales
method achieves the desired level of environmental quality at least cost to the society. It
also encourager firms to adopt pollution reduction technology.
We have discussed four approaches to pollution control in this chapter. These are:
regulatory approach, taxation of effluents, subsidy system and sale of pollution rights.
We compare below these methods in terms of their revenue implications and impact on
output. This comparison considers the efficient level of control for each system.
Figure 9, MC represents the marginal cost of pollution abatement. It is equivalent to MC
in figure 6 and AD in figure 8. The existing level of emission of pollutants is given by
point E. The socially optimal level of emission of pollutants or the efficient level of
environmental quality is given by point D.
T
Figure 9
First, let us consider the regulatory approach to pollution control. If the specified limit of
emission of pollutants is OD, polluters would have to reduce emissions by DE amount.
The cost of reduction of emissions is given by area AED. This cost will be borne by
polluters.
If a tax of T per unit is imposed on emission of pollutants, polluters will reduce emissions
by DE amount. The cost of reduction of emissions is given by area AED. This cost will
be borne by polluters.
If a tax of T per unit is imposed on emission of pollutants, polluters will reduce emissions
by DE amount. Like in the regulatory approach, the cost of reduction of emissions, AED,
will be borne by polluters – in this care also. In addition, however, polluters would have
to pay taxes to the government for emitting OD amount of pollutants. Area OTAD gives
the amount of taxes. Thus, in comparison with regulatory approach, taxation approach
gives government additional revenues given by area OTAD.
As discussed above, control of pollution can also be achieved by sale of pollution rights.
If OD amount of pollution rights are made available to polluters, they would pay OT
price for purchase of pollution rights.
In this case also they would themselves undertake reduction of emission by DE amount,
incurring cost of reduction of emissions giving area AED. Additionally, they would
spend OTAP amount to purchase pollution rights. This approach is thus similar to
taxation approach in terms of revenue implications.
If polluters are paid a subsidy of Rs T per unit on reduction of emission of pollutants,
then they would reduce emissions by DE amount. This would cost them area ADE.
They would, however, receive subsidy-given by area ADEB. Their net gain is then given
by area AEB.
A comparison of the four systems shows that costs to polluters are increased by
regulation, taxation of effluents, and sales of pollution rights, but are reduced by
subsidies. Taxation of effluents and sales of pollution rights cause higher increase in
costs them regulation. Changes in costs of production affect individual firm’s supply
curves.
Industry’s supply curve, which is an aggregate of individual firm’s supply
curves, is thus also affected in the process.
Shift in industry’s supply curve has
implications for market price and quantity of final goods as well as for total emission of
pollutants.
When a regulatory system is adopted, a polluting firm’s costs of production rise. This
increase in cost shifts firm’s average cost (AC) and marginal cost (MC) upward to AC1
and MC1 is shown in figure 10. All polluting firms would experience such shift in their
cost curves.
1
1
Figure 10
Industry’s supply curve is horizontal summation of all individual firms supply
curves (MC curves). It also shifts upward from S to S1 as shown in Figure 11. D
represents demand the commodity. Industry’s output is reduced from Q to Q1 as a result
of adoption of regulating system of pollution control. Buyers would have to pay higher
price for the product: Market price increases from P to P1.
1
Q
Figure 11
With increase in costs of production each polluting firm is forced to reduce its output of
final goods. Some firms with very high pollution control costs will drop out of the
industry. The number of firms operating in the industry thus would be less once the
regulatory system is adopted. These two effects – the reduction in output produced by
each firm and the reduction in number of firms in the industry – would both work to
reduce the output of final goods produced in the industry.
Similar effects will be witnessed when method of taxation of pollutants or sales of
pollution rights is used to control emissions as far as the direction of changes is
concerned. There would, however, be a difference in magnitude of shifts. Since increase
in costs of production is larger in case of taxation of pollutants and sales of pollution
rights methods in comparison to a regulatory system, magnitude of shift in individual
firm’s cost curves and in industry supply curve would be larger in the former cases. As a
result, increase in market price as well as reduction in output of final goods would be
more in there cases.
Since the magnitude of cost increase is higher, the number of firms dropping out of the
industry would be higher under taxation of pollutants and sales of pollution rights
systems in comparison with regulatory system.
If polluters are paid subsidies, their cost of production decreases. As a result, individual
polluting firms’ cost curves shift downward as shown in Figure 12.
Figure 12
Industry supply curves will alone shift downward from S to S1 as shown in Figure – 13.
Unlike the three method discussed above, output of final goods would increase and
market price would decrease in this case.
1
1
Figure 13
If all the required information is available, all the four methods can be used to achieve the
efficient level of emissions for a source.
Under subsidy system, the number of firms operating in the industry would increase.
Some new firms would join the industry. These firms are high cost firms, without
subsidy, these firms would not be able to operate profitably in the market. Subsidies by
reducing costs would make their operations profitable. (This level in shown by point D
in figure 9.) However, these methods differ in terms of their impact on the total emission
of pollutants (by all sources in the industry).
Let us consider the regulatory approach first. Each firm would reduce the emission of
pollutants up to the specified limit. The number of firms operating in the industry would
decline. Total emission of pollutants by all sources in the industry would thus register a
fall. Under taxation of pollutants and sales of pollution rights systems the number of
firms dropping out of market would be much higher. In comparison to regulatory system,
these two systems would achieve greater reduction in total emission of pollutants.
Under subsidy system also, each firms would reduce emissions of pollutants. However,
given that the number of firms in the industry is likely to increase, the net effect of
subsidy systems on total emission of pollutant by all sources is not possible to predict
with certainty.

Sustainable Development
ACTION PLAN FOR SUSTAINABLE DEVELOPMENT:
Technology Issues, Efficient Technology Transfer Issue, Contents of Agenda 21, Priority
Action, Revitalizing Growth with Sustainability, International Policies to Accelerate
Sustainable Development in Developing Countries and related Domestic Policies,
Integration of Environment and Development in Decision-making, Sustainable Living,
Combating Poverty, Charging Patterns, Demographic Dynamics and Sustainability,
Human Health, Human Settlements, Sustainable Human Settlements Development,
Urban Water Supplies, Environmentally Sound Management of Solid Wastes, Urban
Pollution and Health, Efficient Resource Use, Land Resources Planning and
Management, Fresh Water Resources, Sustainable Agriculture and Rural Development,
Sustainable
Forest
Development,
Managing
fragile
ecosystems
:
Combating
Desertification and Drought, Managing Fragile Ecosystem : Sustainable Mountain
Development, Managing Fragile Ecosystems : Sustainable Development of Coastal
Areas, Managing Fragile Ecosystems .
International Cooperation of accelerate Sustainable Development in Developing
Countries, Combating Poverty, Changing Consumption Patterns, Demographic Dynamics
and Sustainability, Protecting and Promoting Human Health, Promoting Sustainable
Human Settlements, Policy-making for Sustainable Development, An Integrated
Approach to Land-Resource Use, Combating Deforestation, Halting the Spread of
Deserts, Protecting Mountain Ecosystems, Meeting Agricultural Needs Without
Destroying the Land, Environmentally Sound Management of Biotechnology,
Safeguarding the Ocean's Resources, Protecting and Managing Freshwater Resources,
Managing Hazardous Wastes, Seeking Solution to Solid Waste Problems, Action for
Women : Sustainable and Equitable Development, Making Environmentally Sound
Technology Available to All, Science for Sustainable Development, Promoting
Environmental Awareness, Building National Capacity for Sustainable Development,
Strengthening Institutions for Sustainable Development, International Legal Instruments
and Mechanisms, Bridging the Data Gap, UNCED : An Agreement to Disagree , The
Earth Summit : A Year After.
ISSUES OF NEGOTIATIONS, ACCOUNTABILITY, IMPLEMENTATION AND
REORIENTATION IN ACHIEVING SUSTAINABLE DEVELOPMENT:
National Accountability, Environment Agency, Japan Unveils Agenda 21 Draft Action
Plan, UNEP Governing Council Reorients it's Activities In-Line with Programme Areas,
Refocusing in Line with the CSD, Biodiversity Convention Progress, Global Action,
Objectives, Activities, Areas Requiring Urgent Action, Research, Data Collection and
Dissemination of Information, International and Regional Cooperation and Coordination,
Means of Implementation, Children and Youth, Advancing the Role of Youth and
Actively Involving them in the Protection of the Environment.
SUSTAINABLE DEVELOPMENT OF SOCIO-ECONOMIC AND ECOLOGICAL
SYSTEMS:
Programme Areas, Promoting Sustainable Development Through Trade, Making Trade
and Environment Mutually Supportive, Providing Adequate Financial Resources to
Developing Countries, Encouraging Economic Policies Conducive to Sustainable
Development, Focusing on Unsustainable Patterns of Production and Consumption,
Developing National Policies and Strategies to Encourage Changes in Unsustainable
Consumption Patterns, Developing and Disseminating Knowledge Concerning the Links
Between Demographic Trends and Factors and Sustainable Development, Formulating
Integrated National Policies for Environment and Development, Implementing Integrated
Environment and Development Programmes at the Local Level, Protecting and
Promoting Human Health, Control of Communicable Diseases, Protecting vulnerable
Groups, Meeting the Urban Health Challenge, Reducing Health Risks from
Environmental Pollution and Hazards, Promoting Sustainable Human Settlement
Development.