Ch' 2: Valuing the Environment: Concepts

1
Ch. 2 Valuing the Environment Concepts

• To Learn this chapter
• interactions between the environment and the
  economy
• positive vs. normative economics
• cost-benefit analysis
• static and dynamic efficiency

2
Interactions between the environment and the
economy

• analogous to closed vs. open economies
• closed system self-contained, with no inputs or
  outputs
• open system accepts inputs and produces outputs.
• Solar system is approx. closed
• 1st and 2nd laws of thermodynamics cap our energy
  potential at the amount we obtain from the sun

3
Some definitions

• 1st law of thermodynamics Total quantity of
  energy and matter is fixed
• 2nd law of thermodynamics Entropy increases
  through time
• Positive economics Describes interactions
  between economic agents or variables. What is
• Normative economics Expresses preferences or
  ideal outcomes. What ought to be

4
Roles of pos. and norm. economics

• Both are useful when used together. Normative
  economics supplies the value judgements necessary
  to formulate policy objectives, then positive
  economics gives the tools and understanding to
  determine the feasibility of possible solutions.

5
Cost-benefit analysis

• The general idea is, if B gt C (or B/C gt 1), and
  the costs include the opportunity costs of the
  next best proposal, then the proposal is a good
  one.
• But there is a normative side. We must choose
  the perspective from which to measure the
  benefits and costs
• users of resource? taxpayers? voters? all
  citizens? all humans? future humans too? all
  lifeforms? Do they all count the same?

6
Demand and WTP

• Demand curves show how much of a good a person or
  group of consumers will buy at a given price
• For non-priced goods, there is still opportunity
  cost.
• Hydro power vs. white-water rafting
• Irrigation/flood control vs. fish species
• Demand Marginal willingness to pay (MWTP) for
  qth unit
• Area under demand curve is WTP TB

7
Costs and Net Benefit

• Marginal opportunity costs typically rise with
  quantity due to diminishing returns
• Area under MC curve TC
• Net benefit is TB - TB, or
• NB sum(MWTP) - sum(MC)

8
Static efficiency (i.e. at one point in time)

• To maximize net benefits, use the first
  equimarginal principle, and set quantity where
• (MWTP ? MB) MC
• Positive implication the equimarginal principle
  minimizes the misallocation of resources
• Normative concern Is that allocation fair?

9
Pareto optimality

• defn One party cannot obtain an increase in
  utility without some other party suffering a
  decrease in utility.
• From ECON 314 an allocation on the PPF is Pareto
  optimal
• a Pareto improving policy helps at least one
  party without hurting anyone.
• Is a Pareto improving policy necessarily free
  from normative criticism?

10
Social choice mechanisms

• Can we give the go-ahead to any projects that
  arent Pareto improving?
• Potential Pareto Improvements
• Kaldor-Hicks compensation principle
• voting rules

11
Dynamic efficiency

• i.e. allocations across time
• require a weighting of utility (net benefits)
  realized in varying time periods
• formally, these weights are obtained by using the
  time value of money, or discount rate, expressed
  as d or r
• The more time elapsed until a benefit is
  realized, the more that benefit is discounted

12
Net Present Value (NPV)

• the net present value of a net benefit obtained t
  time periods in the future,
• NPV(NBt) NBt/(1r)t
• Similarly, the net present value of a series of
  benefits happening over the next t years would be

13
Dynamic Efficiency

• To maximize NPV, set quanities so that the
  marginal unit has equal net benefit in any
  period.
• In Chapter 5, we will work through a problem in a
  simple two-period model.

14
Application of NPV in real situations

• The discount rate has a huge impact.
• Low discount rates (in relative terms) are more
  favorable to future benefits over present
  benefits
• High discount rates (relatively) favor projects
  with quick payoffs
• What discount rate is appropriate?
• Implications for development decisions projects
  with large up-front capital costs.