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The Economy and the Environment
THE ECONOMY AND THE
ENVIRONMENT
The Economy and the Environment
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•Environmental Economics is concerned with the
impact of the economy on the environment,
significance of the environment to the economy, and
the appropriate way of regulating economic activity
for achieving balance among environmental,
economic and other social goals
•Essence of environmental problem is the economyproducer behaviour and consumer desires
The Economy and the Environment
• It is one of the fastest growing branches in
economics
• Many environmental goods have become scarce
resources
• For many decision making problems in
environmental problems an economic approach is
needed to obtain the money value of the damages
• There has been a shift in emphasis from command
and control policy to economic/market based
instruments to achieve environmental policy goals
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The Economy and the Environment
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• Government faces budget constraints
• In reaching binding international agreements on
global environmental issues, economic analysis is
needed to assess the likely impact of different policy
options on distribution of benefits and costs among
the member nations and in devising mechanisms for
sharing the costs and benefits in equitable manner
The Economy and the Environment
• Consumer behaviour, firm behaviour, market
structure,
economics
of
information
and
uncertainty (Microeconomics)
• Externalities, public goods, efficiency and equity
concepts (Welfare Economics)
• Design of taxes and subsidies, public goods (Public
Economics)
• Optimal control theory, input-output model, game
theory and econometrics (Quantitative Economics)
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The Economy and the Environment
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The Economy and the Environment
• Economy: All the firms that make up industry
• Environment: All natural resources, including land,
land cover and ecosystems
• The economy operates from inside the
environmental system, with conditions in the two
systems being simultaneously determined
• Many links between the two systems
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Environmental System
Global Life Support Impact on bio diversity
Economic System
Resource Inputs
Amenity Values
Wastes (Global, regional
And local pollution)
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Linkage between the Economy and the Environment
• Environment provides inputs of raw materials and
energy sources
• Waste sink for the economy
• Direct source of amenity to the environment
• Basic life support services
▫ Climate regulation, operation of water cycle, regulation of
atmospheric composition and nutrient cycling
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Impact on the Environment
• An increase in the use of environment as a waste
sink may reduce the ability to supply basic life
support
• Reduction in amenity flows
▫ developed in national parks, logging reducing
Quarries the area of rainforest
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Impact on the Environment
• Effect on natural diversity (by taking over habitats)
• Co-evolution
▫ The way in which economic subsystem evolves over
time depends on the changing conditions of the
environmental subsystem, and vice versa
• Case of Neolithic Scotland
The Economy and the Environment
Insights from Economics
Environmental Studies
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required
in
• Simultaneously determined
• Behavioral underpinnings of economics
▫ Incentives
▫ Decisions at margins
▫ To expect firms and households to act in their best
interests
• Scarcity
• Market Failure
The Economy and the Environment
The First Law of Thermodynamics: Materials
Balance Principle
“Matter, like energy, can neither be created nor be
destroyed”
• Implications:
▫ As more matter is extracted by the production
process, more waste is generated
▫ Puts limits on the degree to which resources can be
substituted
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The Economy and the Environment
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The Second Law of Thermodynamics: Entropy
Law
“In a closed system, the use of matter-energy causes
a one way flow from low entropy resources to high
entropy resources; from order to disorder”
• Implications:
▫ Energy can not be recycled in such a way that we get
back all the capacity of the original energy source
▫ Helps in understanding the limits of matter-energy
recycling, but is not harbinger of doom
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The Market System is considered failure when a set of
competitive markets fail to generate an efficient allocation
of resources between and within economies.
Efficiency is defined as ‘Pareto Optimality’ which states the
impossibility of reallocating resources to make one person
in the economy better off without making someone else
worse off.
Efficiency defined in terms of ‘Pareto Optimality’ is
achieved when private decision leads to a social Optimum.
The Economy and the Environment
Six Cases of Market Failure:
Incomplete Markets
Externalities
Non-exclusion
Non-rival and Public Goods
Non-convexities
Asymmetric information
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Markets are complete when enough markets exist to cover
each and every possible transaction or contingency so that
resources can move to their highest valued use.
A complete market requires a set of well-defined property
rights system
This well defined property rights system represents a set
of entitlements that define the owner’s privileges and
obligations for use of a resources or asset
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A well-defined property Rights system has the
following key characteristics:
Comprehensively assigned: all resources or assets
should either be privately or collectively owned
Exclusive: all benefits should accrue to the owner only
either directly or through sale
Transferable: from one owner to another in a voluntary
exchange
Secure: from involuntary seizure or encroachment by
other individuals, firms or the government
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One of the prominent reasons for market failure
Normally actions or decisions by one individual
agent does not directly affect anybody else.
For example: purchase of shoes
Some other actions affect others directly.
For example: driving near hospital (harmful
effects
inoculation of children (beneficial effects)
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Two Types Externality: Positive and Negative
Positive: when action of individual agent has
beneficial effects.
Examples: 1. Flowers garden providing
enjoyment, 2. Vaccination, 3. Production of
Honey
Negative: when action has negative effects on the
agents
Examples: 1. if neighbor plays loud music at 4
a.m. in the morning, 2. Riding on a noisy motor
cycle, 3. Smoking in a public place.
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Externality the Problem:
A.C. Pigou in his book titled Wealth and Welfare (1912)
dealt with the problem of Externality systematically for the
first time.
Overall economic efficiency requires that:
MSB = MSC
MSB = Marginal Social Benefit
MSC = Marginal Social Cost
where,
MPB = Marginal Private Benefit
MSB = MPB + MEB
MPC = Marginal Private Cost
MEB = Marginal External Benefit
MSC = MPC + MEC
MEC= Marginal External Cost
If, MSB>MSC, Output can be expanded because additional output adds more
benefits to the society than the cost.
In a situation when MSB≠MSC, the optimal condition of efficiency can be
obtained through imposition of Tax and Subsidy
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Externality in Production: Negative and Positive
Figure 1: Negative Externality in Production
Price, MC
Fig 1 illustrates negative
externality in Production
(MSC>MPC)
MSC
D
MPC
Po
P1
C0
Assuming no externalities
in
consumption,
DD
shows MSB and MPB
(MSB=MPB)
D
Q0
Q1
Quantity
With MSC the optimal output produced is Q0 corresponding to
Price P0 (where MSC=MSB)
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The Competitive Market (when left alone) produces Q1
with a price P1 - There is a tendency to overproduce.
At Q0 the Price is P0 but the MPC is C0
Therefore the Govt. can levy a per unit tax of (P0 - C0 )
which in turn will increase MPC by (P0 -C0) and reduce
output from Q1 to Q0
At Q0 the consumers would pay P0 the full marginal social
cost of Production.
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The extra revenue earned from taxation can be used for
external damage from production of this product.
The tax revenue could be more or less than the external
damage
The tax revenue is equal to (P0 - C0)×Q0 whereas the total
external cost would be equal to area between MSC and
MPC
The Net Gain to the Society is equal to ∑(MSC-MSB) over
Q0 to Q1 (the shaded area) which is eliminated by tax.
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Figure 2: Positive Externality in Production
Price, MC
Fig 2 illustrates positive
externality in Production
(MSC<MPC)
MPC
D
MSC
Co
P1
P0
Assuming no externalities
in
consumption,
DD
shows MSB and MPB
(MSB=MPB)
D
Q1 Q0
Quantity
With MSC the optimal output produced is Q0 corresponding to
Price P0 (where MSC=MSB)
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The Competitive Market (when left alone) produces Q1
with a price P1 where DD intersects MPC, under
production from social point of view
At Q0 the Price is P0 but the MPC is C0
Therefore to produce more output (from Q1 to Q0) the
Govt. has to provide a subsidy of (C0-P0)
At Q0 the consumers would pay P0 {Or (C0-P0)}.
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Govt. could collect the money from people reaping the
external benefits
The expenditure on subsidy could be more or less than the
external benefit
The Net Gain to the Society is equal to ∑(MSB-MSC) over
Q1 to Q0 which is obtained through subsidy.
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Externality in Consumption: Negative and Positive
Figure 3: Negative Externality in Consumption
Price, MC
Fig. 3 illustrates negative
externality
in
Consumption (MPB>MSC)
MSB
D
MPC=MSC
Po
P1
C0
Assuming no externalities
in production (MSC=MPC)
D=MPB
Q0
Q1
Quantity
The optimal quantity is given by Q0 (the point where MSB=MSC)
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In the absence of any intervention, the quantity supplied
and produced is Q1 with a price P1
At Q1 there is overproduction of the commodity
compared to social optimality
To restrict the output to Q0 , the price has to be increased
to P0
But the supply price for Q0 is C0
Hence a tax equal to (P0 - C0 ) needs to be levied
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The price consumers pay is P0 (=MPC + Cost of Externality
in Consumption)
The revenue generated from the consumption of the tax
could be used to compensate those who are hurt by the
external cost arising from the consumption of the product
The shaded area measures net benefit of the tax policy.
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Externality in Consumption: Negative and Positive
Figure 4: Negative Externality in Consumption
Price, MC
Fig. 4 illustrates positive
externality
in
Consumption (MPB<MSC)
D
MPC=MSC
C0
P1
Assuming no externalities
in production (MSC=MPC)
Po
MSB
D=MPB
Q1
Q0
Quantity
The optimal quantity is given by Q0 (the point where MSB=MSC)
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In the absence of any intervention, the quantity supplied
and produced is Q1 with a price P1
At Q1 there is underproduction compared to socially
optimal level
To produce output Q0 , the price is P0 But the supply price
for Q0 is C0
Hence a consumers need be given a subsidy equal to (C0 P0)
The price consumers pay is P0 the producers get C0
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At least part of the cost of the subsidy (C0 - P0)×Q0 could
be collected from those reaping external benefits
arising from the consumption of this good
The shaded area measures net benefit to the society
from the subsidy. It’s the (MSB-MSC) for the output
range Q1 to Q0
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Summary:
1. In the presence of externalities, the socially optimal level of
output (Q0 in out example) is given by the condition MSB=MSC
2. The private production of output Q1 is given by the condition
MPB=MSC
3. To bring about an output to Q0 we can use the tax and subsidy
programs shown in Table-1.
Table 1: Taxes and Subsidies in the presence of Externalities
Condition
Tax or Subsidy
Amount of Tax or Subsidy*
MSC>MPC
Tax Producers
MSC – MPC
MSC<MPC
Subsidize Producers
MPC – MSC
MSB<MPB
Tax Consumers
MPB – MSB
MSB>MPB
Subsidize Consumers
MSB - MPB
*These amount are measured at the socially optimal level
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Ronald Coase (1962) challenged Pigou’s main proposition
that Govt. should intervene through taxes and subsidies in
the presence of externalities.
According to Coase, since administering of taxes or subsidies
cost something, if these costs are higher than the social
benefits from intervention (shown by the areas of the triangles
in figures 1 to 4) then Govt. intervention will not increase
social welfare.
Secondly, Coase argued that the same result that govt. seeks
to achieve through taxes or subsidies can also be attained
through private deals. (Consider figure 5)
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Example: The Paper Mill dumping waste in a river and thus
hurting the fishing
Figure 5: Possibility of private deals under externalities
Price
MC
MSC
B
MPC
A
C
E
Quantity
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In figure 5. Q0 is the socially optimal output while the
competitive market produces Q1
If the paper mill reduces output from Q1 to Q0 the net loss in the
producer’s and consumer’s surplus is ACE but the gain to the
fishers is ABCE (the excess of MSC over MPC for the output
range Q0 to Q1).
Since ABCE>ACE so that gain to the fishers is larger than the
loss to the consumers and producers, there is the possibility for
the fishers to bribe the producers and consumers to cut
production to Q0
Thus, this proves that socially optimal level of output could be
achieved without government taxing or subsidizing.
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If the number of people involved is large, the
bargaining costs will be high
Assignment of property rights to any party also does
not make any difference to the allocation of resources
In our example, if Property rights to the river were
assigned to the fishers, the paper mill would have to
pay the fishers compensation for dumping the waste
in the river equal to (MSC-MPC) per each unit in fig. 5
The paper mill, thus, would have to take the costs of
compensation in to account when calculating its
costs.
Thus the externality has been internalized
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Caose Theorem: Under Perfect Competition, if
income effects and transaction costs are ignored,
voluntary agreements among the different parties
concerned will lead to a socially optimal output
even in the presence of externalities, an the result
will be the same regardless of which party is
assigned the property rights to the contestable
resource.
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Another reason for Market Failure
Non-exclusion implies a situation when it is impossible or at
least very costly to deny access to an environmental asset.
In the presence of non-exclusion, but with rivalry in
consumption user finds incentive to capture the goods as soon
as possible before anyone else captures them
It, in turn, results in over-use as the market fails to signal true
scarcity value of the asset
The problems associated with non-exclusion implied by such
open access property rights have long been recognized, but it
has been popularized by Hardin (1968) through his celebrated
article “The Tragedy of the Commons”.
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Concepts:
Commons: Refers to the environmental resources itself
Common Property Resources: refers to a property right regime
that allows members of a group or collective body to use the
asset and devise rules to exclude non-members from using the
resource.
Open Access Resources: Implies there is no ownership of the
asset in the sense that “everybody’s property is nobody’s
property”.
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An environmental asset is considered a pure public
good
if its consumption is non-rival and nonConcepts:
Commons: Refers to the environmental resources itself
excludable.
Common Property
refers to a property
Non-rival
means Resources:
good is available
to all right
and one
regime that allows members of a group or collective body
person’s consumption does not reduce another
to use the asset and devise rules to exclude non-members
person’s
from usingconsumption
the resource. – it implies that the marginal
cost of supplying the good to an additional individual
isOpen
zero.Access Resources: Implies there is no ownership of
the asset in the sense that “everybody’s property is
property”.
Itsnobody’s
is not Pareto
efficient to set prices that will exclude
anyone who derives positive marginal benefits from
the public, hence, market failure occurs.
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InConcepts:
addition, with the provision of pure public goods
Commons:
to the environmental
resources itself
there
is alsoRefers
the problem
of free riding.
Common Property Resources: refers to a property right
A regime
free that
rider
is one who conceals his or her
allows members of a group or collective body
preferences
for and
thedevise
goodrules
in order
to enjoy
benefits
to use the asset
to exclude
non-members
without
paying
for them
from using
the resource.
Resources:
Impliesmarket
there is no
InOpen
the Access
presence
of free-ride,
willownership
provide of
less
asset in
the sense
propertyresulting
is
ofthe
public
good
thanthat
is “everybody’s
socially desired
in
nobody’s property”.
misallocation of resources
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Convexities associated with environmental bads (e.g.
pollution):
Concepts:
1. results
from
assumption that
marginal
benefits
Commons:
Refers
to the environmental
resources
itself
and cost functions are well behaved: i.e. marginal
benefits
are decreasing
while
marginal
costsright are
Common
Property
Resources:
refers
to a property
increasing.
regime
that allows members of a group or collective body
to use the asset and devise rules to exclude non-members
implies
that if an equilibrium level of pollution exists,
from 2.
using
the resource.
it is unique
3. therefore, if a set of complete markets exist for clean
water or pollution control, the market will send the
correct signal about the socially optimal level
of
pollution.
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Concepts:
In
real situation, for many physical systems the
Commons: Refers to the environmental resources itself
marginal benefit or cost curve need not be so well
behaved
assumed
by convexities
Common as
Property
Resources:
refers to a property right
regime that allows members of a group or collective body
Marginal
costs and
may
at first
increased
to use the asset
devise
rulesincrease
to excludewith
non-members
from using but
the resource.
pollution
then may actually decrease or go to
zero as the physical system so badly damaged that
there are simply no more costs as pollution costs as
pollution increases.
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Concepts:
Commons: Refers to the environmental resources itself
Thus Non-convexities implies that there may be
Common Property Resources: refers to a property right
more than one locally optimal level of pollution
regime that allows members of a group or collective body
to use the asset and devise rules to exclude non-members
Infrom
theusing
presence
of non-convexities, market fails to
the resource.
send correct signal about the socially optimal level of
pollution.
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Asymmetric Information arises when there exists
Concepts:
differences
amongitself the
Commons: Refersofto the information
environmental resources
agents/parties involved in a transaction.
Common Property Resources: refers to a property right
regime
that allows members of a group or collective body
For
example:
to use the asset and devise rules to exclude non-members
from using the resource.
1. when an insuree knows more about his
precautionary
behaviour
thanthere
the isinsurer
Open Access Resources:
Implies
no ownership of
the asset in the sense that “everybody’s property is
2.nobody’s
Seller property”.
knows more about the quality of a product
than a buyer
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Two types of Asymmetric Information: Moral Hazard
and Adverse Selection
Moral Hazards: the moral hazards or incentive
problem arises when the actions of one person
unobservable to a second person.
Adverse Selection: the adverse selection problem
exists when one person can not identify the type or
character of the second problem.