Download Environmental Economics

Environmental Economics
Lecture 1
Prof. Dr. Carsten Vogt
University of applied sciences Bochum
Summer term 2013
• Core problem of economics:
– How to use scarce resources?
• Evaluation criterion:
– Efficiency
– Means: scarce resources are used best if they are
used efficiently
• Minimum principle
• Maximum principle
• Is efficiency a senseful criterion?
• Yes, because:
– Loosely speaking: efficient use means there is no
waste of resources
– Ethically: step from inefficient to an efficient
allocation is a pareto-improvement
– Hard to justify why we should not realize such
improvements
• Ways of achieving efficiency?
• What are institutions suited to guarantee
efficiency?
• Historically, two approaches:
– Central planning
– markets
Market economies
• Supply and demand model
p
inverse
supply function
p*
E
Inverse demand
function
Q*
Q
Question 1: Equilibrium
Excess supply
p
inverse
supply function
p1
p*
p2
Excess demand
inverse
demand function
QD  p1 
Q*
QS  p2 
QD  p2 
QS  p1 
quantity
Self regulation: The price mechanism
(„invisible hand“)
• Market tends towards equilibrium, because:
– Excess supply: prices decline
• Leading to reactions by market participants that drives
the market towards equilibrium (as p decreases,
quantity supplied increases while the quantity
demanded increases)
– Excess demand: just vice versa
•
•
•
•
Important:
No need for governmental intervention
No regulation needed to achieve equilibrium
Market clearance guaranteed by the price
mechanism
•  theoretical basis for laisser-faire conception
of economic policy
Question 2: Welfare
• What about welfare in equilibrium?
• First: measures for human welfare:
– Consumers‘ surplus
– Producers‘ surplus
p
p
B
inverse
supply function
Consumers‘ Surplus
p*
A
E
p*
A
E
Producers’ Surplus
inverse
demand function
C
Menge
Menge
Welfare
• Welfare in market equilibrium:
p
B
inverse
Angebotsfunktion
p*
A
E
inverse
Nachfragefunktion
C
Q*
• Achieves a maximum !
Menge
Welfare
• social welfare reaches a maximum in market
equilibrium
• Trick of the market: All individuals only pursue
their self interest
– Producers: maximizing profits
– Consumers: Maximizing utility
• Nevertheless, optimal allocation for society as
a whole is achieved!
Welfare
• Harmony between
– Individual rationality
– Collective rationality
– What turns out to be good for individuals also
turns out to be good for society!
– Strong justification for market economies
•  link to environmental economics?
• Very simple: If all goods (services, natural
resources …) were allocated efficiently via
markets there was no „environmental
problem“ (from an economic point of view).
•  Can we expect real world markets to work
efficiently in the management of
environmental goods?
Why markets are efficient
• Main reason:
– Equilibrium price reflects
• The marginal value (benefit) of providing a good for
consumers
• The marginal costs of provision for producers
• Hence: In equilibrium, marginal benefits equal marginal
costs
• The good ina a perfectly working market is provided as
long as marginal benefits exceed marginal costs or both
are equal
External effects
• Thus: Markets work efficiently if prices truly
reflect costs and benefits
• Not always given.
• EXTERNAL EFFECTS AND EXTERNAL COSTS
• If external effects are present, the first law of
welfare economics does NOT hold.
External effects: Definition and examples
• Definition:
– External effect is given, if economic activity of one
economic agent has a DIRECT impact on another
economic agent
– Examples:
• External effects between consumers (consumer externality)
– Someone smokes at the neighbour restaurant table
• External effects between producers (porducer externality)
– Waste of one plant (e.g. steel plant) leads to lower profits in
another plant (e.g. a fishery)
Kinds of external effects
• Further distinction: negative or positive
– Negative external effects: someone is doing harm
to someone else (the steels plant lowers the
profits of the fishery)
– Positive external effects: someone is doing good
to someone else (beekeeper doing good to an
orchard)
External effects: Characteristics
• Main characteristic:
– Has to be a DIRECT impact
– i.e. an impact NOT reflected in market prices
Example: South Corea increases its steel production
 world market price declines
 external effect?
(No! Just the working of the price mechanism)
External effects: Characteristics
Steel plant produces more steel and more waste
water
Yield in the fishery is directly affected (decreases)
This decrease is not reflected in the market price
for steel
Thus: An external effect is only given, if market
prices do NOT react to a change in activity
External effects in detail
• If external effects come into play, efficiency is
destroyed
•  comes to a divergenc of individual and
collective rationality
• First: what is individually rational for the steel
producer?
• Simplifying assumption: steel market is
competitive
External effects in detail
• Steel plant produces until marginal costs equal
the market price:
• Graphically:
p
Marginal costs
p*
QMarket
Q
External effects in detail
• For the single enterprise, this is efficient
• Production is worthwhile as long marginal
revenue is higher or equal to marginal costs!
• Steel plant takes into account
– All costs ist has to bear (to pay for)
– E.g. costs for labour force, costs for machines
(capital), costs for rental of buildings …
External effects in detail
• Steel plant does not take into account
– All costs imposed on others it does not have to
pay for
– E.g. foregone revenue of the fishery due to water
pollution
– What is the effect of these external costs?
External effects in detail
• If external costs are present, the total cost of
production are higher than those costs, the
steel plant has to bear
• i.e. there is an extra cost
• The true cost function froma collective point
of view (taking ALL welfare effects into
account) is simply higher then the private cost
function of the steel plant
External effects in detail
• Graphically:
p
MCsoz
p*
MC priv
MCext QMarket 
QOpt
QMarktet
Q
• Social costs of production are higher than the
private costs
MCsoc  MC priv  MCext
External effects in detail
• Main effect: Market outcome is no longer
efficient!
• Efficient: Provision until social marginal costs
equal market price
• Equilibrium: Provision until private marginal
costs equal market price
• Since MCsoz  MC priv  QMarket  QOPT
External effects in detail
• Also holds at the market level:
p
MCsoc
inverse
supply function
= MC priv
inverse
demand function
QOpt QMarket
Q
External effects in detail: Market failure
• Hence:
– Quantity supplied in equilibrium is too high
– Welfare loss associated to this (triangle between
social, private cost function and inverse demand
function)
– Note: Generally efficiency requires still positive
amounts of the good!
– Not efficient to reduce production down to zero
– Or: Generally, it exists an optimal degree of pollution
and/or environmental degradation (sometimes odd
for other disciplines like, e.g. natural sciences)
External effects in detail: Market failure
• Due to welfare loss:
– Market outcome does not lead to a maximum of
social welfare
– Individual and collective rationality are at odds
– Functioning of the „invisible hand“ (price
mechanism) is distorted
• Market price does not reflect all costs of
production