Environmental Economics Week 2

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Environmental EconomicsWeek 2

• MARKET FAILURE AND ENVIRONMENTAL ECONOMICS
• READING
•  
• Common Chapter 4
• Perman et al Chapter 5 and 6

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SOME ENVIRONMENTAL PROBLEM AREAS

• Global climate change
• greenhouse gases
• ozone depletion
• International air pollution
• acid rain 
• Local air pollution
• particulates and ozone smogs
• Water pollution
• nitrate spillovers
• Water scarcity
• Miscellaneous
• Intensive agriculture
• Population conglomeration
• Loss of biodiversity irreversible eco-system
  change
• Soil fertility losses
• Accumulation of toxins in various media

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ALL OF THESE CAN USEFULLY BE ANALYSED UNDER THE
FRAMEWORK OF MARKET FAILURE
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MARKET EQUILIBRIUM OUTCOMES UNDER IDEAL
CONDITIONS

• S MC SMC (social marginal cost)
• D MB SMB (social marginal benefit)
• That is
• market supply properly takes account of all
  relevant costs
• market demand properly takes account of all
  relevant benefits
• And so the competitive market mechanism generates
  a maximisation of SOCIAL net benefits.

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MARKET EQUILIBRIUM OUTCOMES UNDER IDEAL
CONDITIONS

• S MC SMC (social marginal cost)
• D MB SMB (social marginal benefit)
•  
• Also note that consumer and producer surpluses (
  social surplus) are maximised.
• But market economies in practice do not satisfy
  the set of ideal conditions, and so privately
  optimal outcomes do NOT lead to socially optimal
  ones.

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MARKET FAILURE OCCURS WHERE ONE OR MORE OF THESE
CONDITIONS IS NOT SATISFIED (AND AN INEFFICIENT
OUTCOME OCCURS AS A RESULT).

• We focus in this course on two kinds of market
  failure
•  
• EXTERNALITY
•  
• An externality arises when the activity of a firm
  or household gives rise to unintended
  consequences for other firms or households, and
  do not figure in the costs or benefits of the
  activity as perceived by the originating firm or
  household.
•  
•  
• PUBLIC GOOD
• A public good has the property of non-rivalry
  that is, consumption of it by one person does not
  reduce the amount of it available for others.

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• EXTERNALITIES
• An externality occurs when an activity generates
  unintended effects on others for which no payment
  or compensation is made.
• Externalities arise because of the absence of
  private property rights if they existed
  payment/compensation would occur.
• Externalities can be thought of as missing
  markets.
• Or, as unpriced goods and services.
• Externalities may be beneficial or harmful
• In the absence of corrective policy, the level of
  an activity that gives rise to a
  harmful/beneficial externality will be too
  high/low.

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Externality Originating In Beneficial Harmful
Production Activity Externality Honey production Pollination for fruit growing Fossil fuel combustion Atmospheric pollution
Consumption Activity Externality Vaccination of one person Reduced risk of infection for rest of population High stereo volume in apartment Noise pollution
A classification of externalities
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Two ways of visually showing how externalities
lead to a divergence between privately efficient
(market) and socially efficient outcomes. In the
diagrams, we have an adverse externality such
that social costs exceed private costs.
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B, C
SC C External cost
C
B
Q
Q
Q
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Price
SMC PMC EMC
PMC
P
P
EMC
PMB
Quantity per period
Q
Q
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Note at Q that SMC ? SMB But it does at Q
(i.e. in the situation where the externality is
internalised).
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Situation where no externality exists
P
Consumer Surplus
S
P
Producer Surplus
D
Q
Q
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The efficiency loss due to an externality
P
SMC
S PMC
P
P
D SMB
Q
Q
Q
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Consumer and producer surpluses with an
externality
P
CS
SMC
S PMC
P
D SMB
Q
Q
Q
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Efficiency loss from ignoring externality NB1 -
NB2
NB
NB without externality
NB0
NB1
NB2
NB incl externality
Q
Q
Q
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PUBLIC GOODS/PUBLIC BADS External effects often
have the characteristics of public goods/bads.
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• Public goods/bads have two characteristics
• Non-rivalry consumption by one agent does not
  reduce the amount available to others
• Non-excludability if provided for one agent,
  others cannot be excluded from consumption
• Examples of public goods national defence,
  lighthouses, air pollution abatement.
• Examples of public bads air pollution

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All of these externalities are non-rivalous and
non-excludable so they are public (goods/bads)
externalities.
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• PROBLEMS ASSOCIATED WITH PUBLIC GOODS/BADS
• The free-rider problem. So not feasible to supply
  via markets.
• Even if there were no free rider problem,
  non-rivalry may imply zero marginal costs. So
  efficient price is zero! (For a bridge, for, toll
  charge should be zero provided there is no
  congestion).
• It is difficult to estimate the marginal benefits
  (or marginal costs) associated with these goods.
  Why?
• Think about pollution abatement, as an example.

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Marginal benefits of pollution abatement
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• PROBLEMS ASSOCIATED WITH PUBLIC GOODS/BADS
• Pollution abatement.
• There may be no market here so nothing to
  observe directly.
• Free rider issues again will people reveal
  preferences?
• Even if the good were traded, then market demand
  curves would not correctly express socially
  valuation. (Market demand curves are horizontal
  sums we need vertical sums here).

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Pollution Control Two Questions for Public Policy

• How much pollution should be allowed? What is the
  policy objective?
• 2. How to affect polluters behaviour so as to
  bring about the desired level of pollution? What
  policy instrument to use?

We will answer these questions later.