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Water Board Training Academy Introduction to Environmental Economics Jonathan Kaplan What will we be doing today This morning, we will • look at basic principles in microeconomics • apply these principles to natural resources This afternoon, we will • discuss cost benefit analysis, and then • analyze a few water quality-related problems • nutrient standards • NPS pollution • groundwater contamination So what is microeconomics all about? Providing an explanation for why people do what they do Predicting how people will react to change Microeconomics is the study of individual choice, and how that choice is influenced by economic, technological, environmental, political, and social forces. Why do we have to make choices? Scarcity exists because individuals want more than can be produced. • The degree of scarcity is constantly changing. • The quantity of goods, services, and usable resources depends on technology and human action. Economic reasoning suggests we make decisions by comparing costs and benefits. Marginal Costs and Marginal Benefits • Marginal = expected incremental, or additional If MB ≥ MC We Do It If MB < MC We Do Not • Marginal cost – the additional cost to you over and above the costs you have already incurred. – This means not counting sunk costs – costs that have already been incurred and cannot be recovered. • Marginal benefit – the additional benefit above and beyond what you’ve already accrued. Trout Catch Total Benefit Marginal benefit 1 $48.00 $48.00 2 $83.00 $35.00 3 $106.00 $23.00 4 $121.00 $15.00 Economic reasoning is based on the premise that everything has a cost. Opportunity Cost The benefit foregone of the next-best alternative to the activity you have chosen. The opportunity cost of state revenue spent on wetlands restoration is less spending on other priorities. Total Cost Marginal Cost 1 $18.00 $18.00 2 $49.00 $28.00 3 $87.00 $38.00 4 $135.00 $48.00 Trout Restoration Economics and Market Forces When goods are scarce, they must be rationed. – That means a mechanism must be chosen to determine who gets what. – Markets ration by changing prices. • When there is a shortage, the price goes up. • When there is a surplus, the price goes down. Market reality, however, is controlled by three forces: – Economic forces. – Social and cultural forces. – Political and legal forces. Demand for Goods and Services Demand Who demands? • • Buyers of goods and service who are willing and able to pay. Prices limit willingness and ability to pay Law of demand – the inverse relationship between price and quantity demanded, holding all else constant. • Quantity demanded rises as price falls, other things constant. • Quantity demanded falls as prices rise, other things constant. Why? People tend to substitute for goods whose price has gone up. Price (per unit) A Demand Curve PA A D 0 QA Quantity demanded (per unit of time) Other Things Constant • Other things constant places a limitation on the application of the law of demand. – All other factors that affect quantity demanded are assumed to remain constant, whether they actually remain constant or not. – When one of these other factors changes, the entire demand curve shifts Shift in Demand Price (per unit) Change in demand (a shift of the curve) $1 B A D0 D1 250 100 200 Quantity demanded (per unit of time) Price (per unit) Change in Quantity Demanded $2 B Change in quantity demanded (a movement along the curve) $1 A D1 0 100 200 Quantity demanded (per unit of time) Market Demand Market demand is simply an aggregation of each individual’s demand. How they are aggregated may differ. Private Good: can be consumed in separate and possibly different amounts by each individual in a group, depending on their tastes, preferences, and wealth. Public Good: once made available to one person, automatically becomes available to others as well. Going from WTP to Benefits. The marginal benefit an individual receives from consuming another unit of a good equals the maximum they are willing to pay for that additional unit. If we add up everyone’s marginal WTP, it follows that we get a measure for total benefits across all consumers. This suggests that we can measure benefits by examining market demand curve. Demand Curve represents Aggregate WTP Total Benefits are area under Market Demand Curve Supply of Goods and Services Supply • • Individuals control the factors of production – inputs, or resources, necessary to produce goods. Individuals supply factors of production to intermediaries or firms. The Law of Supply - there is a direct relationship between price and quantity supplied. – Quantity supplied rises as price rises, other things constant. – Quantity supplied falls as price falls, other things constant. Why? – When prices rise, firms substitute production of one good for another. – A higher price means firms can incur higher marginal costs. Price (per unit) A Supply Curve S PA 0 A QA Quantity supplied (per unit of time) Shifts in Supply Versus Movements Along a Supply Curve • Quantity supplied refers to a specific amount that will be supplied at a specific price. • Changes in price causes changes in quantity supplied represented by a movement along a supply curve. Change in Quantity Supplied Price (per unit) S0 B $25 $15 A Change in quantity supplied (a movement along the curve) 1,250 1,500 Quantity supplied (per unit of time) Shift in Supply S0 Price (per unit) S1 $15 A B Shift in Supply (a shift of the curve) 1,250 1,500 Quantity supplied (per unit of time) Individual and Market Supply Curves • The market supply curve is derived by horizontally adding the individual supply curves of each supplier. The Market Equilibrium $ S1 S0 p D q Q Consumer and Producer Surplus Equilibrium • Equilibrium is a concept in which opposing dynamic forces cancel each other out. • In a market, the forces of supply and demand interact to determine equilibrium quantity and equilibrium price. • Equilibrium isn’t a state of the world, it is a characteristic of a model. • Equilibrium isn’t inherently good or bad, it is simply a state in which dynamic pressures offset each other. • When the market is not in equilibrium, you get either excess supply or excess demand, and a tendency for price to change. • Excess supply – a surplus, the quantity supplied is greater than quantity demanded P S0 Pe D Qe •Prices tend to fall. Q •Excess demand – a shortage, the quantity demanded is greater than quantity supplied P S0 Pe D Qe • Prices tend to rise. Q Price Adjusts • The greater the difference between Qs and Qd, the more pressure there is for prices to rise or fall. • When Qd equals Qs, prices have no tendency to change. • Political and social forces can push price away from a market equilibrium. • These forces create an equilibrium where Qs≠Qd. Quantity Restrictions • Governments often regulate markets with licenses which limit entry into a market. Quantity restrictions tends to increase price. • P S0 PD Pe PS D QR Qe Q Government Policies Excise Taxes • An excise tax is a tax that is levied on a specific good. • A tariff is an excise tax on an imported good. $ Use Tax S+tax S a pD pm pS b c g i h j d k e D f q2 q1 Quantity Sales Tax P A tax consumers pay in addition to the price the supplier receives S0 P* Pe P^ D’ Q’ Qe D Q Environmental (Natural Resource) Economics Nature Economy Flows Residuals Nature as Sink Assimilative Capacity The flows from nature that have value will depend on Technological Adoption Economic, Legal, and Regulatory Institutions Socio-demographic factor Tastes and Preferences External costs or benefits generate a gap between market efficiency and social efficiency Dynamics implies use today can affect future use Value may be difficult to measure because flow is not traded in a market. Socially Optimal Rates of Resource Use Social Efficiency Resources are used efficiently if they produce the maximum net social benefits. optimal use will depend upon value of resources in alternative uses natural rate of replenishment economic incentives institutional arrangements (property rights) Are there other criteria to determining best use? Sustainability Equity Externalities External Costs are costs incurred by people who are not party to the decision making process. External Benefits are benefits enjoyed by people who are not party to the decision making process. Environmental Costs / Externalities MC + EC P MC Ps Pm a b c d e f i g h qs qm MB Q 40 Environmental Benefits / Externalities P MC a Ps Pm b c d e f h g i qm qs MPB + EB MPB Q Accounting for Benefits and Costs Over Time Aggregate Stream of Current and Future Net Benefits Resource Use is Inherently Dynamic Benefits and costs may accrue today and in the future How then do we add up the net benefits from use today with use in the future? PV FV t (1 r) Year3 35 35 35 Year4 30 30 Year1 25 WTP($) 20 15 20 10 15 WTP($) 30 Year0 25 WTP($) 35 25 Year2 30 5 20 10 0 0 25 1 2 15 q4 WTP($) 5 0 10 20 0 1 2 q3 5 15 0 0 1 2 10 q2 5 0 0 1 2 3 q1 q0 4 5 3 4 5 3 4 5 3 4 5 PV PV M0 (1 r) 0 100 (1 0.05) 0 FV1 (1 r)1 FV2 (1 r) 2 t year0 year1 Benefit 100 100 5% 100 95.24 year2 year3 year4 75 50 25 68.03 43.19 20.57 PV 350 327.02 100 (1 0.05) 1 75 (1 0.05) 2 50 (1 0.05) 3 FVt (1 r) t 25 (1 0.05) 4 $327 .02 Present Value of Costs t=0 t=2 t=1 P P P MC1 MC0 C1 C0 q0 PVof Costs Q C0 0 (1 r) MC2 C2 q1 Q C1 1 (1 r) C2 2 (1 r) q2 Q t Ct t (1 r) B0 C t (1 r) 0 PV Bt C t (1 r)1 Bt C t (1 r) 2 t 0.05 0.06 sum PV PV year0 year1 year2 benefit 500 450 120 1070 1037.42 1031.33 cost 400 350 337 1087 1039.00 1030.12 year0 year1 year2 year3 sum PV PV 500 450 120 1070 988.01 972.95 400 350 337 1087 1039.00 1030.12 year0 year1 year2 year3 sum PV PV benefit 500 450 120 0 1070 1037.42 1031.33 cost 0 400 350 337 1087 1035.41 1025.86 benefit cost year3 NB t (1 r) t Dynamic Efficiency = Maximum Present Value of Flow of Net Benefits Requires selection of a time series of decisions that incorporates future consequences stemming from today’s decisions (user costs) P MTC = MCC+UC MCC Equilibrium Condition MB = MCC + UC MCB qf qm Q Public Policy Public Policy - Collective Action -Different policies for different circumstances -Policies involve political Ideologies and strategies -What are the economic incentives embodied in various policies? -Which policy is “Best” for the given resource problem? What criteria shall we use to evaluate policies? Policy Objective: Economic Efficiency Max Social Net Benefits Why is this Difficult? -Includes Market And Nonmarket Benefits and Costs Information Problem Goal of Max Social Net Benefits seems reasonable for policy that favors public interest. All else the same, an efficient policy is preferred to an inefficient policy Policy Objective: Equity – “Fair” Distribution of Net Benefits Why Is This Difficult? -Hard to determine what is a fair distribution. -Benefits are widely spread across population while costs are localized -Costs are widely spread across population while benefits are localized -Local optimal rates of use may differ from national rates -Ability to pay may provide access to political markets -Intergenerational equity All else the same, a more equitable distribution of the PVNB is preferred to a less equitable distribution Flexibility – Does a policy adapt to changing circumstances Policy must be able to adapt to new circumstances Enforceability -Enforcement is costly and budgets are limited -Leads to less than perfect enforcement Types Of Policies Incentive-based Policies •Market/Property Right Policies Ill-Defined Property Rights Are Commonplace Among Resource Use Problems These Policies Define and Enforce Property Rights and Markets For Trading • Government-Sponsored Incentive Policies Taxes and Subsidies Direct Controls •Command and Control Policies Establish Controls on Private Use of Resources Examples: Catch Limits, equipment limits, season limits •Direct Government Ownership of Resource Government Produces and Distributes Resource Examples: National Parks, Grazing on BLM Land, Timber Sales Consider the problem of protecting the CA sea urchin fishery from being overfished due to ill-defined property rights. Divers Pluck Urchins From Rocky Coastline How would each policy look? The Sea Urchin Fishery Market/ Property Right Regime Delineate Coastline And Provide Individual Tradable Leases For Each Segment Agency Records Lease Ownership and Trades, and Enforces Exclusive Rights – No trespassing Policy Internalizes Externality and User Costs Important Characteristics of Property Rights 1) Completeness -Non-attenuated No limits impede the owners ability to maximize stream of net benefits 2) Enforceable Exclusion provides strong incentive to maintain maximum stream of net benefits 3) Transferable Without transferability there is no incentive to maintain maximum market value of resources (i.e., Include user costs) 4) Competitive Marketplace Markets must exist so resource owners can capture the full value of services produced by the resources Ensures resources are used in a way that maximizes social value Market/property right policy creates excludability of access to resource! What incentive does this create for owners of the resource? Incentive to invest in long-term viability of urchin beds Problem: How should property rights or leases be distributed? Government-sponsored Incentive Policy Agent can impose tax per pound of harvested urchins Tax increases the cost of harvesting urchins thereby affecting the harvest rate The agent now must determine tax rate, acquire data on harvest rate, and then collect tax Taxes And Subsidies Distributional implications? The agency collects the tax and thus the bulk of net benefits from optimal use go to the agency not the divers. Will this be a politically attractive policy? How can we see distribution of social net benefits? How can we see the change in this distribution after a policy is enacted or removed? $ MWTP Use Tax MC+EC MC a pD pm pS b g j h k e l c d i f q2 q1 Quantity Command And Control Approach Specify use rate and then enforce What use rate? Agent needs to gather info on market and nonmarket costs and benefits MSC $ MWTP S=MC a p2 pm MC b g Quota Rents c h d i j k l e f q* qm Quantity How are quota rents allocated? What if q* is aggregate output level? Need to know costs to each firm to allocate q* efficiently What other means would you propose for allocating q*? What is the incentive to be noncompliant? Direct Government Production Examples: Public Parks National Forests National Monuments Utilities Would we expect government agencies to manage resources use such that social net benefits are maximized? 1) Private Firms are Residual Claimant They get to keep the rewards (resource rents) from resource use This reward creates an incentive for firms to strive toward efficiency 2) Disjoint Between Generated Net Benefits and Politically-Determined Government Budgets We can also consider combinations of these policies Cap and Trade A combination of a quantity restriction and tradable property rights. Whomever receives quota can then trade it Market Failures Versus Gov’t Failures Markets left to themselves results in resource use that is not socially equitable or efficient What Gives Rise to Market Failures? External Costs and Benefits Myopia Government action may also result in less than socially efficient and equitable resource use. What gives rise to government failures? Inadequate enforcement Perverse incentives Redistributive not efficiency improving Protection of privilege Excessive information requirement Government Failure Subsidies as a tool to encourage resource development Examples: Constructing Logging Roads Building Dams Below-cost Grazing On Public Land Lifting these subsidies improves social welfare. MSC $ a p3 p2 p1 Subsidy k b c d l i h MSC-Sub j e g f q2 MWTP q1 Quantity LUNCH?