Download FREC 424 – Resource Economics

FREC 424 – Resource Economics
Efficiency, Welfare Measures, Market Distortions
We identify three main resource management objectives: efficiency, equity and sustainability. The principal
focus of this course is the positive analysis of allocative efficiency. Under what conditions do markets allocate
resources to their highest-valued uses at the most appropriate times? Under what conditions do markets fail to
achieve theese efficient resource allocations? What is the best way to correct these allocative inefficiencies?
These are "positive" economic questions in the sense that economics provides the analytical tools to make
objective determinations of efficiency.
Most normative questions of equity—deciding what allocation of benefits and costs is “fair,” who should
benefit and who should pay—extend far beyond the purview of economics. Equity involves subjective
judgments made by society as a whole via politics, religion, etc.
The concept of sustainability is not as simple as it sounds because it involves both efficiency and equity issues.
“Strict sustainability” means bequeathing to posterity the same world we enjoy. Taken literally, this means not
using any exhaustible resources at all! “Weak sustainability” means bequeathing to posterity at least as high a
standard of living as we enjoy. We may diminish the natural resource base, but we fully compensate for this by
augmenting capital stocks and developing technologies to make much more efficient use of resources in the
future.
It should be pointed out that economics is inherently anthropocentric. Resource economics analyzes the choices
made by people and the underlying values of natural resources to people as reflected in those choices. People
vote and spend money. Animals, plants and the rest of the natural world don’t, so their values don’t get
expressed in any direct way. This is why some environmentalists accuse economists of reducing the natural
world to crass money terms, and ignoring its “intrinsic” values. Most of these criticisms are based on
misperceptions of what economics is about. Obviously many natural resources, including environmental
quality, are not market goods, and their values to people are not expressed in market prices. So economists
have developed various techniques for gauging the non-market values of things such as biodiversity and air
quality, and empirical applications of these methods indicate such values are indeed substantial. The
anthropocentric framework is broad enough to encompass peoples' appreciation for the simple "existence value"
of resources, independent of any human use of them. At least in theory, this concept of existence value could
even be extended to resources about which people are unaware.
Efficiency
Pareto efficiency is defined as any situation where no one can be made better off without someone else being
made worse off. The Edgeworth box is a diagram of this concept:
The horizontal and vertical dimensions of the box represent fixed quantities of two goods, X and Y, to be
allocated between two individuals, A and B. A few of A’s indifference curves are represented in red, radiating
outward from A’s zero-consumption origin at the southwest corner of the box. A few of B’s indifference curves
are represented in blue, radiating outward from B’s zero-consumption origin at the northeast corner of the box.
The green line represents all points of tangency between all of A’s and B’s indifference curves.
Any point within the Edgeworth box represents a specific allocation of goods X and Y between individuals A
and B. If A and B start at some initial allocation that is not on the green line, and if they can trade freely, they
will trade X for Y for mutual benefit until they reach some point along the green line, which is known as the
contract curve. The contract curve is the set of Pareto-efficient allocations, where A’s and B’s marginal rates of
substitution between X and Y (the slopes of their indifference curves) are equal. Once A and B have traded to
the contract curve, no additional mutually beneficial trade is possible.
Note that the Pareto-efficiency criterion does not address issues of equity (fairness) in the a priori distribution
of goods or resources. For example, an allocation where A gets everything and B gets nothing would be Paretoefficient. A logical extension of the Pareto-efficiency concept is that any redistribution of resources among
individuals is efficient only if the gainers from the redistribution could fully compensate the losers and still be
better off.
Welfare Measures
This course analyzes how markets allocate resources between uses and through time. Briefly, we define
economic efficiency as maximizing the stream of net benefits accruing from the resource stock across all uses
and time periods. Net benefits are defined as total benefits minus total costs. Consider the simple market
model below, where the equilibrium quantity and price are determined by the intersection of the supply and
demand schedules.
“Demand” is defined as the schedule of quantities consumers are willing to buy at various prices. But a demand
schedule can also be interpreted as a “willingness to pay” schedule, i.e., the schedule of prices consumers would
be willing to pay for various quantities. The beauty of markets is that they have no price discrimination, which
means that all consumers get to pay the same price per unit, regardless of how much more some consumers
might actually be willing to pay. Sellers can’t read buyers’ minds. So any downward-sloping demand schedule
implies that there are consumers represented all along the demand schedule above the market equilibrium price
who would be willing to pay higher prices for the good, but they don’t have to. They get to keep this “surplus”
money. Consumer surplus is defined as the total amount consumers would be willing to pay beyond what they
actually do pay. Graphically, it is represented by the triangular area beneath the demand schedule and above the
equilibrium price. Mathematically, it is calculated as the integral of the inverse demand (WTP) schedule minus
actual expenditures. And if the demand schedule is linear, consumer surplus is a simple triangle, calculable as
one-half the base (Q) times the height (price-axis intercept of the demand schedule minus equilibrium P)
“Supply” is defined as the schedule of quantities firms are willing to produce and sell at various prices. The
inverse interpretation of supply is a “willingness to sell” schedule, i.e., the schedule of prices at which sellers
would be willing to sell various quantities. In the absence of price discrimination, all sellers receive the same
price per unit, regardless of how much less some sellers might actually be willing to sell for. Buyers can’t read
sellers’ minds. Any upward-sloping supply schedule implies sellers are willing to sell some units for less than
the market equilibrium price, but they all get the full market price. So they collect a “surplus” payment.
Producer surplus is defined as the total revenue sellers receive beyond what they would be willing to sell for.
Graphically, it is represented by the triangular area above the supply schedule and below the equilibrium price.
Mathematically, it is calculated as actual expenditures minus the integral of the inverse supply (WTS) schedule.
If the supply schedule is linear, producer surplus is a triangle calculable as one-half the base (Q) times the
height (equilibrium P minus the price-axis intercept of the supply schedule).
Total market benefit is measured as total willingness to pay--the area under the market demand curve up to the
market equilibrium quantity. Total costs are measured as the area under the supply curve up to the market
equilibrium quantity. Total benefits minus total costs equals total economic surplus, the sum of consumer
surplus and producer surplus.
Market Distortions and Inefficiency
In general, competitive markets are pretty efficient, and policies that distort markets typically result in reduced
efficiency and economic waste.
Consider the effects of a rent-control law that imposes a price ceiling on the rents landlords can charge their
tenants. In the short term, tenants win (pay lower rents) and landlords lose. But the long-term effects of an
urban rent-control program can be devastating: Rental caps leave landlords no incentive to invest in or maintain
properties, so in the long run the neighborhood becomes a slum, the tax base collapses, buildings are eventually
abandoned and condemned. This what ruined the South Bronx.
If you want to rent an apartment in a place like Manhattan which has had rent control and a consequent shortage
of housing for decades, you will probably have to negotiate an illegal sublet for whatever squalid little place
you can afford. You will pay a very high rent to whatever tenant has his or her name on the lease, and this
tenant will pay the landlord the contractual rent and pocket the rest of your money. So the rent control law has
made housing scarcer and shabbier, and housing expenses are actually higher, than they otherwise would be. It
creates an illegal sublet market in which most of the rent you pay is diverted from the legal owner to an illegal
intermediary.
The following graph illustrates the general effect of a price-ceiling policy such as a rent-control law. In
equilibrium the market price is Peq, but the government caps the price at Pc. So now sellers reduce output from
Qeq to Qc, creating a shortage. Since some consumers are willing to pay a lot more, a black market emerges
with a black market price of Pbm.
One bad policy often begets another. What if the government decides to stamp out the black market by issuing
rationing coupons and requiring sellers to collect a coupon along with a price of Pc for each unit sold? If the
government issues Qc rationing coupons to some lucky consumers, there will likely be a black market in
coupons, where the price of a coupon would be Pbm minus Pc! Total revenues from coupon sales would be the
area of the square outlined in green: (Pbm – Pc) x Qc. This is more or less what happened with gasoline
rationing in the US during the Second World War.
The result of a policy like this is a quantifiable loss of total economic surplus, a “deadweight loss” (DWL). In
this case, even though some consumers benefited from the lower price (or from black market sales of rationing
coupons) and captured some of the original producer surplus, there was an overall loss of surplus represented by
the black DWL triangle in the graph. The market distortion is inefficient because the buyers gained less than
the sellers lost.
Market-distorting policies generally arise from the economic ignorance of politicians. They reflect good
intentions gone wrong. The first lesson for economic policy-making is "The road to hell is paved with good
intentions!"
Here's another real-world example of a horribly wasteful market-distorting policy:
In 1816 the “infant” US sugar industry in the newly-purchased Louisiana territory got Congress to restrict
foreign imports of sugar. They argued that tariffs were necessary to maintain their plantation profits and a
healthy market for slaves. In 1934, Congress established sugar import quotas in addition to tariffs on sugar
imports and direct government subsidies to US producers. US sugar producers have supported a powerful
Washington lobby, the Sugar Association, that has kept sugar quotas in place ever since. This has lots of
unintended consequences:
1. US consumers spend more on sugar than they should, and thus have slightly less income to spend on other
goods. It’s not enough for individual consumers to get mad about, but in the aggregate it’s a big
misallocation of money. The difference between the US price and world price is about 18 cents per pound,
but each additional penny represents about $250 million of the US food bill!
2. Cropland gets diverted from other crops such as soybeans to less efficient sugar production, which increases
prices of other crops slightly and reduces US farm exports.
3. The quotas deny poor sugar-producing countries fair access to our markets. The quota increases the global
surplus of sugar, driving world prices lower, and these countries suffer. The US’s “Quota Offset Program”
was a counter-productive effort to compensate poor Caribbean sugar-producing countries by dumping $200
million of free food on their economies, further depressing their farm incomes.
4. US sugar quotas invite trade retaliations from other countries. They have been ruled illegal under various
trade agreements and are a constant sticking point in US trade negotiations.
5. US sugar beet producers don't benefit as much as they hoped, because the high price of sugar has stimulated
the development and consumption of substitute sweeteners. Without sugar quotas, the market for artificial
sweeteners would have been much slower to develop. The Sugar Association has fought FDA approval of
competing sweeteners for years, and is now suing the makers of Splenda charging unfair trade practices.
Similarly, high sugar prices have driven many food and beverage manufacturers (including Coke and Pepsi)
to switch to corn sweeteners.
6. Since the quotas restrict sugar but not sugar products, some major candy manufacturers have left the US for
Canada (which grows no sugar!), costing the US thousands of jobs. It’s more profitable to make candy at
world sugar prices and import it to the US.
7. The US has prosecuted dozens of companies for smuggling sugar into the US, although the fines collected
don’t come close to matching the political contributions the sugar lobby makes to favorite legislators.
8. Subsidized sugar production has caused enormous environmental damage in the Everglades and Louisiana.
9. Some sugar-producing countries switch to alternative crops like cocaine and marijuana. Since Columbia
can't sell sugar to the US, its drug lords sell us cocaine instead. So the US has a booming illegal drug
market; lots of drug addicts; lots of money spent on drug interdiction, mandatory jail sentences for drug
offenders and extra police; and lots of drug-related crime. So the next time you're mugged or robbed, you
should probably thank America's sugar beet growers and the US Congressmen they bought.
The US sugar industry certainly can’t survive in a global market without enormous government help. But even
with this help, their economic power is slipping. US sugar consumption continues to fall. But the sugar
industry is still in Washington buying legislators and whining for even more government help. Rep. Dick
Armey (R-TX) calls the US sugar program "the most costly cartel to American consumers since OPEC" (no
sugar producers in his district). One of the Sugar Association’s favorites, Rep. John Breaux (D-LA), discussing
his log-rolling deal to win White House backing of the 1981 sugar program, explained that his vote was
“rented” rather than bought.
Topic Previews
Discounting allows us to compare net benefits across time periods. The discount rate is a social rate of time
preference: we would rather have benefits today rather than next year, so we "discount" next years benefits
slightly relative to current benefits. Financial interest rates reflect this discount rate as well as inflationary
expectations and risk costs. An optimal allocation implies that the marginal net benefits accruing from the
resource in each use are equal, and that the time-discounted marginal net benefits accruing from the resource in
each time period are equal.
Students are frequently surprised to see that competitive markets can achieve near-optimal allocations of
resources. Monopolistic markets generally result in excess conservation. Various other market failures also
compromise allocative efficiency. For example, some "common property" or "open-access" resources such as
marine fisheries are vulnerable to over-harvesting; non-excludable "public goods" such as scenic quality are
typically under-supplied.