The Economic Approach to Environmental and Natural

Resources, 3e By James R. Kahn

© 2005 South-Western, part of the Thomson Corporation

Theory and Tools of Environmental and Resource Economics 3e

Part I

Economic Efficiency and Markets: How the Invisible

Hand Works

Chapter 2

© 2004 Thomson Learning/South-Western

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The Working of the Invisible HandAdam Smith’s The Wealth of Nations argues that

markets lead to socially efficient allocation of resources. People acting in their own best interests tend to promote the social interest.

Anti-globalization protestors counter that free markets are the root of all social evils.

The truth probably lies somewhere in between.

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Market Fundamentals

Begin by looking at an every day private good.

The goal is to understand the differing components of a market.

After we understand how a market works, we can add the complexity associated with the impact of market activity on the environment, and the impact of the environment on market activity and society in general.

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Figure 2.1 – Market for Blue Jeans

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The Market for Blue JeansThe marginal costs of blue jeans are reflected in the

upward sloping supply function. These costs include: Production costs such as labor, energy, capital, and

materials.

The downward sloping function is the demand curve which represents how much people are willing to pay for an additional pair of jeans. Consumer demand is influenced by tastes and

preferences, prices of substitutes and complements, income, numbers of consumers and consumer expectations.

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The Market for Blue JeansEquilibrium is the price at which quantity

demanded equals to quantity supplied.

What happens when price is not at equilibrium? There is an automatic adjustment back to equilibrium. If price is less than equilibrium (P*), then quantity

demanded will be greater than quantity supplied and there will be pressure on price to rise (up to equilibrium).

If price is greater than equilibrium (P*), then quantity supplied will be greater than quantity demand and there will be pressure on price to fall (down to equilibrium).

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Measuring Net Benefits

If we make two simple assumptions: All costs associated with blue jeans are

incorporated into the supply curve.All the benefits associated with blue jeans are in the

demand curve.Then equilibrium in this market also equates

marginal benefits with marginal costs.

The market maximizes total net benefits.

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Measuring Net Benefits

The demand curve can viewed as a marginal value function based on willingness to pay.The market demand curve is the sum of all

individual demand curves.Every individual demand curve reflects a

willingness to pay based on a perceived value (or benefit) of the good.

As a result, the market demand curve reflects private benefits.

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Measuring Net Benefits

The supply curve reflects the costs of producing the good or service.

These costs are incurred in production and can be viewed as private, since all these costs are borne by the suppliers.

As such, the supply curve embodies private costs.

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Maximizing Private and Social Benefits

Private net benefits are maximized at equilibrium.

In order for social net benefits to be maximized, it is necessary that private marginal benefits be identical to social marginal benefits and private marginal costs be identical to social marginal costs.

If this condition holds, then market forces will equate both marginal private costs and benefits and marginal social costs and benefits.

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Market Failure: When the Invisible Hand Doesn’t WorkMarket Failure occurs when the market does

not allocate resources efficiently.One possible cause of market failure is a

divergence between private and social costs.Consider a production process which

reflects all the private costs of production but does not reflect all the social costs associated with production (for example, if the process generates air pollution).

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Figure 2.3. Steel Production Example

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Market Failure

Market forces generate an equilibrium production level and price associated with private costs (Q1 and P1).

This output level is greater than the socially optimal level of Q* (which considers additional cost from pollution).

The shaded area in Figure 2.3 represents the costs to society of having this higher than optimal level of output.

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Market Failure

There are 5 categories of market failure: Imperfect competition.

Imperfect information.

Public goods.

Inappropriate government intervention.

Externalities.

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Imperfect Competition Imperfect competition occurs when the individual

actions of particular buyers or sellers have an impact on market price.

In imperfectly competitive markets, marginal revenue diverges from price and marginal social cost is not equal to marginal social benefit at equilibrium.

Market failure due to imperfect competition has an impact on the study of environmental and natural resources because of the monopoly power in extractive industries such as oil and coal.

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Figure 2.4. Imperfect Competition

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Imperfect Information Imperfect information means that some segment of

the market (either consumers, producers, or both) does not know the true costs or benefits associated with the good or activity.

For example: High risk occupations where workers do not have

complete information about risks. Hazards of using chemicals in your home where you may

not be fully aware of dangers and potential side-effects. Potential that farmers in developing countries are not

aware of environmentally friendly alternatives to clear cutting.

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Public GoodsPublic goods are distinguished from private goods

by two primary characteristics: nonrivalry and nonexcludability.

Nonrivalry means that one individual’s consumption does not diminish the amount of the public good available for other’s to consume.

Nonexcludability means that if one person has the ability to consume the public good, then others can’t be excluded from consuming it.

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Public Good

National defense is an example of a pure public good.

Nonexcludability holds because in protecting one citizen in a region from missile attack, every citizen is protected.

Nonrivalry holds because one citizen’s consumption of protection does not reduce the level of protection available to other citizens.

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Public Good

Not all public goods are pure public goods.

It is possible to build a long fence around the Grand Canyon to exclude people.

It is also true that beyond some point, more people at the Grand Canyon reduces the quality of the experience for everyone.

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Figure 2.5 Spectrum of public goods

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Inappropriate Government Intervention

Government intervention is a potential source of disparity between private and social values.

Often government action to address an alternative issue creates this divergence.

As Figure 2.6 illustrates, government policy regarding leasing of timbering has created a greater than socially optimal level of timber harvest.

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Figure 2.6 – Inappropriate Government Intervention

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ExternalitiesExternalities are best described as “spillover

costs or benefits”, unintended consequences or side effects, associated with market transactions.

These unintended costs or benefits will result in a divergence between private and social benefits and costs (as illustrated in Figure 2.3).

Externalities are perhaps the most important class of market failures for the field of environmental and resource economics.

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Externalities

A more complete definition is provided by Baumol and Oates (1988, p.17)

“An externality is present whenever some individual’s (say A’s) utility or production relationships include real (that is nonmonetary) variables, whose values are chosen by others (persons, corporations, governments) without particular attention to the effects on A’s welfare.”

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Externalities

Key points from this definition:

Production and UtilityReal variablesUnintended effects

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Unintended Effects

If you were intentionally blowing cigar smoke in someone’s face, that is not an externality.

If your cigar smoke drifts from your table to someone else’s, then this is an externality.

Intent is important.

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Real Variables

Real variables are not prices.Unintended price change is not an

externality.Price changes are viewed as “pecuniary

externalities”, not real.

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Production and Utility Relationships

Air pollution has the potential to impact both production and utility relationships.

Air pollution may create a less ideal growing condition and impact yields.

Air pollution may also make outdoor activities less enjoyable (reduce utility).

These are examples of technological externalities.

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Technological vs. Pecuniary Externalities

Consider Figure 2.8 which represents a production possibilities frontier for two goods: cotton and steel.

The production possibilities frontier shows all feasible production points.

Consumer preferences determine the actual combination of cotton and steel produced.

A change in consumer preferences will result in a change in demand, which changes prices and profit potential, which, in turn, will cause a change in production levels of both goods (along the same production possibilities frontier). This is a pecuniary externality.

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Figure 2.8- Production Possibilities Frontier

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Technical vs. Pecuniary Externalities

Notice the second lower curve in Figure 2.8. This represents a situation where the

production of steel generates pollution (an externality).

Pollution reduces the yield per acre of cotton with the existing resource base.

A new lower production possibilities curve results from this externality.

This is a technical externality.

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Externalities as Public Goods

Referred to as nondepletable externalities, these are characterized by the public good property of nonrivalry.

The pollution of drinking water is a good example where one person’s consumption of the water pollution does not reduce the amount of water pollution to which others are exposed.

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Market Failure and Property RightsA special class of externality that is

generated by the lack of property rights (or the inability to enforce property rights) is the open-access externality.

In this case property rights are insufficient to prevent general use of a resource and uncontrolled use leads to destruction or damage of the resource.

Even when property rights exist, an inability to enforce them will lead to open-access externalities.

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The Invisible Hand and Equity

Market allocation of resources, absent of market failure, is efficient.

An efficient allocation maximizes the difference between social benefits and social costs.

An efficient allocation, however, does not imply equitable allocation.

The “best” distribution depends on what view of equity or fairness is held.

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The Invisible Hand and Dynamic EfficiencyA static analysis is only concerned with one

time period.

If the optimal allocation of resources in one period depends on the optimizing decisions of the past or future periods, then a dynamic analysis must be employed.

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The Invisible Hand and Dynamic EfficiencyStatic example – a farmer has 100 acres of

cropland and decides to plant one type of crop this year and a different crop next year, in response to changes in market forces.

Dynamic example – a farmer has 100 acres of forest land and 100 acres of cropland. A choice to cut trees this year means that in the next time period the trees will be gone.

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Dynamic Efficiency and Exhaustible ResourcesSince decisions made today can influence

the quality and stock of resources far into the future, one would expect dynamic considerations to be important in the study of environmental and resource economics.

For example, the decision of how much oil to take out the ground today effects our ability to take oil out of the ground in the future.

This will be based on how much people will be willing to pay for oil in the future.

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Dynamic Efficiency and Exhaustible Resources

Efficiency requires that you continue to sell oil today until the point at which marginal cost equals marginal revenue.

The way in which the future is represented in this decision is to incorporate an opportunity cost (user cost or rent) into the decision making process.

The interest rate becomes important also.

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Dynamic Efficiency and Exhaustible ResourcesThe individual oil owner has two choices for

producing income in the future:Sell oil today and invest money and earn interest

income.Hold on to oil, sell in the future.

Intertemporal efficiency requires that the producer make a choice that will maximize the sum of the present values of the earnings potentially received in each period.

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Dynamic Efficiency and Exhaustible ResourcesAssume that oil producers believe that the future

price will be too low, and they will be better off selling oil now.

Sales of oil now mean less oil available in the future (this will cause future oil prices to rise).

Sales of oil now will also depress current price of oil.

This combination of prices changes in the future and now will make holding oil for sale in the future more attractive.

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Dynamic Efficiency and Exhaustible ResourcesAs long as one option (selling in the present

versus selling in the future) appears to be a more attractive option than the other, prices will adjust.

The process of price adjustment will continue until owners of oil are indifferent between the options of selling in the present and selling in the future.

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Dynamic Efficiency and Exhaustible ResourcesSince the present price is dependent on the

future price, and the future price is dependent on the present price, there is an opportunity cost for using a barrel of oil at any particular point in time.

This opportunity cost is associated with NOT having the barrel of oil available in another time period.

This opportunity cost is both a social cost and a private cost and is referred to as a user cost.

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Dynamic Efficiency and Exhaustible ResourcesThe price of oil, at any particular time can be

represented by the following equation:

P1 = MUC1 + MEC1

WhereMUC refers to Marginal User Cost, and MEC refers to Marginal Extraction Cost

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Marginal User Cost and Marginal Extraction CostThe most important thing to understand about this

equation is that it is possible to predict the changes in the price of oil by predicting changes in the marginal extraction cost and the marginal user cost.

Your text illustrates this point by considering the rise in MUC when Iraqi forces invaded Kuwait in early August 1990. Fear about potential changes in production levels in Kuwait drove up the opportunity cost (MUC) of using a barrel of oil. Prices rose dramatically but fell again when US forces established dominance and removed concerns about falling production.

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Marginal User Cost and Marginal Extraction CostTwo important points:

The existence of MUC means that price will always be different from MEC. MUC is a form of scarcity rent (not monopoly profit).

In order for an owner of oil to be indifferent as to the period in which he or she sells, the present value of the MUC must be the same in all periods. This means that MUC of an exhaustible resource will increase with the discount rate.

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Other Examples of Dynamic Problems

Persistent pollutants, chronic pollutants, or stock pollutants that accumulate in the environment.Today’s decision to generate a stock pollutant has an

effect on environmental quality far into the future.Changes in land use patterns can change

environmental resources that can never be restored.Over-grazing of grasslands has allowed the Sahara

desert to move south at an alarming rate.

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ConclusionThe bulk of this chapter focuses on markets

and how markets efficiently allocate goods and services.

When market failure occurs, marginal private benefits diverge from marginal social benefits and marginal private costs diverge from marginal social costs.

Market failure results from externalities, public goods, imperfect information, imperfect competition, and inappropriate government intervention.