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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