HARAMAYA UNIVERSITY

COLLEGE OF AGRICULTURE AND ENVIRONMENTAL SCIENCE

SCHOOL OF AGRICULTURAL ECONOMICS AND AGRIBUSINESS

DEPARTMENT OF AGRICULTURAL ECONOMICS

HANDOUT

NATURAL RESOURCE AND ENVIRONMENTAL ECONOMICS

Oct, 2018, HU

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Chapter one: An introduction to natural resource and environmental economics
1.1. Definition and concepts of basic terms
The first theme is efficiency - One way of thinking about efficiency is in terms of missed
opportunities. If resource use is wasteful in some way then opportunities are being wasted;
eliminating that waste (or inefficiency) can bring net benefits to some group of people. An
example is energy inefficiency. It is often argued that much energy is produced or used
inefficiently, and that if different techniques were employed significant resource savings could
be gained with no loss in terms of final output. This kind of argument usually refers to some kind
of technical or physical inefficiency. Economists usually assume away this kind of inefficiency,
and focus on allocative inefficiencies. Even where resources are used in technically efficient
ways, net benefits are sometimes wasted. For example, suppose that electricity can be, in
technically efficient ways, generated by the burning of either some heavily polluting fossil fuel,
such as coal, or a less polluting alternative fossil fuel, such as gas. Because of a lower price for
the former fuel, it is chosen by profit-maximising electricity producers. However, the pollution
results in damages which necessitate expenditure on health care and clean-up operations. These
expenditures, not borne by the electricity supplier, may exceed the cost saving that electricity
producers obtain from using coal. If this happens there is an inefficiency that results from
resource allocation choices even where there are no technical inefficiencies. Society as a whole
would obtain positive net benefits if the less polluting alternative were used. A substantial part of
environmental economics is concerned with how economies might avoid inefficiencies in the
allocation and use of natural and environmental resources.
The second concept – optimality – is related to efficiency, but is distinct from it. To understand
the idea of optimality we need to have in mind:
a. a group of people taken to be the relevant ‘society’;
b. some overall objective that this society has, and in terms of which we can measure the
extent to which some resource-use decision is desirable from that society’s point of view.
Then a resource-use choice is socially optimal if it maximises that objective given any relevant
constraints that may be operating. The reason efficiency and optimality are related is that it turns
out to be the case that a resource allocation cannot be optimal unless it is efficient. That is,
efficiency is a necessary condition for optimality. This should be intuitively obvious: if society
squanders opportunities, then it cannot be maximising its objective (whatever that might be).
However, efficiency is not a sufficient condition for optimality; in other words, even if a
resource allocation is efficient, it may not be socially optimal. This arises because there will
almost always be a multiplicity of different efficient resource allocations, but only one of those
will be ‘best’ from a social point of view.
The third theme is sustainability. Sustainability involves taking care of [Link] an allocation
of resources is socially optimal, then surely it must also be sustainable? If sustainability matters,
then most likely it would enter into the list of society’s objectives and would get taken care of in
achieving optimality. Things are not quite so straightforward. The pursuit of optimality as
usually considered in economics will not necessarily take adequate care of posterity. If taking
care of posterity is seen as a moral obligation, then the pursuit of optimality as economists
usually specify it will need to be constrained by a sustainability requirement.
1.2. The emergence of resource and environmental economics
1.2.1. Classical economics: the contributions of Smith, Malthus, Ricardo and Mill to the
development of natural resource economics

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Adam Smith (1723–1790) was the first writer to systematise the argument for the importance of
markets in allocating resources. His major work, An Inquiry intothe Nature and Causes of the
Wealth of Nations (1776), contains the famous statement of the role of the ‘invisible hand’. This
belief in the efficiency of the market mechanism is a fundamental organising principle of the
policy prescriptions of modern economics, including resource and environmental economics. A
central interest of the classical economists was the question of what determined standards of
living and economic growth. Natural resources were seen as important determinants of national
wealth and its growth. Land (sometimes used to refer to natural resources in general) was viewed
as limited in its availability. When to this were added the assumptions that land was a necessary
input to production and that it exhibited diminishing returns. They saw the inevitability of an
eventual stationary state, in which the prospects for the living standard of the majority of people
were bleak.
This is most strongly associated with Thomas Malthus (1766–1834), who argued it most
forcefully in his Essay on the Principle of Population (1798), giving rise to the practice of
describing those who now question the feasibility of continuing long-run economic growth as
‘neo-Malthusian’. For Malthus, a fixed land quantity, an assumed tendency for continual positive
population growth, and diminishing returns in agriculture implied a tendency for output per
capita to fall over time. There was, according to Malthus, a long-run tendency for the living
standards of the mass of people to be driven down to a subsistence level. At the subsistence wage
level, living standards would be such that the population could just reproduce itself, and the
economy would attain a steady state with a constant population size and constant, subsistence-
level, living standards.
This notion of a steady state was formalised and extended by David Ricardo (1772–1823),
particularly in his Principles of Political Economy andTaxation (1817). Malthus’s assumption of
a fixed stock of land was replaced by a conception in which land was available in parcels of
varying quality. Agricultural output could be expanded by increasing the intensive margin
(exploiting a given parcel of land more intensively) or by increasing the extensive margin
(bringing previously uncultivated land into productive use). However, in either case, returns to
the land input were taken to be diminishing. Economic development then proceeds in such a way
that the ‘economic surplus’ is appropriated increasingly in the form of rent, the return to land,
and development again converges toward a Malthusian stationary state.
John Stuart Mill (1806–1873) work utilises the idea of diminishing returns, but recognises the
countervailing influence of the growth of knowledge and technical progress in agriculture and in
production more generally. In addition to agricultural and extractive uses of land, Mill saw it as a
source of amenity values (such as the intrinsic beauty of countryside) that would become of
increasing relative importance as material conditions improved.
1.2.2. Neoclassical economics: marginal theory and value
A series of major works published in the 1870s began the replacement of classical economics by
what subsequently became known as ‘neoclassical economics’. Classical economics saw value as
arising from the labour power embodied (directly and indirectly) in output, a view which found
its fullest embodiment in the work of Karl Marx. Neoclassical economists explained value as
being determined in exchange, so reflecting preferences and costs of production. The concepts of
price and value ceased to be distinct. Moreover, previous notions of absolute scarcity and value
were replaced by a concept of relative scarcity, with relative values (prices) determined by the
forces of supply and demand. At the methodological level, the technique of marginal analysis

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was adopted, allowing earlier notions of diminishing returns to be given a formal basis in terms
of diminishing marginal productivity in the context of an explicit production function.
Leon Walras (1834–1910) developed neoclassical General Equilibrium Theory, and in so doing
provided a rigorous foundation for the concepts of efficiency and optimality. Alfred Marshall
(1842–1924) was responsible for elaboration of the partial equilibrium supply-and an
introduction to natural resource and environmental economics demand-based analysis of price
determination so familiar to students of modern microeconomics.
John Maynard Keynes (1883–1946) developed his theory of income and output determination.
The Keynesian agenda switched attention to aggregate supply and demand, and the reasons why
market economies may fail to achieve aggregate levels of activity that involve the use of all of
the available inputs to production. Keynes was concerned to explain, and provide remedies for,
the problem of persistent high levels of unemployment, or recession. This direction of
development in mainstream economics had little direct impact on the emergence of resource and
environmental economics. However, Keynesian ‘macroeconomics’, as opposed to the
microeconomics of neoclassical economics, was of indirect importance in stimulating a
resurgence of interest in growth theory in the middle of the twentieth century, and the
development of a neoclassical theory of economic growth. What is noticeable in early
neoclassical growth models is the absence of land, or any natural resources, from the production
function used in such models. Classical limits to-growth arguments, based on a fixed land input,
did not have any place in early neoclassical growth modelling. The introduction of natural
resources into neoclassical models of economic growth occurred in the 1970s, when some
neoclassical economists first systematically investigated the efficient and optimal depletion of
resources. This body of work, and the developments that have followed from it, is natural
resource economics.
1.3. Fundamental issues in the economic approach to resource and environmental issues
1.3.1. Property rights, efficiency and government intervention
A central idea in modern economics is that, given the necessary conditions, markets will bring
about efficiency in allocation. Well-defined and enforceable private property rights are one of the
necessary conditions. Because property rights do not exist, or are not clearly defined, for many
environmental resources, markets fail to allocate those resources efficiently. In such
circumstances, price signals fail to reflect true social costs and benefits, and a prima facie case
exists for government policy intervention to seek efficiency gains. Some environmental
problems cross the boundaries of nation states and are properly treated as global problems. In
such cases there is no global government with the authority to act on the problem in the same
way as the government of a nation state might be expected to deal with a problem within its
borders.
1.3.2. The role, and the limits, of valuation in achieving efficiency
As just observed, many environmental resources – or the services yielded by those resources –
do not have well-defined property rights. Clean air is one example of such a resource. Such
resources are used, but without being traded through markets, and so will not have market prices.
A special case of this general situation is external effects, or externalities. An externality exists
where a consumption or production activity has unintended effects on others for which no
compensation is paid. Here, the external effect is an untraded – and unpriced – product arising
because the victim has no property rights that can be exploited to obtain compensation for the
external effect. Sulphur emissions from a coal-burning power station might be an example of this
kind of effect. However, the absence of a price for a resource or an external effect does not mean

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that it has no value. Clearly, if well-being is affected, there is a value that is either positive or
negative depending on whether well-being is increased or decreased. In order to make
allocatively efficient decisions, these values need to be estimated in some way. Returning to the
power station example, government might wish to impose a tax on sulphur emissions so that the
polluters pay for their environmental damage and, hence, reduce the amount of it to the level that
goes with allocative efficiency. But this cannot be done unless the proper value can be put on the
otherwise unpriced emissions. There are various ways of doing this – collectively called
valuation techniques.
1.3.3. The time dimension of economic decisions
Natural resource stocks can be classified in various ways. A useful first cut is to distinguish
between ‘stock’ and ‘flow’ resources. Whereas stock resources, plant and animal populations and
mineral deposits, have the characteristic that today’s use has implications for tomorrow’s
availability, this is not the case with flow resources. Examples of flow resource are solar
radiation, and the power of the wind, of tides and of flowing water. Using more solar radiation
today does not itself have any implications for the availability of solar radiation tomorrow. In the
case of stock resources, the level of use today does have implications for availability tomorrow.
Within the stock resources category there is an important distinction between ‘renewable’ and
‘nonrenewable’ resources. Renewable resources are biotic, plant and animal populations, and
have the capacity to grow in size over time, through biological reproduction. Non-renewable
resources are abiotic, stocks of minerals, and do not have that capacity to grow over time. What
are here called non-renewable resources are sometimes referred to as ‘exhaustible’, or
‘depletable’, resources. This is because there is no positive constant rate of use that can be
sustained indefinitely – eventually the resource stock must be exhausted. Renewable resources
are exhaustible if harvested for too long at a rate exceeding their regeneration capacities. From
an economic perspective, stock resources are assets yielding flows of environmental services
over time. In considering the efficiency and optimality of their use, we must take account not
only of use at a point in time but also of the pattern of use over time. Efficiency and optimality
have, that is, an intertemporal, or dynamic, dimension, as well as an intratemporal, or static,
dimension. In thinking about the intertemporal dimension of the use of environmental resources,
attention must be given to the productiveness of the capital that is accumulated as a result of
saving and investment. If, by means of saving and investment, consumption is deferred to a later
period, the increment to future consumption that follows from such investment will generally
exceed the initial consumption quantity deferred. The size of the pay-off to deferred consumption
is reflected in the rate of return to [Link] resource stocks similarly have rates
of return associated with their deferred [Link] relations between rates of return to capital as
normally understood in economics and the rates of return on environmental assets must be taken
into account in trying to identify efficient and optimal paths of environmental resource use over
time. Many pollution problems also have an intertemporal dimension, and it turns out that the
analysis developed for thinking about the intertemporal problems of resource use can be used to
analyse those problems.
1.3.4. Substitutability and irreversibility
Substitutability and irreversibility are important, and related, issues in thinking about policy in
relation to the natural environment. If the depletion of a resource stock is irreversible, and there
is no close substitute for the services that it provides, then clearly the rate at which the resource
is depleted has major implications for sustainability. To the extent that depletion is not
irreversible and close substitutes exist, there is less cause for concern about the rate at which the

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resource is used. There are two main dimensions to substitutability issues. First, there is the
question of the extent to which one natural resource can be replaced by another. Can, for
example, solar power substitute for the fossil fuels on a large scale? This is, an especially
important question given that the combustion of fossil fuels not only involves the depletion of
non-renewable resources, but also is a source of some major environmental pollution problems,
such as the so-called greenhouse effect which entails the prospect of global climate change.
Second, there is the question of the degree to which an environmental resource can be replaced
by other inputs, especially the human-made capital resulting from saving and investment. This
question is of particular significance when we address questions concerning long-run economy–
environment interactions, and the problem of sustainability. Human-made capital is sometimes
referred to as reproducible capital, identifying an important difference between stocks of it and
stocks of nonrenewable resources. The latter are not reproducible, and their exploitation is
irreversible in a way that the use of human-made capital is [Link] renewable resource stocks,
depletion is reversible to the extent that harvesting is at rates that allow regeneration. Some
pollution problems may involve irreversible effects, and the extinction of a species of plant or
animal is certainly irreversible. Some assemblages of environmental resources are of interest for
the amenity services, recreation and aesthetic enjoyment that they provide, as well as for their
potential use as inputs to production. A wilderness area, for example, could be conserved as a
national park or developed for mining. Some would also argue that there are no close substitutes
for the services of wilderness. A decision to develop such an area would be effectively
irreversible, whereas a decision to conserve would be reversible.

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Chapter two: Concept of sustainability
2.1. The origins of sustainability problem
Since the 1950s and 1960s economic growth has been generally seen as the solution to the
problem of poverty. Without economic growth, poverty alleviation involves redistribution from
the better-off to the poor, which encounters resistance from the better-off. In any case, there may
be so many poor in relation to the size of the better off group,that the redistributive solution to
the problem of poverty is simply impossible – the cake is not big enough to provide for all,
however thinly the slices are cut. Economic growth increases the size of the cake. With enough
of it, it may be possible to give everybody at least a decent slice, without having to reduce the
size of the larger [Link], the world’s resource base is limited, and contains a complex,
and interrelated, set of ecosystems that are currently exhibiting signs of fragility. It is
increasingly questioned whether the global economic system can continue to grow without
undermining the natural systems which are its ultimate foundation. This set of issues we call ‘the
sustainability problem’– how to alleviate poverty in ways that do not affect the natural
environment such that future economic prospects suffer.
2.2. Economic-Environment Interdependence
The economy is simplified into two sectors (production and consumption). Exchange of goods,
services and factors of production take place in these sectors.
The environment is shown in two different ways: one of them having three different linkages
with production and consumption and one with a general element. The one set of linkages are
given by E1, E2, and E3.
Figure 1 Economy-environment interactions

E4. Global life-support services

E1, production extracts energy and materials from the environment-transformed into outputs
(some useful-goods/services sold to consumers, some are harmful-emissions such as SO 2). Some
recycling takes place in the production sector and in the consumption sector- R 1 and R2. Here the
role of the environment is supplying resources.

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E2, the role of E = sink/receptor for waste products from both consumption and production. Some
wastes are biodegradable/ chemically processed. This depends on: volume of waste relative to
the receiving substance, the temperature and rate of replacement of the estuary. The estuary may
have limited assimilative capacity for waste. Assimilative capacity has been criticized it does this
up to a fixed point—emission can occur with no deleterious (adverse) impact. Not true in most
cases, since we mostly have increasing damage, of course the rate of increase may exhibit abrupt
changes due to ‘threshold’ effects. There are no natural processes to transform some inputs to the
harmless/less harmful, substances. These are called ‘cumulative’/ ‘conservative’ pollutants.
E.g. lead and cadmium, and manmade substances such as polychlorinated biphenyls and
dichloro-diphenyl-trichloro-ethane. Not broken down by chemical or biological processes. They
build up through ‘bioaccumulation’. Thus forconservativepollutants a positive flow in a year
c
(Ft)adds to the stock, St and the stock at any time t* is given as
S t=t∗¿ F ¿
t
t ∗¿ c = ∑ ¿
ti
1
Where tiis the historical date when emissions began (since assimilation is zero.)
c
Note that equation (1) may not accurately predict St because
a) of possible movement pollutants to another location,
b) sediments may build up over the stock pollutant and put it ‘out of harm’s reach’
a
Assimilativewastes/degradable pollutants, where the stock in any time period St depends
on current flows less that amount removed by biodegradation, or by chemical reactions in the
case of gases such as methane. In this case the stock in any time period t is given by
Sat =F t − At 2
Where A = amount assimilated in any period.
With regard to equation (2), we note that the amount assimilated in any period (At)may
depend on the level of emissions in previous periods: emissions of either
 the pollutant whose stock is being modelled or
 another pollutant.
E3: The environment acts as a supplier of amenity, educational and spiritual values to society.
 Nonnatives may derive pleasure fromthe existence of wilderness areas.
 Natives may attach spiritual and cultural values to them, and the flora and fauna therein.
E4:represents the global life-support services provided by the environment. These include
maintenance of an atmospheric composition suitable for life.
2.3. Sustainable Development Defined
According to the 1987’s report of the World Commission on Environment and Development,
“sustainable development is development that meets the needs of the present without
compromising the ability of future generations to meet their own needs”. This is the definition
that we will stick to and it contains within it two key concepts:
 The concept of 'needs', in particular the essential needs of the world's poor, to which
overriding priority should be given, and
 The idea of limitations imposed by the state of technology and social organization on the
environment's ability to meet present and future needs.
Let us now define sustainable development as a path of rising per capita wellbeing. Figure 2
shows three hypothetical development paths.

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 Per Capita
Well Being

C
B

Time
Figure 2: Paths of sustainable and unsustainable development
Path A would be described as 'sustainable' development, path B would be unsustainable, but path
C would also be sustainable since per capita wellbeing does not decline. Note that the wellbeing
concept is defined in per capita terms: one would hardly define a society where total wellbeing
was rising but average wellbeing was falling as 'developing'.
Sustainability Criteria
Weak Sustainability Criteria or the harkwick-Solow rule: A development path would be
sustainable if consumption or welfare per capita is non-declining across generations. This is
possible so long as the stock of capital did not decline over time. The stock of capital (K) could
be held constant by re-investing the rents or proceeds from resource extraction in to other forms
of capital, like manmade capital or human [Link] implicit assumption in the Weak
Sustainability Criteria (WS) is that all forms of capital are substitutable for each other. This is
because it is the total capital stock that matters, not the composition of that stock. On this rule,
we can run down any one form of capital, say natural capital, provided we build up some other
form of capital. We can engage in deforestation so long as we build new factories and roads; we
can pollute the environment so long as we build new schools and universities, and so on. Of
course, if capital stocks are genuinely substitutable this must work in reverse - we must be able
to let factories and schools decay so long as we create a new wetland, grow more trees, and so
on. Which way the substitution works will depend on the social rate of return to each form of
capital. If the rate of return is highest on manmade capital (K M) then KM should be substituted for
other forms of capital, and vice versa. This observation underlines the importance of being able
to estimate the rate of return not just in financial terms, but in terms of overall social wellbeing.
Weak sustainability embodies a basic assumption of neoclassical economics, namely that factors
of production can be substituted for each other. Of course, the marginal rate of substitution is
very likely to change the more of one factor we have and the less of another. Weak sustainability
does not imply that substitution is easy or inexpensive - we may have to surrender a great deal to
obtain one extra unit of some forms of capital, a feature of weak sustainability that tends to be
ignored by those who have criticized it.
Moreover, Weak Sustainability (WS) requires that the running down of any form of capital is
compensated by investment in some other form of capital. It is not consistent with running down
capital stocks and 'consuming' the proceeds. As a 'weak' rule, then, WS is not particularly weak,
and it is quite easy for a country to fail a weak sustainability test. Objections to weak
sustainability tend to center on the assumed substitutability of capital stocks.

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Arguments in defence of weak sustainability
The defence of weak sustainability rests on the following arguments:
a. The issue is about substitution at the margin. Humankind has systematically depleted K N
over thousands of years, yet standards of living have risen (compare life expectancy today
with that in Roman times, of in ancient Egypt, for example). The past is not always a guide
to the future but we have little evidence to suggest that the process of substitution is
making us worse off. Strong sustainability advocates might respond that the process has
gone 'too far' and that we are seeing the signs of real long term damage that this process of
substitution has created: ozone layer depletion, global warming, global declines in fish
stocks, worsening health because of pollution etc.
b. The advocates of SS have advanced no empirical estimates to suggest that K N has no
substitutes. They speak of resources and other forms of capital being 'complementary' but
this is of little validity in a world that has quite decidedly substituted away from natural
resources over long periods of time. A strong sustainability advocate might reply that WS
advocates have similarly not presented empirical estimates to suggest the elasticity of
substitution is greater than unity.
c. At the practical level, WS does require that the proceeds of depleting any capital stock be
reinvested to bring the total capital stock back to a constant level. This is in fact quite a
tough policy requirement.
A critique of weak sustainability
A lot of criticisms have also been inflicted on the weak sustainability criterion.
a. Along with SS, WS offers no empirical evidence about substitutability beyond the 'historical
evidence' argument advanced above;
b. Weak sustainability has no concept of an optimal capital stock, any more than SS has a
concept of an optimal natural capital stock.
c. The practice of discounting future benefits and costs downplays the wellbeing of future
generations and exposes resources to the greed of current generations.
d. Weak sustainability assumes that stocks can be measured in monetary terms, using market
and non-market prices to value the components of the stock. These prices reflect the current
generation's values only.
Strong Sustainability Criteria: A development path would be sustainable if consumption or
welfare per capita is non-declining across generations. This is possible if some amount of natural
capital stock (KN) is made to be non-declining across [Link] sustainability (SS) does
not imply that weak sustainability (WS) is irrelevant. What SS requires in addition to WS is that
the stocks of KN should not decline. 'In addition to' is needed because a situation in which
natural capital is preserved but other forms of capital are allowed to decline could hardly be
called 'sustainable development' (it might be 'survivable' but even that seems very unlikely). SS
implies WS, but WS does not imply SS. Environmental economists tend to favor weak
sustainability over strong sustainability, while 'ecological economists' tend to favor strong
sustainability. This is one difference between environmental and ecological economists.
Arguments in defence of strong sustainability
There are several reasons for favoring the strong sustainability rule:
a. Uncertainty about the value of the elasticity of substitution should be one reason for a
cautious approach to natural capital conservation. That uncertainty remains as long as we
are ignorant about the workings of global and local ecosystems. This is the uncertainty
problem.

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 b. There is a fundamental asymmetry of the two types of capital with respect to reversibility:
once certain natural capital stocks are lost they cannot be re-introduced. That is generally
not true of man-made capital. This is the irreversibility problem;
c. The unknown scale of effects from loss of critical natural capital. Witness the divergent
views about the effects of global warming. This is the scale problem.
The combination of irreversibility, uncertainty and unknown scale should make us more cautious
about depleting natural capital.
A critique of strong sustainability
a. Strong sustainability does not require that trees never be cut, or that oil and gas should not
be exploited, although it is not hard to find some advocates of SS who appear to believe this
wholly infeasible state of affairs. The 'constant K N' requirement is expressed as a restriction
on the stock of heterogeneous forms of natural capital. That stock can only then be
measured by finding some numeraire or aggregating mechanism. In economics the obvious
numeraire is money, so that 'constant natural capital' would be interpreted as a constant
value of the natural capital stock. Advocates of SS tend to evade the issue of what exactly a
constant stock means. If it refers to some aggregate then there has to be some numeraire that
aggregates the stock, and if this numeraire is not money it is not clear what it is. But,
whatever the numeraire, a constant total stock implies substitution between the sub-
components of the stock. In other words, unless SS is about conserving each and every
heterogeneous unit of KN, which is impossible, it must assume the substitutability that it
denies for total capital or the weak sustainability. This seems inconsistent. It makes no more
sense to assume that the loss of the African elephants is compensated for by an increase in
oil reserves, than it does to assume the loss of the elephants is compensated for by an
increase in schools.
b. Strong sustainability says nothing about the quantity of the stock of K N that is to be
conserved. Is it the current level of natural capital, some amount that we will reach in the
near future, or some amount passed in the past? In short, SS has no concept of the 'optimal'
stock. The motivation for looking at what there is now probably emanates from a fairly
realistic assessment of the impossibility of reinstating some past stocks, and from the feeling
that 'things have gone far enough': there should be no more resource loss.
c. Strong sustainability, as we have seen, offers no empirical evidence that the elasticity of
substitution is zero which is what is required if KN has no actual substitutes.
d. The focus of strong sustainability tends to be on future generations and their 'rights'. This is
misconceived because it places the emphasis on benefiting individuals who are likely to be
richer than us anyways, and certainly richer than the poor today.

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Table2.1 summarizes the weak and strong sustainability debate.
Forms of Sustainability Requirement
WEAK ∆K/∆t > 0 where
K = KM + KN + KH + KS
WS requires that capital depreciation on any form of
capital must be at least offset by capital appreciation on
other forms of capital.
There must be 'reinvestment of rents'. The proceeds of
capital depreciation must not be consumed. Forms of
capital are assumed to be substitutable at the margin.
STRONG:Environmenta ∆K/∆t > 0 and
l ∆KN/∆t > 0
∆K/∆t > 0 and
Social ∆KS/∆t > 0
SS requires the same rule as WS but in addition requires
that the stock of the 'targeted' capital stock should also not
decline. Hence, the elasticity of substitution between the
critical capital stock and other forms of capital is assumed
to be zero.

2.4. Sustainability and Efficiency

Sustainability and efficiency examine with a two-period model. The simplification of life into
two periods permits a useful perspective on activities in the present (Period 1) and the future
(Period 2). The implications generally carry over to relatively complex models with a more
realistic number of periods. Consumers in each period are assumed to have the same preferences
and receive diminishing marginal benefits (net of any associated costs) from a depletable
resource. This resource might be coal, oil, clean water, or a combination of resources. The
"consumption" described in this example refers to resource expenditures for the sake of utility in
the period of consumption, not investments in the first period that would provide utility in the
second period.
Figure 2.4 models the two-period allocation dilemma. Consumption in Period 1 starts at zero on
the left side of the graph and increases to the right. Consumption in Period 2 starts at zero on the
right side and increases to the left.

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The sustainable level of use is 50 percent, meaning that half of the resource is used in Period 1
and the other half in Period 2. For an allocation to be sustainable or fair generation the coming
generation must be able to consume at least what its predecessors have enjoyed. The solid arrow
below the graph represents Period 1 consumption, and the double-lined arrow below the graph
represents Period 2 consumption. Similarly, the solid MB curve represents marginal benefit in
Period 1, and the double-lined MB curve represents marginal benefit in Period 2.
In order to achieve dynamic efficiency, each unit of the resource would be allocated to the period
in which it provides the largest present value of its marginal benefit. In terms of the graph, this
allocation occurs at the intersection of the marginal benefit curves, with the marginal benefit in
Period 2 discounted as desired. With any other allocation, the last units received in one period
would be worth more in the other period and therefore should be reallocated to the other period.
An equal division is dynamically efficient only if the discount rate placed on benefits in the
second period is zero. In that case, the appropriate allocation occurs at the intersection of the
solid and double-lined MB curves, which are mirror images of each other and cross in the middle
of the graph. A positive discount rate decreases the present value of marginal benefits in Period
2, as from the double line to the dotted line. The dynamically efficient consumption level in
Period 1 then exceeds the sustainable level of 50 percent, as indicated by the intersection of the
solid and dotted MB curves. With any positive discount rate, equity and dynamic efficiency are
at odds, and the distinction between equity and efficiency outcomes grows larger with the
discount rate. One can therefore conclude that efficiency doesn’t imply sustainability and,
likewise, sustainability doesn’t imply efficiency.

13
Chapter three: Welfare Economics and the Environment
3.1. Efficiency and Optimality
At any point in time, an economy will have access to particular quantities of productive
resources. Individuals have preferences about the various goods that it is feasible to produce
using the available resources. An ‘allocation of resources’, or just an ‘allocation’, describes what
goods are produced and in what quantities they are produced, which combinations of resource
inputs are used in producing those goods, and how the outputs of those goods are distributed
between [Link] this we make two assumptions. First, that no externalities exist in either
consumption or production; roughly speaking, this means that consumption and production
activities do not have unintended and uncompensated effects upon others. Second, that all
produced goods and services are private (not public) goods; roughly speaking, this means that all
outputs have characteristics that permit of exclusive individual consumption on the part of the
[Link] the interests of simplicity, but with no loss of generality, we strip the problem down to
its barest essentials. Our economy consists of two persons (A and B); two goods (X and Y) are
produced; and production of each good uses two inputs (K for capital and L for labour) each of
which is available in a fixed [Link] U denote an individual’s total utility, which depends
only on the quantities of the two goods that he or she consumes. Then we can write the utility
functions for A and B in the form:
UA = UA(XA, YA)
UB = UB(XB, YB)
The total utility enjoyed by individual A, denoted UA, depends upon the quantities, XA and YA, he
or she consumes of the two goods. An equivalent statement can be made about B’s utility. Next,
we suppose that the quantity produced of good X depends only on the quantities of the twoinputs
K and L used in producing X, and the quantity produced of good Y depends only on the quantities
of the two inputs K and L used in producing Y. Thus, we can write the two production functions
in the form:
X = X(KX, LX)
Y = Y(KY, LY)
Each production function specifies how the output level varies as the amounts of the two inputs
are varied. In doing that, it assumes technical efficiency in production. The production function
describes, that is, how output depends on input combinations, given that inputs are not simply
wasted. Consider a particular input combination KX1 and LX1 with X1 given by the production
function. Technical efficiency means that in order to produce more of X it is necessary to use
more of KX and/or LX.
The marginal utility that A derives from the consumption of good X is denoted UAX; that is, UAX=
∂UA/∂XA. The marginal product of the input L in the production of good Y is denoted as MPYL;
that is, MPYL= ∂Y/∂LY. Equivalent notation applies for the other three marginal [Link]
marginal rate of utility substitution for A is the rate at which X can be substituted for Y at the
margin, or vice versa, while holding the level of A’s utility constant. It varies with the levels of
consumption of X and Y and is given by the slope of the indifference curve. We denote A’s
marginal rate of substitution as MRUSA, and similarly for B.
The marginal rate of technical substitution as between K and L in the production of X is the rate
at which K can be substituted for L at the margin, or vice versa, while holding the level output of
X [Link] varies with the input levels for K and L and is given by the slope of the isoquant.
We denote the marginal rate of substitution in the production of X as MRTSX, and similarly for Y.

14
The marginal rates of transformation for the commodities X and Y are the rates at which the
output of one can be transformed into the other by marginally shifting capital or labour from one
line of production to the other. Thus, MRTLis the increase in the output of Y obtained by shifting
a small, strictly an infinitesimally small, amount of labour from use in the production of X to use
in the production of Y, or vice versa. Similarly, MRTKis the increase in the output of Y obtained
by shifting a small, strictly an infinitesimally small, amount of capital from use in the production
of X to use in the production of Y, or vice versa. With this notation we can now state, and
provide intuitive explanations for, the conditions that characterize efficient and optimal
allocations.
3.1.1. Economic efficiency
An allocation of resources is said to be efficient if it is not possible to make one or more persons
better off without making at least one other person worse off. A gain by one or more persons
without anyone else suffering is known as a Pareto improvement. When all such gains have been
made, the resulting allocation is sometimes referred to as Pareto optimal, or Pareto efficient. A
state in which there is no possibility of Pareto improvements is sometimes referred to as being
allocatively efficient, rather than just efficient, so as to differentiate the question of efficiency in
allocation from the matter of technical efficiency in production. Efficiency in allocation requires
that three efficiency conditions are fulfilled – efficiency in consumption, efficiency in
production, and product-mix efficiency.
Efficiency in consumption
Consumption efficiency requires that the marginal rates of utility substitution for the two
individuals are equal:
MRUSA = MRUSB (3.1)
If this condition were not satisfied, it would be possible to rearrange the allocation as between A
and B of whatever is being produced so as to make one better off without making the other worse
off.

Figure 3.1. Efficiency in consumption

Figure 3.1 shows what is involved by considering possible allocations of fixed amounts of X and
Y between A and B. The top right-hand corner, labelled A 0, refers to the situation where A gets
nothing of the available X or Y, and B gets all of both commodities. The bottom left-hand corner,
B0, refers to the situation where B gets nothing and A gets everything. Starting from A 0 moving
horizontally left measures A’s consumption of X, and moving vertically downwards measures

15
A’s consumption of Y. As A’s consumption of a commodity increases, so B’s must decrease.
Starting from B0 moving horizontally right measures B’s consumption of X, and moving
vertically upwards measures B’s consumption of Y. Any allocation of X and Y as between A and
B is uniquely identified by a point in the box SA 0TB0. At the point a, for example, A is
consuming A0AXa of X and A0AYa of Y, and B is consuming B0BXa of X and B0BYa of Y. The point
a is shown as lying on I AIA, which is an indifference curve for individual A. I AIA may look odd
for an indifference curve, but remember that it is drawn with reference to the origin for A which
is the point A0. Also shown are two indifference curves for B, I B0IB0and IB1IB1. Consider a
reallocation as between A and B, starting from point a and moving along IAIA, such that A is
giving up X and gaining Y, while B is gaining X and giving up Y. Initially, this means increasing
utility for B, movement onto a higher indifference curve, and constant utility for A. However,
beyond point b any further such reallocations will involve decreasing utility for B. Point b
identifies a situation where it is not possible to make individual B better off while maintaining
A’s utility constant – it represents an efficient allocation of the given amounts of X and Y as
between A and B. At b, the slopes of IAIA and IB1IB1 are equal – A and B have equal marginal
rates of utility substitution.
Efficiency in production
Turning now to the production side of the economy, recall that we are considering an economy
with two inputs, L and K, which can be used (via the production functions of equations 3.2) to
produce the goods X and Y. Efficiency in production requires that the marginal rate of technical
substitution be the same in the production of both commodities. That is,
MRTSX= MRTSY (3.2)
If this condition were not satisfied, it would be possible to reallocate inputs to production so as to
produce more of one of the commodities without producing less of the other. Figure 3.2 shows
why this condition is necessary. It is constructed in a similar manner to Figure 3.1, but points in
the box refer to allocations of capital and labour to the production of the two commodities rather
than to allocations of the commodities between individuals.

Figure 3.2. Efficiency in production

At X0 no capital or labour is devoted to the production of commodity X – all of both resources is

used in the production of Y. Moving horizontally to the left from X0 measures increasing use of

16
labour in the production of X, moving vertically down from X0 measures increasing use of capital
in the production of X. The corresponding variations in the use of inputs in the production of Y –
any increase/decrease in use for X production must involve a decrease/ increase in use for Y
production – are measured in the opposite directions starting from origin Y0. IXIX is an isoquant
for the production of commodity X. Consider movements along it to the ‘southeast’ from point a,
so that in the production of X capital is being substituted for labour, holding output constant.
Correspondingly, given the full employment of the resources available to the economy, labour is
being substituted for capital in the production of Y. IY0IY0 and IY1IY1 are isoquants for the
production of Y. Moving along IXIX from a toward b means moving onto a higher isoquant for Y –
more Y is being produced with the production of X constant. Movement along IXIX beyond point
b will mean moving back to a lower isoquant for Y. The point b identifies the highest level of
production of Y that is possible, given that the production of X is held at the level corresponding
to IXIX and that there are fixed amounts of capital and labour to be allocated as between
production of the two commodities. At point b the slopes of the isoquants in each line of
production are equal – the marginal rates of technical substitution are equal. If these rates are not
equal, then clearly it would be possible to reallocate inputs as between the two lines of
production so as to produce more of one commodity without producing any less of the other.
Product-mix efficiency
The final condition necessary for economic efficiency is product-mix efficiency. This requires
that

Figure [Link]-mix-efficiency

MRTL= MRTK= MRUSA = MRUSB (3.3)

This condition can be understood using Figure 5.3. Given that equation 5.3 holds, so that the two
individuals have equal marginal rates of utility substitution and MRUS A = MRUSB, we can
proceed as if they had the same utility functions, for which II in Figure 3.1 is an indifference
curve with slope MRUS. The individuals do not, of course, actually have the same utility
functions. But, given the equality of the MRUS, their indifference curves have the same slope at
an allocation that satisfies the consumption efficiency condition, so we can simplify, without any
real loss, by assuming the same utility functions and drawing a single indifference curve that
refers to all consumers. Given that Equation [Link], when we think about the rate at which the
economy can trade off production of X for Y and vice versa, it does not matter whether the

17
changed composition of consumption is realised by switching labour or capital between the two
lines of production.
Consequently, in Figure 3.3 we show a single production possibility frontier, YMXM, showing the
output combinations that the economy could produce using all of its available resources. The
slope of YMXM is MRT. In Figure 3.3 the point a must be on a lower indifference curve than II.
Moving along YMXM from point a toward b must mean shifting to a point on a higher indifference
curve. The same goes for movement along YMXM from c toward b. On the other hand, moving
away from b, in the direction of either a or c, must mean moving to a point on a lower
indifference curve. We conclude that a point like b, where the slopes of the indifference curve
and the production possibility frontier are equal, corresponds to a product mix – output levels for
X and Y– such that the utility of the representative individual is maximised, given the resources
available to the economy and the terms on which they can be used to produce commodities. We
conclude, that is, that the equality of MRUS and MRT is necessary for efficiency in allocation.
At a combination of X and Y where this condition does not hold, some adjustment in the levels
of X and Y is possible which would make the representative individual better off. An economy
attains a fully efficient static allocation of resources if the conditions given by equations 3.1, 3.2
and 3.3 are satisfied simultaneously. Moreover, it does not matter that we have been dealing with
an economy with just two persons and two goods. The results readily generalise to economies
with many inputs, many goods and many individuals. The only difference will be that the three
efficiency conditions will have to hold for each possible pairwise comparison that one could
make, and so would be far more tedious to write out.
3.1.3. The social welfare function (SWF) and optimality
A SWF can be used to rank alternative allocations. For the two-person economy that we are
examining, a SWF will be of the general form:
W = W(UA, UB) (3.4)
The only assumption that we make here regarding the form of the SWF is that welfare is non-
decreasing in UA and UB. That is, for any given level of U A welfare cannot decrease if U B were to
rise and for any given level of UB welfare cannot decrease if UA were to rise. In other words, we
assume that WA = ∂W/∂UA and WB = ∂W/∂UB are both positive. Given this, the SWF is formally
of the same nature as a utility function. Whereas the latter associates numbers for utility with
combinations of consumption levels X and Y, a SWF associates numbers for social welfare with
combinations of utility levels UA and UB. Just as we can depict a utility function in terms of
indifference curves, so we can depict a SWF in terms of social welfare indifference
[Link] 3.4 shows a social welfare indifference curve WW that has the same slope as the
utility possibility frontier at b, which point identifies the combination of U A and UB that
maximises the [Link] reasoning which establishes that b corresponds to the maximum of
social welfare that is attainable should be familiar by now – points to the left or the right of b on
the utility possibility frontier, such as a and c, must be on a lower social welfare indifference
curve, and points outside of the utility possibility frontier are not attainable. The fact that the
optimum lies on the utility possibility frontier means that all of the necessary conditions for
efficiency must hold at the optimum. Conditions 3.1, 3.2 and 3.3 must be satisfied for the
maximisation of welfare.

18
 Figure [Link] social welfare

Also, an additional condition, the equality of the slopes of a social indifference curve and the
utility possibility frontier, must be satisfied.

(3.5)
The left-hand side here is the slope of the social welfare indifference curve. The two other terms
are alternative expressions for the slope of the utility possibility frontier. At a social welfare
maximum, the slopes of the indifference curve and the frontier must be equal, so that it is not
possible to increase social welfare by transferring goods, and hence utility, between persons.
While allocative efficiency is a necessary condition for optimality, it is not generally true that
moving from an allocation that is not efficient to one that is efficient must represent a welfare
improvement. Such a move might result in a lower level of social welfare. This possibility is
illustrated in Figure 3.5. At C the allocation is not efficient, at D it [Link], the allocation at
C gives a higher level of social welfare than does that at D. Having made this point, it should
also be said that whenever there is an inefficient allocation, there is always some other allocation
which is both efficient and superior in welfare terms. For example, compare points C and E. The
latter is allocatively efficient while C is not, and E is on a higher social welfare indifference
curve. The move from C to E is a Pareto improvement

Figure 3.5. Welfare and efficiency

19
where both A and B gain, and hence involves higher social welfare. On the other hand, going
from C to D replaces an inefficient allocation with an efficient one, but the change is not a Pareto
improvement – B gains, but A suffers – and involves a reduction in social welfare. Clearly, any
change which is a Pareto improvement must increase social welfare as defined here. Given that
the SWF is non-decreasing in UA and UB, increasing UA/UB without reducing UB/UA must
increase social welfare. For the kind of SWF employed here, a Pareto improvement is an
unambiguously good thing. It is also clear that allocative efficiency is a good thing (subject to
the same qualification) if it involves an allocation of commodities as between individuals that
can be regarded as fair. Judgments about fairness, or equity, are embodied in the SWF in the
analysis here. If these are acceptable, then optimality is an unambiguously good thing. To
anticipate, we shall see that what can be claimed for markets is that, given ideal institutional
arrangements and certain modes of behaviour, they achieve allocative efficiency. It cannot be
claimed that, alone, markets, even given ideal institutional arrangements, achieve what might
generally or reasonably be regarded as fair allocations. Before looking at the way markets
allocate resources, we shall look at economists’ attempts to devise criteria for evaluating
alternative allocations that do not involve explicit reference to a social welfare function.
3.1.3. Allocation in a market economy
Efficiency given ideal conditions
A variety of institutional arrangements might beemployed to allocate resources, such as
dictatorship,central planning and free markets. Any of thesecan, in principle, achieve an efficient
allocation ofresources. Here, we are particularly interested in theconsequences of free-market
resource allocationdecisions. This is for three, related, reasons. First,for dictatorship and central
planning to achieveallocative efficiency it is necessary that the dictatoror central planner know
all of the economy’s productionand utility functions. This is clearly infeasible,and is one of the
reasons that attempts to runeconomies in these ways have been [Link] great attraction
of free markets as a way oforganising economic activity is that they do notrequire that any
institution or agent have suchknowledge. That is the second reason for ourconcentration on
markets – they are decentralized information-processing systems of great power. Thethird reason
is that the modern welfare economicsthat is the basis for environmental and resourceeconomics
takes it that markets are the way economiesare mainly organised. Environmental andresource
issues are studied, that is, as they arise inan economy where markets are the dominant
socialinstitution for organising production and consumption.
The market economy is now the dominantmode of organising production and consumption
inhuman [Link] economics theory points to a set ofcircumstances such that a system
of free marketswould sustain an efficient allocation of resources.
The ‘institutional arrangements’include the following:
1. Markets exist for all goods and servicesproduced and consumed.
2. All markets are perfectly competitive.
3. All transactors have perfect information.
4. Private property rights are fully assigned in allresources and commodities.
5. No externalities exist.
6. All goods and services are private [Link] is, there are no public goods.
7. All utility and production functions are‘well behaved’.
In addition to these institutional arrangements, it isnecessary to assume that the actors in such a
system– firms and individuals, often referred to jointly as‘economic agents’ or just ‘agents’ –

20
behave in certainways. It is assumed that agents always striveto do the best for themselves that
they can in thecircumstances that they find themselves in. Firmsare assumed to maximise profits,
individuals tomaximise utility.
An efficient allocation would be the outcome in amarket economy populated entirely by
maximisersand where all of these institutional arrangementswere in place. Before explaining
why and how thisis so, a few brief comments are in order on theseconditions required for a
market system to be capableof realisingallocative efficiency. First, note that, as we shall see in
later sections of this chapter wherewe discuss public goods and externalities, arrangements5 and
6 are really particulars of 4. Second,note that 4 is necessary for 1 – markets can onlywork where
there are private property rights and ajustice system to enforce and protect such [Link], that
an important implication of 2 is thatbuyers and sellers act as ‘price-takers’, believingthat the
prices that they face cannot be influencedby their own behaviour. No agent, that is, acts inthe
belief that they have any power in the [Link], note that these are a very stringent setof
conditions, which do not accurately describe anyactual market economy. The economy that they
dodescribe is an ideal type, to be used in the welfareanalysis of actual economies as a benchmark
againstwhich to assess performance, and to be used todevise policies to improve the
performance, in regardto efficiency criteria, of such actual [Link] now explain why a
market allocation ofresources would be an efficient allocation in suchideal circumstances.
Consider, first, individuals and their consumptionof produced commodities. Any one individual
seeksto maximise utility given income and the fixedprices of commodities.

Figure 3.6. Utility maximisation

Figure 3.6, refers to an individualin a two-commodity economy. The line YmaxXmax isthe budget
constraint. Ymax is the amount of Y availableif all income is spent on Y, Xmax is consumptionif all
income is spent on X. The slope of the budgetconstraint gives the price ratio PX/PY. Utility
maximization requires consumption X* and Y* correspondingto point b on the indifference curve
U*U*.Consumption at points on YmaxXmax to the left or rightof b, such as a and c, would mean
being on a lowerindifference curve than U*U*. Consumption patternscorresponding to points to
the northeast ofYmaxXmax are not attainable with the given incomeand prices. The essential
characteristic of b is thatthe budget line is tangential to an indifference [Link] means that the
slope of the indifference curve isequal to the price ratio. Given that the slope of theindifference
curve is the MRUS, we have:

21
 Px
MRUS=
Py
In the ideal conditions under consideration, all individuals face the same prices. So, for the two
individual, two-commodity market economy, we have
A B Px
MRUS =MRUS = (3.6)
Py
Comparison of equation 3.6 with equation 3.1 showsthat the consumption efficiency condition is
satisfiedin this ideal market system. Clearly, the argument here generalizesto many-person,
[Link] consider firms. To begin, instead of assumingthat they maximise
profits, we will assume thatthey minimise the costs of producing a given level ofoutput. The
cost-minimisation assumption is in noway in conflict with the assumption of profit
[Link] the contrary, it is implied by the profitmaximisationassumption, as, clearly, a
firm couldnot be maximising its profits if it were producingwhatever level of output that
involved at anythingother than the lowest possible cost. We are leavingaside, for the moment, the
question of the determinationof the profit-maximising level of output, andfocusing instead on the
prior question of cost minimization for a given level of output. This questionis examined in
Figure 5.9, where X*X* is the isoquantcorresponding to some given output level X*.The straight
lines K1L1, K2L2, and K3L3 are isocostlines. For given prices for inputs, PKand PL, an isocostline
shows the combinations of input levels forK and L that can be purchased for a given
totalexpenditure on inputs. K3L3 represents, for example, a higher level of expenditure on inputs,
greater cost, than K2L2.

Figure 3.7. Cost minimisation

The slope of an isocost line is the ratio ofinput prices, PK/PL. Given production of X*, thecost-
minimising firm will choose the input combinationgiven by the point b. Any other
combination,such as a or c, lying along X*X* would mean highertotal costs. Combinations
represented by pointslying inside K2L2 would not permit of the productionof X*. The essential
characteristic of b is that anisocost line is tangential to, has the same slope as, anisoquant. The
slope of an isoquant is the MRTS sothat cost-minimising choices of input levels must
becharacterised by:
PK
MRTS=
PL

22
In the ideal circumstance, all firms, in all lines of production, face the same PK and PL, which
means that
MRTS X =MRTS Y (3.7)
which is the same as equation 3.2, the productionefficiency condition for allocative efficiency –
costminimisingfirms satisfy this [Link] remaining condition that needs to be satisfiedfor
allocative efficiency to exist is the product mixcondition, equation 3.3, which involves both
individualsand firms. In explaining how this conditionis satisfied in an ideal market system we
will also seehow the profit-maximising levels of production aredetermined. Rather than look
directly at the profit- maximising output choice, we look at the choice of input levels that gives
maximum profit. Once theinput levels are chosen, the output level followsfrom the production
function. Consider the input oflabour to the production of X, with marginal productXL. Choosing
the level of XLto maximise profitinvolves balancing the gain from using an extra unitof labour
against the cost of so doing. The gain hereis just the marginal product of labour multiplied bythe
price of output, i.e. PXXL. The cost is the price oflabour, i.e. PL. If PLis greater than PXXL,
increasinglabour use will reduce profit. If PL is less than PXXL,increasing labour use will increase
profit. Clearly,profit is maximised where PL= PXXL.
The same argument applies to the capital input,and holds in both lines of production. Hence,
profitmaximisation will be characterised by
P X X L =PL
P X X K =PK
PY Y L =PL
PY Y K =PK
which implies
P X X L =PY Y L =P L ∧P X X K =PY Y K =P K
Using the left-hand equalities here, and rearranging, this is
Px Y L
= ∧(3.8 a)
PY X L
Px Y K
= (3.8b)
PY X K
Now, the right-hand sides here are MRTLandMRTK, as they are the ratios of marginal products
inthe two lines of production and hence give the termson which the outputs change as labour and
capitalare shifted between industries. Given that the lefthandsides in equations 3.8a and 3.8b are
the samewe can write
PX
MRT L =MRT K = (3.9)
PY

23
 Figure 3.8. Profit maximisation

Showing that the marginal rate of transformation is the same for labor shifting as for capital
[Link] back to equation 5.8, we can now write
PX A B
MRT L =MRT K = =MRUS =MRUS (3.10)
PY
showing that the profit-maximising output levels inthe ideal market economy satisfy the product
mixcondition for allocative efficiency, equation 3.6.
This completes the demonstration that in an idealmarket system the conditions necessary for
allocativeefficiency will be satisfied. We conclude thissection by looking briefly at profit-
maximisingbehaviour from a perspective that will be familiarfrom an introductory
microeconomics course. There,students learn that in order to maximise profit, afirm which is a
price-taker will expand output up tothe level at which price equals marginal cost. Figure3.8
refers. For output levels below X*, priceexceeds marginal cost so that increasing output willadd
more to receipts than to costs, so increasingprofit as the difference between receipts and
[Link] output levels greater than X*, marginal costexceeds price, and reducing output would
increaseprofit. This is in no way inconsistent with the discussionabove of choosing input levels
so as tomaximise profit. It is just a different way of tellingthe same story. In order to increase
output, assumingtechnical efficiency, more of at least one input mustbe used. In thinking about
whether or not to increaseoutput the firm considers increasing the input ofcapital or labour, in the
manner described above. For the case of labour in the production of X, forexample, the profit-
maximising condition was seento be PL =PXXL, which can be written as
PL
=P X
XL

which is just marginal cost equals price, because theleft-hand side is the price of an additional
unit oflabour divided by the amount of output produced bythat additional unit. Thus if the wage
rate is £5 perhour, and one hour’s extra labour produces 1 tonneof output, the left-hand side here
is £5 per tonne,so the marginal cost of expanding output by onetonne is £5. If the price that one
tonne sells for isgreater(less) than £5 it will pay in terms of profit toincrease(decrease) output by
one tonne by increasingthe use of labour. If the equality holds and theoutput price is £5, profit is
being maximised. Thesame argument goes through in the case of capital,and the marginal cost
equals price condition forprofit maximisation can also be written as

24
 PK
=P X
XK
3.2. Market Failure, Public Policy And The Environment
3.2.1. The existence of markets forenvironmental services
To recapitulate, we have seen that for markets to produce efficient allocations, it is necessary
that:
1. Markets exist for all goods and servicesproduced and consumed.
2. All markets are perfectly competitive.
3. All transactors have perfect information.
4. Private property rights are fully assigned in allresources and commodities.
5. No externalities exist.
6. All goods and services are private [Link] is, there are no public goods.
7. All utility and production functions are‘well behaved’.
8. All agents are maximisers.
Clearly, 1 here is fundamental. If there are goodsand services for which markets do not exist,
then themarket system cannot produce an efficient allocation,as that concept applies to all goods
and servicesthat are of interest to any agent, either as utility orproduction function arguments.
Further, 4 is necessaryfor 1 – a market in a resource or commodity canonly exist where there are
private property rights inthat resource or commodity.
3.2.2. What are public goods?
There are two characteristics of goods and servicesthat are relevant to the public/private
[Link] are rivalry and excludability. What we callrivalry is sometimes referred to in the
literature asdivisibility. Table 3.1 shows the fourfold classificationof goods and services that
these two characteristicsgive rise to, and provides an example of eachtype. Rivalry refers to
whether one agent’s consumptionis at the expense of another’s [Link] refers
to whether agents can beprevented from consuming. We use the term ‘agent’here as public goods
may be things that individualsconsume and/or things that firms use as inputs toproduction. In
what follows here we shall generallydiscuss public goods in terms of things that are ofinterest to
individuals, and it should be kept in mindthat similar considerations can arise with someinputs to
production.
Pure private goods exhibit both rivalry andexcludability. These are ‘ordinary’ goods and
services,the example being ice cream. For a givenamount of ice cream available, any increase in
consumptionby A must be at the expense of consumptionby others, is rival. Any individual can
beexcluded from ice cream consumption. Ice creamcomes in discrete units, for each of which a
consumption entitlement can be identified and traded (or gifted).

Table [Link] of private and public goods

Excludable Non-excludable
Rivalrous Pure private good Open-access resource
Ice cream Ocean fishery
(outside territorial waters)
Non-rivalrous Congestible resource Pure public good
Wilderness area Defence

Pure public goods exhibit neither rivalrynor excludability. The example given is the servicesof
the national defence force. Whatever level thatit is provided at is the same for all citizens of

25
thenation. There are no discrete units, entitlement towhich can be traded (or gifted). One
citizen’s consumptionis not rival to, at the cost of, that of others,and no citizen can be excluded
from consumption.
Open-access natural resources exhibit rivalry butnot excludability. The example given is an
oceanfishery that lies outside of the territorial waters ofany nation. In that case, no fishing boat
can be preventedfrom exploiting the fishery, since it is notsubject to private property rights and
there is nogovernment that has the power to treat it as commonproperty and regulate its
exploitation. However,exploitation is definitely rivalrous. An increase inthe catch by one fishing
boat means that there is lessfor other boats to take.
Congestible resources exhibit excludability butnot, up to the point at which congestion sets
in,rivalry. The example given is the services to visitorsprovided by a wilderness area. If one
person visits awilderness area and consumes its services – recreation,wildlife experiences and
solitude, for example– that does not prevent others from consuming thoseservices as well. There
is no rivalry between theconsumption of different individuals, provided thatthe overall rate of
usage is not beyond a thresholdlevel at which congestion occurs in the sense thatone individual’s
visit reduces another’s enjoymentof theirs. In principle, excludability is possible if thearea is
either in private ownership or subject tocommon-property management. In practice, of
course,enforcing excludability might be difficult, but, often,given limited points of access to
vehicles it is not.
The question of excludability is a matter of lawand convention, as well as physical
[Link] have already noted that as the result of an internationalagreement that
extended states’ territorialwaters, some ocean fisheries that were open accesshave become
common property. We also notedabove that a similar process may be beginning inrespect to the
global atmosphere, at least in regardto emissions into it of greenhouse gases. In somecountries
beaches cannot be privately owned, and insome such cases while beaches actually have thelegal
status of common property they are generallyused on a free-access basis. This can lead to
congestion.
In other countries private ownership is the rule,and private owners do restrict access. In some
caseswhere the law enables excludability, either on thebasis of private ownership or common
property, it isinfeasible to enforce it. However, the feasibility ofexclusion is a function of
technology. The inventionof barbed wire and its use in the grazing lands of
North America is a historical example. Satellitesurveillance could be used to monitor
unauthorized use of wilderness areas, though clearly this would beexpensive, and presumably at
present it is not consideredthat the benefit from so doing is sufficient towarrant meeting the cost.

3.2.3. Externalities
An externality exists whenever the welfare of some agent, either a firm or a house hold, depends
not only on his or her activities but also on activities under the control of some other agent. In
other words it occurs whenever the activity (or consumption & production decisions) of one
agent affect the utility of another agent in unintended way, and when no compensation is made
by the producer of the external effect to the affected party (i.e. when the effect of the causer is
not reflected in the market transaction).
E.g. Consider the case of steal factory & the resort hotel (both using the same river).
In analyzing externality, we have to distinguish between social & private values.
Distinction between private and social values

26
Private costs: cost that are borne to undertake an activity by the economic agent undertaking the
activity
Social costs: cost that are borne to undertake an activity by the economic agent undertaking the
activity plus costs imposed on all other economic agents.
Social costs = private costs + external cost
Social costs ≥ private costs
As with any other type of input cost, we are most concerned with its marginal effect. So we can
also say, marginal social cost = marginal private cost + marginal external cost, MSC = MPC +
MEC
Private benefit: benefit obtained from the realization of an activity by the economic agent
undertaking the activity.
Social benefits: benefits obtained from the realization of an activity by the economic agent
undertaking the activity plus benefits obtained by all other economic agents.
Social benefits = Private benefits +External benefits
Social benefits ≥ private benefits
Problem 1:Assume an otherwise well-functioning competitive market with the following:
Demand: P = 1050 – 0.1Q; Private-cost supply: P = 50 + 0.2Q. Production of each unit of
output Q above leads to a marginal external cost of $150, which implies social-cost supply: P =
200 + 0.2Q.
A. Assuming firms can freely pollute in the absence of regulation, compute the "free market"
equilibrium P, Q?
B. Compute the dollar amount of total external cost generated when firms can freely pollute in
the market equilibrium above, and derive the actual total net gains from trade. Show your
work?
C. Assuming firms pay a tax and thus operate along the social cost supply curve, compute the
"socially optimal" equilibrium P, Q, and total actual gains from trade. Assume the tax
revenue fully offsets any remaining negative externalities. Show your work?
Types of Externalities
Negative Externality (External diseconomy)
It is cost of resources not reflected in the price of the product.
It causes additional cost to the other members of society that consumers and producers of the
good will not take into account.
It leads to an excess of social cost(SC) over private cost (PC). A steel manufacturing firm for
instance produces both the steel & pollution. Here, the society consider both the cost of pollution
& the cost of producing the steel
⇒ Private cost = cost of producing the steel
Social cost = cost of producing the steel & cost of pollution SC = PC + EC
Hence, social marginal cost function (MCs) includes both of these costs as well.
Eg -emission of smoke form factory
-a noise of air plane, etc
Positive Externality (external economies)
It is a benefit not reflected in prices
It causes additional benefit to other member of the society that consumer or producer of the good
& service will not take into account.
It results in excess of social benefit over private benefit. i.e MSB > MPB by MEB
e.g. – Vaccination - plainest certain infections disuse

27
 - Education - Directly benefit the individual
- Spillover effects to society
- Discovery of HIV /Aids vaccine
- Bees keeper benefit fruits producers & vice-versa.
Externalities and Economic Efficiency
Here, we are going to analyze the impact of externality on the market system and demonstrate
the condition for efficiency. Recall that, in the presence of externalities social cost are different
form private costs and /or social benefit are different form private benefit.
=> MSC≠MPC and /or MSB≠M$B
Hence, in the existence of externalities the traditional condition of MC=MB has to be revised so
as to incorporate the external costs & benefit.
When there are external benefits
In this case an unregulated market system would under produce (desired) quantity of a given
good.
⇒ Qs>Qm, where Qs = social optimum
Qm= Private (market) optimum

MPB= marginal private benefit

MSB = marginal social benefit
MEB = marginal external benefit
Qm= output produced by the market system
Qs = socially optimum output level
Social optimum occurs when MSB= MSC
Private optimum occurs when MPB = MPC
Alternative method of depicting positive externality

28
Concussion: when there are positive externalities not enough of the activity is undertaken by the
market system
When there are external costs:
In this case an unregulated market system would over produce the [undesired] quantity of a give
good. ⇒Qs <Qm

Alternative method of depicting a negative externality

The following table summarizes the main issues about externalities.

29
Government failure
Government intervention offersthe possibility of realising efficiency gains, by eliminatingor
mitigating situations of market [Link], many environmental resources are not subjectto
well-defined and clearly established propertyrights. Efficiency gains may beobtained if
government can create and maintainappropriate institutional arrangements for establishingand
supporting property rights as the basis forbargaining. However, we have also seen that thescope
of this kind of government action to correctmarket failure is limited to cases where non-
rivalryand non-excludability are absent. In such cases, possible governmentinterventions to
correct market failure are oftenclassified into two groups. So-called commandand-control
instruments take the form of rules andregulations prohibiting, limiting or requiring certainforms
of behaviour. Fiscal instruments – tax and subsidy systems and marketable permits – aredesigned
to create appropriate patterns of incentiveson private behaviour. As notedimmediately above,
another form that governmentintervention to correct market failure could take isproviding
information, or funding research activitythat can increase the stock of knowledge. The
argumentsallpointed to the possibility of efficiency gains arisingfrom public-sector intervention
in the economy. Butactual government intervention does not always ornecessarily realise such
gains, and may entail [Link] would be wrong to conclude from an analysis of‘market failure’
that all government intervention inthe functioning of a market economy is either desirableor
effective.

30
Chapter four: Valuing the Environment
Economic values of ecosystem goods and services are anthropocentric notions. In economics a
good or service is valuable if it increases human well-being. This implies that the values of
goods and services defined in the context of human welfare. The economic value of ecosystem
goods and service does not imply only the monetary source of values. Many people gain
happiness from non-consumptive use of goods and services. Despite the fact that people have not
and may never plan to use the resources directly, they may value the ecosystem goods and
services from knowledge that a resource is maintained.
Theory of environmental Valuation
The goods that fall within the scope of the market mechanism are called marketable goods
because their market demand and market supply are well defined. All marketable goods have
two common characteristics:
 They can all be measured in terms of physical quantity
 They can all be valued in monetary terms
Think of the goods at your home that are usually purchased. Bread can be measured in terms of
either number of loaves or weight of a loaf in grams. Clothes can be measured in terms of either
the numbers of pieces as well as the sizes they fit. Beverages can be measured in terms of either
the number of containers (bottles) or the capacity of such containers in liters. All these items also
have specific prices. In a perfectly functioning market, the price of each good will equal the cost
of producing the last unit of producing the last unit of the good and will result in an equilibrium
between demand and supply. We shall now examine why this does not easily happen with all
environmental goods and services.
Now consider the various types of environmental goods say clean air, rivers, lakes, and forests
cannot be either measured in terms of a physical quantity or valued in monetary terms. Some,
however, may appear to be measurable. For example one might say that a lake could be
measured by its surface area or its volume of water, and that a forest could be measured by the
number of trees. But, note that an environmental resource cannot be considered as an entity by
itself. So a lake is not simply the water it holds. Rather a resource system that includes water and
a range of living and non living items. This inadequacy in terms of measurement implies that
market demand and supply curves cannot be constructed and hence a value in terms of price
cannot be ascertained. The goods that present such difficulties are usually labelledunpriced
goods or non marketable goods.
Several environmental goods are exchanged in the market: For example iron ore, coal, Uranium,
timber and the like. However, this does not imply that these environmental goods do not
experience market failure. Environmental economists argue that these resources are often
undervalued, because their valuation has invariably been based on the resource as an entity by
itself and not as the components of resource system. Mining firms price their mineral on the
basis of the cost of extracting them and these prices do not include the value of for example the
ecology that is lost. The price of a tone of coal is currently around $45. Does this price
adequately reflect the value of trees and wild life that have been lost or displaced in order to
recover the coal? No. The concern, in this unit, is therefore to get introduced with methodologies
that can be used to estimate the value of environmental goods and services for which the market
fails to provide one.
Types of Values
The market system doesn’t give an economic value or price for most environment goods and
services. But estimates of the economic values of environmental and resource services can be a

31
useful part of the information base supporting environmental and resource management
decisions.
Depending upon the circumstances, we may need to place a value on either a stock or a flow. For
example, the standing forest is a stock of trees, while the harvest of timber from the forest
represents one of the service flows. Economists have decomposed the total economic value
conferred by resources as in to the following basic components.
Use value: the benefits people get from direct use of a good. This type of value again divided in
to two. These are direct use value and indirect use value. Example: Fish harvested from the sea,
the value of recreation at a site etc.
Option value: the amount a person would be willing to pay to preserve the option of being able
to experience a particular environmental amenity in the future, even if one is not currently using
it.
Nonuse value: Reflects the common observation that people are more than willing to pay for
improving or preserving resources that they will never use. This type of value again divided in to
two ways. These are Existence Value and Bequest Value.
Existence value: a willingness to pay simply to help preserve the existence of some
environmental amenity. Protection of endangered species is an example.
Bequest value: a willingness to pay to leave behind environmental quality for future
generations.
These categories of value can be combined to produce the total willingness to pay (WTP):
TWP = Use value + Option value + Nonuse value

32
Economic Values Measurement Techniques
Key principles of conventional methods:
 The basis of valuation of environmental goods and services is individual preferences: the
impacts they have on individuals’ utilities, as measured by the individuals themselves
 Environmental “goods” enter individual’s utility functions (or preference structures) in
same way as other goods or services
Methods for measuring values (non-market valuation) of environmental goods and services may
be classified in to two broad categories based on the source of data;
Stated Preference Methods
A. No proxies
In this approach, information on the value of an environmental benefit is obtained by posing
direct questions to consumers in a hypothetical market about their:
Willingness to pay for it, or,
Willingness to accept cash compensation for losing the benefit.
The objective is to estimate the population WTP for a particular environmental quality from the
responses of a sample group. This is done by estimating the total WTP of the survey sample, and
then aggregating up to the population.
Examples of CVM applications include:
 Improvements in water quality for fishing or swimming
 Improvements in visibility from reduced pollution
 Preservation of endangered species
The key elements of a CVM survey are:
 A description of the good to be valued
 A method of hypothetical payment: the “payment vehicle”. The most common payment
vehicles are user fees and tax increases.
These two represent the scenario of the terms under which the good or service is to be offered
which must clearly be presented to the respondents.
A set of questions to obtain data on preference and socioeconomic factors those are likely to
affect valuation (including interest in nature, income, education, age, etc.)
A “value elicitation” method. This refers to the procedure by which a stated value is elicited
from the respondent.
The main distinction between different types of CVM surveys is the value elicitation method
used. There are two main methods:
 Open-ended
 Closed-ended (discrete choice)
An open-ended survey asks the respondent to state his/her maximum WTP (or less commonly,
minimum WTA) for a change in environmental quality.
It is “open-ended” in the sense that there is no limit imposed on the amount that a respondent
could potentially state.
A closed-ended survey provides the respondent with less latitude:the respondent is asked to
choose from a discrete set of possible values. (Hence often called “discrete choice surveys”).
There are two types of closed-ended approaches: a payment card format and a referendum
format.
The payment card format provides the respondent with a card with a list of possible payment
amounts. The respondent is then asked to circle the maximum amount he/she would be willing
to pay.

33
The referendum format asks the respondent to state “yes” or “no” as to whether he/she is
willing to pay a particular amount, the “bid value”.
The referendum format is increasingly becoming the method of choice in most CVM studies.
Because it closely approximates a real market setting, in which consumers either buy or do not
buy the good at a specified price, and so is more familiar to respondents.
Issues and shortcomings with contingent valuation
a. Strategic bias
Survey respondents have an incentive to misrepresent their WTP depending on how they
believe any actual payment will be tied to their stated valuation. Are the people able to
understand clearly the change in environmental quality being offered? Ex-ante (before
the change) vs. ex-post (after the change) behavior? Respondent's perceived payment
obligation and expectation about the provision of a good.? Hope for a free ride? Strategic
bias can be minimized by framing the CVM questions in an incentive compatible way.
One particular approach is to ask respondents to make bids for a good under three
scenarios:
 Only the highest bidders get the good; assumed to give true WTP.
 Everyone gets the good if WTP is above a certain level; has a weak free-riding
incentive
 Everyone with a positive WTP gets the good.
b. Artificiality (or “hypothetical bias”)
Because respondents in a CVM survey do not actually have to pay, they may have little
incentive to put much thought into their responses.
c. The embedding problem
Will be very apparent when respondents interpret the hypothetical offers of a specific
good or service to be indicative of an offer for a broader set of similar goods and services.
This is known as the embedding problem since the value of the good being sought is
embedded in the value of the more encompassing set of goods or services expected by the
respondent.
d. Information bias
Survey respondents often have very little prior knowledge of the environmental goods
and services to be valued.
e. Aggregation bias: Problems in aggregating individual valuation responses. Arises from:
sampling errors (a non-random sample selection); insufficient sample size; The
characteristics of the sample will not be representative of the general population.
f. Interviewer bias: the way the interview is conducted(mail, telephone, face-to-face) and
communicated
g. Respondent bias: ‘’compliance’’ bias whereby the respondent makes a poor guess
h. Payment vehicle bias: WTP varies depending on whether an income tax increase or an
entrance fee is used as a method of payment for the good.
Revealed Preference Methods
Revealed Preference Methods: (Observed Methods, indirect proxy methods, surrogate market
approaches). Data obtained from observations of people acting in real-world settings. Are based
on actual behavior of people reflecting utility maximization subject to constraints.
A. Indirect proxies

34
These are based on the observed behavior of individuals with respect to related markets.
Examples, Travel Cost Method (TCM) derives the value of a recreational site from revealed
information on the time and costs people spent to get there.
Hedonic prices infer the value of an environmental attribute from the price of a related market
good. E.g. lower land or real estate value reflecting the effect of noise or other pollution in a
residential area.
Have the advantage over direct proxy method of relying on observed behavior and existing
market prices directly related to the environmental attribute being valued.
Are more costly, time consuming and require skilled analysis.
i. Travel cost method (TCM)
The travel cost method is used to estimate the value of recreational benefits generated by
ecosystems. It uses actual behavior and choices to infer values.
It assumes a weak complementary relationbetween the environmental good (such as scenery) and
the private good (such as visits to forests).
In this method, the area surrounding a site is divided into concentric zones of increasing distance.
The basic premise of the TCM is:
The time and travel cost expenses that people incur to visit a site represent the “implicit or
surrogate price” (value) of the site or its recreational services.
Peoples’ WTP to visit the site can be estimated based on the number of trips that people make at
different travel costs. This is analogous to estimating peoples’ WTP for a marketed good based
on the quantity demanded from origin zones at different distances from the site, and travel cost
from each zone.
To apply the TCM, information must be collected about (survey):
 Distance from origin (which is focus of the TCM); number of visits from each origin zone
 Demographic (socio-economic) information about people from each zone
 Round-trip mileage from each zone and travel costs per mile
 The value of time spent traveling or the opportunity costof travel time
A demand curve is constructed (based on the WTP for entry into the site, costs of getting to the
site, and foregone earnings or opportunity cost of time spent) and the associated consumer
surplus can then be determined.
This surplus represents an estimate of the value of the environmental good in question.
Advantages of the TCM include:
Closely approximates the more conventional empirical techniques used by economists to
estimate economic values based on market prices.
The method is based on actual behavior rather than what people say they would do in a
hypothetical [Link] method is relatively inexpensive to apply. On-site surveys provide
opportunities for large sample sizes, as visitors tend to be interested in participating. The results
are relatively easy to interpret and explain.
Disadvantages of the TCM include:
The method assumes that people perceive and respond to changes in travel costs the same way
that they would respond to changes in admission [Link] simplest models assume that
individuals take a trip for a single purpose – to visit a specific recreational site. Thus, if a trip has
more than one purpose, the value of the site may be overestimated and it can be difficult to
apportion the travel costs among the various purposes.

35
Defining and measuring the opportunity cost of time, or the value of time spent traveling, can be
[Link] is the appropriate measure?Is there an opportunity cost involved when people
enjoy the visit?
The availability of substitute sites will affect values. Those who value certain sites may choose to
live nearby. If this is the case, they will have low travel costs, but high values for the site
will not be captured by this method. Interviewing visitors on site can introduce sampling
biases to the analysis. The method it is not well suited for sites near major population centers
where many visitors may be from "origin zones" that are quite close to one another.
ii. Hedonic Pricing Method (HPM)
The hedonic pricing method is used to estimate the value of environmental amenities that affect
prices of marketed goods. The HPM may be used to estimate economic benefits or costs
associated with: Environmental Amenities (Such As Aesthetic Views or Proximity to
Recreational Sites) Or,Environmental quality (including the effects of air, water pollution, or
noise pollution).The method is based on the assumption that the prices people pay for goods are
influenced by the set of characteristics that they consider important when purchasing the good.
Some specific hedonic-type techniques include the property value approach and the wage
differential approach.
a. Property value approach. This is based on the general land value approach and on a
competitive real estate market. Most HPM applications use residential housing prices to
estimate the value of environmental amenities assuming that the functions are fully
reflected in land prices. The price of a house is related to:
 The characteristics of the house and property (size, number of rooms, age,
structure)
 The characteristics of the neighborhood and community, and,
 Environmental quality.
If the non-environmental factors are controlled for, then any remaining differences in price can
be attributed to differences in environmental quality.
To apply the HPM: A measure or index of the environmental amenity of interest must be
developed (for example, distance to a park or open space from a house).Cross-section and/or
time-series data must be obtained concerning property values and property and household
characteristics for a well-defined market [Link] data set must include homes with different
levels of environmental quality, or different distances to an environmental [Link] data are
typically analyzed using regression analysis, which relates the price of the property to its
characteristics and the environmental characteristic(s) of interest. The regression results indicate
how much property values will change for a small change in each characteristic, holding all other
characteristics constant.
b. Wage Differential approach. Very similar to the property value approach, this method
is based on the theory that in a competitive market the demand for labor equals the
value of its marginal product and that the supply of labor varies with working and living
conditions in an area.
A higher wage is therefore necessary to attract workers to locate in polluted areas or to undertake
more risky occupations. This method can only be used if the labor market is perfectly
[Link] impacts of the environment is worked out after accounting for the effects of
factors other than the environment (skill level, job responsibility, alternative jobs available in
the area, etc.) that might influence wages.

36
Advantages of the HPM include:
 It can be used to estimate values based on actual market transactions.
 Property markets are relatively efficient in responding to information, so can be good
indications of value.
 Data on property sales and characteristics are readily available through many sources,
and can be related to other secondary data sources to obtain descriptive variables for the
analysis.
 The method can be adapted to consider several possible interactions between market
goods and environmental quality.
Disadvantages of the HPM include:
 The scope of environmental benefits that can be measured is limited to things that are
related primarily to housing prices.
 The method will only capture people’s WTP for perceived differences in environmental
attributes and their direct consequences. If people aren’t aware of the linkages, the value
will not be reflected in home prices.
 The method assumes that people have the opportunity to select the combination of
features they prefer, given their income. However, the housing market may be affected by
outside influences, like taxes, interest rates, or other factors.
 May be limited where markets are distorted, choices are constrained by income,
information about environmental conditions is not widespread and data are scarce.
 The results depend heavily on model specification.
 Large amounts of data must be gathered and manipulated.
B. Direct proxies:
These methods involve cost or price information, which approximate values of environmental
[Link] actual costs incurred as a result of environmental degradation can represent the
minimum benefits from avoiding environmental impacts.
Examples of direct proxies include:
 The loss of agriculture productivity from soil erosion (productivity loss);
 Medical expenditure due to air pollution (cost of illness);
 Averting or mitigating environmental impacts (response/preventative cost);
 Replacing environmental goods or services (replacement costs);
 Cost per unit of output (cost-effectiveness); and
 A close substitute (substitute costs).
All these can be considered opportunity costs of environmental [Link] Preference
Methods: (Hypothetical methods, direct or indirect methods).What would you do if …? How
much would you be willing to pay for …?
All of the methods attempt to express consumer demand (or preferences) in monetary terms, i.e.
the willingness to pay (WTP) of consumers for a particular non-marketed benefit, or their
willingness to accept (WTA) monetary compensation for the loss of the same.

37
Chapter five: Economics of pollution control
5.1. Pollution control: targets
Pollution may be defined as the presence/release of certain substances (harmful environmental
contaminants) beyond the absorptive capacity of the [Link] of the substances that cause
pollution are naturally present in the environment in low concentration, and are usually
considered to be harmless. Thus a particular substance is considered as pollution only when its
concentration is relatively high and cause adverse effects.
In thinking about pollution policy, the economist is interested in two major questions.
 How much pollution should there be? And, given that some target level has been chosen,
 What is the best method of achieving that level?
How much pollution there should be depends on the objective that is being sought. Many
economists regard economic optimality as the ideal objective. This requires that resources should
be allocated so as to maximize social welfare. Associated with that allocation will be the optimal
level of pollution. Economic efficiency is one way of thinking about pollution targets, but it is
certainly not the only way. For example, we might adopt sustainability as the policy objective, or
as a constraint that must be satisfied in pursuing other objectives. Then pollution levels (or
trajectories of those through time) would be assessed in terms of whether they are compatible
with sustainable development. Optimal growth models with natural resources, and the materials
balance approach just outlined, lend themselves well to developing pollution targets using a
sustainability criterion. In the final analysis, pollution targets are rarely, if ever, set entirely on
purely economic grounds. A standard setting is usually a matter of trying to attain multiple
objectives within a complex institutional environment.
Modelling pollution mechanisms
Before going further, it will be instructive to develop a framework for thinking about how
pollution emissions and stocks are linked, and how these relate to any induced damage. In
particular, residual flows impose loads upon environmental systems. The extent to which these
waste loads generate impacts that are associated with subsequent damage depends upon several
things, including:
 The assimilative (or absorptive) capacity of the receptor environmental media;
 The existing loads on the receptor environmental media;
 The location of the environmental receptor media, and so the number of people living
there and the characteristics of the affected ecosystems;
 Tastes and preferences of affected people.
Figure 5.1 illustrates some of these ideas schematically for pollution problems in general. Some
proportion of the emission flows from economic activity is quickly absorbed and transformed by
environmental media into harmless forms. The assimilative capacity of the environment will in
many circumstances be sufficient to absorb and transform into harmless forms some amount of
wastes. However, carrying capacities will often be insufficient to deal with all wastes in this way,
and in extreme cases carrying capacities will become zero when burdens become excessive.
Furthermore, physical and chemical processes take time to operate. Some greenhouse gases, for
example, require decades to be fully absorbed in water systems or chemically changed into non
warming substances. This implies that some proportion of wastes will, in any time interval,
remain unabsorbed or untransformed.

38
 Figure 5.1. Economic activity, residual flows and environmental damage
These may cause damage at the time of their emission, and may also, by accumulating as
pollutant stocks, cause additional future damage. Stocks of pollutants will usually decay into
harmless forms but the rate of decay is often very slow. The half-lives of some radioactive
substances are thousands of years, and for some highly persistent pollutants, such as the heavy
metals, the rate of decay is approximately zero.
Pollution flows, pollution stocks and pollution damage
Pollution can be classified in terms of its damage mechanism. We define the following two
classes of pollution: flow-damage pollution and stock-damage pollution.
Flow-damage pollution occurs when damage results only from the flow of residuals: that is, the
rate at which they are being discharged into the environmental system. By definition, for pure
cases of flow-damage pollution, the damage will instantaneously drop to zero if the emissions
flow becomes zero. This can only be exactly true when the pollutant exists in an energy form
such as noise or light so that when the energy emission is terminated no residuals remain in
existence. However, this characterisation of damages may be approximately true in a wider
variety of cases, particularly when the residuals have very short life spans before being
transformed into benign forms.
Stock-damage pollution describes the case in which damages depend only on the stock of the
pollutant in the relevant environmental system at any point in time. This corresponds to the
central branch in Figure 5.1. For a stock of the pollutant to accumulate, it is necessary that the
residuals have a positive lifespan and that emissions are being produced at a rate which exceeds

39
the assimilative capacity of the environment. An extreme case is that in which the assimilative
capacity is zero, as seems to be approximately the case for some synthetic chemicals and a
number of heavy metals. Metals such as mercury or lead accumulate in soils, aquifers and
biological stocks, and subsequently in the human body, causing major damage to human health.
Using M to denote the pollution flow, A to denote the pollution stock and D to denote pollution
damage, we therefore have two variants of damage function:
 Flow-damage pollution: D =D(M)
 Stock-damage pollution: D =D(A)
The efficient level of pollution
We now investigate how pollution targets can be set using an efficiency criterion. Given that
pollution is harmful, some would argue that only a zero level of pollution is desirable. But,
pollution can also be beneficial. Therefore, zero pollution is not economically efficient except in
particular special circumstances. In what sense is pollution beneficial? One answer comes from
the fact that producing some goods and services that we do find useful may not be possible
without generating some pollution, even if only a small amount. More generally, goods might
only be producible in nonpolluting ways at large additional expense. Thus, relaxing a pollution
abatement constraint allows the production of goods that could not otherwise have been made, or
to produce those goods at less direct cost. This is the sense in which pollution could be described
as beneficial. With both benefits and costs, economic decisions about the appropriate level of
pollution involve the evaluation of a trade-off. Thinking about pollution as an externality arising
from production or consumption activities makes this trade-off clear. The efficient level of an
externality is not, in general, zero as the marginal costs of reducing the external effect will,
beyond a certain point, exceed its marginal benefits.
A static model of efficient flow pollution
A simple static model – one in which time plays no role – can be used to identify the efficient
level of a flow pollutant. In this model, emissions have both benefits and costs. The costs of
emissions are called damages. These damages can be thought of as a negative (adverse)
externality. Production entails joint products: the intended good or service, andthe associated
pollutant emissions. In an unregulated economic environment, the costs associated with
production of the intended good or service are paid by the producer, and so are internalised. But
the costs of pollution damage are not met by the firm, are not taken into account in its decisions,
and so are externalities. An efficient level of emissions is one that maximizes the net benefits
from pollution, where net benefits are defined as pollution benefits minus pollution costs (or
damages). The level of emissions at which net benefits are maximized is equivalent to the
outcome that would prevail if the pollution externality were fully internalized. In the case of flow
pollution, damage (D) is dependent only on the magnitude of the emissions flow (M), so the
damage function can be specified as D =D(M). Matters are a little less obvious with regard to the
benefits of pollution. Let us expand a little on the earlier remarks we made about interpreting
these benefits. Suppose for the sake of argument that firms were required to produce their
intended final output without generating any pollution. This would, in general, be extremely
costly (and perhaps even impossible in that limiting case). Now consider what will happen if that
requirement is gradually relaxed.
As the amount of allowable emissions rises, firms can increasingly avoid the pollution abatement
costs that would otherwise be incurred. Therefore, firms make cost savings (and so profit
increases) if they are allowed to generate emissions in producing their goods. The larger is the
amount of emissions generated (for any given level of goods output), the greater will be those

40
cost savings. A sharper, but equivalent, interpretation of the benefits function runs as follows.
Consider a representative firm. For any particular level of output it chooses to make, there will
be an unconstrained emission level that would arise from the cost minimizing method of
production. If it were required to reduce emissions below that unconstrained level, and did so in
the profit-maximizing way, the total of production and control costs would exceed the total
production costs in the unconstrained situation.
So there are additional costs associated with emissions reduction. Equivalently, there are savings
(or benefits) associated with emissions increases. It is these cost savings that we regard as the
benefits of pollution. Symbolically, we can represent this relationship by the function B =B(M)
in which B denotes the benefits from emissions. The social net benefits (NB) from a given level
of emissions are defined by NB =B(M) −D(M). It will be convenient to work with marginal,
rather than total, functions. Thus ∂ B/∂ M is the marginal benefit of pollution and ∂ D/∂ M is the
marginal damage of pollution. Economists often assume that the total and marginal damage and
benefit functions have the general forms shown in Figure 5.2. Total damage is thought to rise at
an increasing rate with the size of the pollution flow, and so the marginal damage will be
increasing in M. In contrast, total benefits will rise at a decreasing rate as emissions increase
(because per-unit pollution abatement costs will be more expensive at greater levels of emissions
reduction). Therefore, the marginal benefit of pollution would fall as pollution flows increase.
It is important to understand that damage or benefit functions (or both) will not necessarily have
these general shapes.

Figure 5.2. Total and marginal damage and benefit functions, and the
efficient level of flow pollution emissions
To maximise the net benefits of economic activity, we require that the pollution flow, M, be
chosen so that: which states that the net benefits of pollution can be maximised only where the
marginal benefits of pollution equal the marginal damage of pollution. This is a special case of
the efficiency condition for an externality.

41
dNB (M ) dB (M ) dD(M )
= = =0 (5.1)
dM dM dM

The efficient level of pollution is M* (see Figure 5.2 again). If pollution is less than M* the
marginal benefits of pollution are greater than the marginal damage from pollution, so higher
pollution will yield additional net benefits. Conversely, if pollution is greater than M*, the
marginal benefits of pollution are less than the marginal damage from pollution, so less pollution
will yield more net [Link] value of marginal damage and marginal benefit functions at
their intersection is labeled μ¿ in Figure 5.2. We can think of this as the equilibrium ‘price’ of
pollution. This price has a particular significance in terms of an efficient rate of emissions tax or
¿
subsidy. However, as there is no market for pollution, μ is a hypothetical or shadow price rather
than one which is actually revealed in market transactions. More specifically, a shadow price
emerges as part of the solution to an optimization problem (in this case the problem of choosing
¿
M to maximise net benefits). We could also describe μ as the shadow price of the pollution
externality. If a market was, somehow or other, to exist for the pollutant itself (thereby
¿
internalising the externality) so that firms had to purchase rights to emit units of the pollutant, μ
would be the efficient market price.
Efficient levels of emission of stock pollutants
There were two reasons why it was unnecessary to distinguish between flows and stocks of the
pollutant. First, both benefits and damages depended on emissions alone, so as far as the
objective of net benefit maximisation was concerned, stocks – even if they existed – were
irrelevant. But we also argued that, strictly speaking, stocks do not exist for pure flow pollutants
(such as noise or light). How do we need to change the analysis in the case of stock pollutants
where damage depends on the stock level of the pollutant? It turns out to be the case – as we
shall see below – that the flow pollution model also provides correct answers in the special (but
highly unlikely) case where the pollutant stock in question degrades into a harmless form more-
or less instantaneously. In that case, the stock dimension is distinguishable from the flow only by
some constant of proportionality, and so we can work just as before entirely in flow units. But in
all other cases of stock pollutants, the flow pollution model is invalid.
The majority of important pollution problems are associated with stock pollutants. Pollution
stocks derive from the accumulation of emissions that have a finite life (or residence time). The
distinction between flows and stocks now becomes crucial for two reasons. First, without it
understanding of the science lying behind the pollution problem is impossible. Second, the
distinction is important for policy purposes. While the damage is associated with the pollution
stock, that stock is outside the direct control of policy makers. Environmental protection
agencies may, however, be able to control the rate of emission flows. Even where they cannot
control such flows directly, the regulator may find it more convenient to target emissions rather
than stocks. Given that what we seek to achieve depends on stocks but what is controlled or
regulated are typically flows, it is necessary to understand the linkage between the two.
5.2. Pollution Control: Instruments
Criteria for choice of pollution control instruments
There are many instruments available to attaining some pollution target. How should it choose
from among these? Instrument choice can be envisaged in the following way. Each available
instrument can be characterised by a set of attributes, relating to such things as impacts on
income and wealth distribution, the structure of incentives generated, and the costs imposed in

42
abating pollution. A score can be given to each instrument, dependent on how well its attributes
match with the set of objectives sought by the environmental protection agency.
Criteria for selection of pollution control instruments
Criterion Brief description
Cost-
effectiveness Does the instrument attain the target at least cost?
Does the influence of the instrument strengthen, weaken or remain
Long-run effects constant over time?
Dynamic Does the instrument create continual incentives to improve products or
efficiency production processes in pollution-reducing ways?
Does the use of the instrument allow for a ‘double dividend’ to be
Ancillary benefits achieved?
What implications does the use of an instrument have for the distribution
Equity of income or wealth?
Dependability To what extent can the instrument be relied upon to achieve the target?
Is the instrument capable of being adapted quickly and cheaply as new
Flexibility information arises, as conditions change, or as targets are altered?
Costs of use How large are the efficiency losses when the instrument is used with
under uncertainty incorrect information?
Information How much information does the instrument require that the control
requirements authority possess, and what are the costs of acquiring it?
Cost efficiency and cost-effective pollution abatement instruments

Suppose a list is available of all instruments which are capable of achieving some predetermined
pollution abatement target. If one particular instrument can attain that target at lower real cost
than any other can then that instrument is cost-effective. Cost effectiveness is clearly a desirable
attribute of an instrument. Using a cost-effective instrument involves allocating the smallest
amount of resources to pollution control, conditional on a given target being achieved. It has the
minimum opportunity [Link], the use of cost-effective instruments is a prerequisite for
achieving an economically efficient allocation of resources. Let us explore some ramifications of
the cost effectiveness criterion. There will (usually) be many sources of an emission, and so
many potential abaters. This raises the question of how the overall target should be shared among
the sources. The principle of cost efficiency provides a very clear answer: a necessary condition
for abatement at least cost is that the marginal cost of abatement be equalized over all abaters.
This result is known as the least cost theorem of pollution [Link] intuition behind this result
is easily found. Consider a situation in which marginal abatement costs were not equalised. For
example, suppose that at present abatement levels two firms, A and B, have marginal abatement
costs of 60 and 100 respectively. Clearly if B did one unit less abatement and A did one more (so
that total abatement is unchanged) there would be a cost reduction of 40. Cost savings will
accrue for further switches in abatement effort from B to A as long as it is more expensive for B
to abate pollution at the margin than it is for [Link] us examine these ideas a little further.
Suppose government wishes to reduce the total emission of a particular pollutant from the
current, uncontrolled, level M (say, 90 units per period) to a target level M* (say, 50 units). This
implies that the abatement target is 40 units of emission per period. Emissions arise from the
activities of two firms, A and B. Firm A currently emits 40 units and B 50 units. The following
notation is used. The subscript I indexes one firm (so here i = A or B). Mi is the actual level of

43
the ith firm’s emissions, which will depend on what control regime is in place. Two particular
levels are of special interest. Mi is the profit maximisinglevel of emissions by firm i in the
absence of any controls set by government and in the absence of any pollution charges. Mi*is an
emission ceiling (upper limit) set for the firm by the environmental protection agency (EPA).
The quantity of pollution abatement by the ith firm is Zi, given by Zi = Mi − Mi*. Hence we
assume that

Figure 5.3. Marginal abatement cost functions for the two firms
Whenever an emissions regulation is in operation the amount of emissions the firm actually
produces is that set by the EPA. Ciis the total abatement cost of the ith firm. Suppose that the
total abatement cost functions of the two firms are CA = 100 + 1.5ZA2 andCB = 100 +2.5ZB2 .
Therefore, the marginal abatement cost functions are MCA = 3ZA and MCB = 5ZB. These are
sketched in Figure 5.3. The least-cost solution is obtained by finding levels of ZA and ZB which
add up to the overall abatement target Z = 40 andwhich satisfy the least-cost condition that MCA
= MCB. This gives the answer ZA = 25 and ZB = 15. Figure 5.3 shows this least cost solution. At
those respective abatement levels both firms have marginal abatement costs of 75. Minimised
total abatement costs (1700) can be read from the diagram. The darker shaded area denoted β
shows B’s total abatement costs (662.5), while the lighter area denoted α represents A’s total
abatement costs (1037.5). To verify this result, you could use the Lagrange multiplier technique,
obtain the necessary first-order conditions, and solve these for the two firms’ abatement levels.
It is instructive to compare this solution with two others. First, one might think that as firm A has
a lower marginal abatement cost schedule than B it should undertake all 40 units of abatement. It
is easy to verify that this results in higher costs (2500) than those found in the least-cost solution
(1700). Second, an equity argument might be invoked to justify sharing the abatement burden
equally between the two firms. But it is easy to show that this also leads to higher costs (1800 in
fact). If the regulator wanted such an equitable outcome, it would come at an additional real cost
to the economy of 100 units (1800 − 1700). Note that the greater the difference in the firms’
abatement cost functions, the greater would be the cost penalty from not pursuing the least-cost
outcome. Some important conclusions emerge from this analysis:
 A least-cost control regime implies that the marginal cost of abatement is equalised over
all firms undertaking pollution control.
 A least-cost solution will in general not involve equal abatement effort by all polluters.

44
  Where abatement costs differ, cost efficiency implies that relatively low-cost abaters will
undertake most of the total abatement effort, but not all of it.
Instruments for achieving pollution abatement targets
 Command and control instruments
Environment policy has traditionally been secured through the use of the command-and control
regulatory standards approach. Under this approach, the regulatory authority set an
environmental standard (target) and the polluter is required to honour the standard, under the
threat of some penalty systems. This target setting process is well-meaning but may not always
represent a feasible policy objective because of information deficiencies and the lack of a
proper ‘systems’ perspective.
 Economic incentive (quasi-market) instruments
Command and control instruments operate by imposing mandatory obligations or restrictions on
the behaviour of firms and individuals. Incentive-based instruments work by creating incentives
for individuals or firms to voluntarily change their behaviour. These instruments alter the
structure of pay-offs that agents face. Employing incentives to make behaviour less polluting can
be thought about in terms of prices and markets. Taxes, subsidies and transferable permits create
markets (or quasi-markets, something equivalent to markets) for the pollution externality. In
these markets, prices exist which generate opportunity costs that profit-maximising firms will
take account of in their behaviour.
 Emissions taxes and pollution abatement subsidies
In this section, we examine tax and subsidy instruments used to alter the rate of emissions of
uniformly mixed pollutants, for which the value of the damage created by an emission is
independent of the location of its source. It is shown later that the results also apply, with minor
amendment, to non-uniformly mixing pollutants. Given that taxes on emissions are equivalent to
subsidies (negative taxes) on emissions abatement, it will be convenient to deal explicitly with
tax instruments, and refer to subsidy schemes only when there is a difference that matters.
Looking again at Figure 5.4, it is evident that there are several points at which a tax could be
applied (just as there were several points of intervention for command and control regulations).
We focus here on taxation of emissions. It is important to note that taxes on output of the final
product, or on the levels of particular inputs (such as coal), will not have the same effect as
emissions taxes, and will generally be less efficient in attaining pollution targets.

Figure [Link] economically efficient emissions tax

45
A tax on pollutant emissions has for long been the instrument advocated by economists to
achieve a pollution target. It is useful to distinguish between three cases:
 the pollution target is the economically efficient level of pollution (the level which
maximises social net benefits);
 a specific target is sought, but it is set according to some criterion other than economic
efficiency;
 an emission reduction of some unspecified amount is sought.
Figure 5.4 illustrates the working of an emissions tax. Note that the diagram uses aggregate,
economy wide marginal benefit and marginal damage functions (not those of individuals or
single firms). If firms behave without regard to the pollution they generate, and in the absence of
an emissions tax,emissions will be produced to the point where the private marginal benefit of
emissions is zero.

Figure 5.5. The economically efficient level of emissions abatement

This is shown as M, the pre-tax level of emissions. Now suppose an emissions tax was
introduced at the constant rate μ* per unit emission, the value of marginal damage at the efficient
pollution level. Given this, the post-tax marginal benefit schedule differs from its pre-tax
counterpart by that value of marginal damage. Once the tax is operative, profit maximizing
behaviour by firms leads to a pollution choice of M* (where the post-tax marginal benefits of
additional pollution are zero) rather than M as was the case before the tax. Note that levying an
emissions tax at the rate μ* creates just the right amount of incentive to bring about the targeted
efficient emission level, M*.
It is sometimes more convenient to view the problem in terms of abatement, Z, rather than the
level of pollution itself. This can be done by reinterpreting Figure 5.4. Viewed in this new light,
the emission tax causes abatement to increase from zero (at M) to its efficient level Z* = M − M*
at the point M* on the horizontal axis. Alternatively, we can map the relevant parts of Figure 7.3
into abatement space, from which we obtain Figure 5.5. It is important to be clear about the
relationships between these two diagrams. First, the curve labelled ‘marginal cost of abatement’
is just the mirror image of the (before tax) marginal benefit curve in Figure 5.4; what firms
privately forgo when they abate emissions is, of course, identical to the benefits they receive
from emissions. The ‘marginal benefit of abatement’ to a representative firm is the tax rate
applied, μ*. Each unit of abated emissions reduces the firm’s total tax bill by that amount. As the
tax rate is constant, the marginal benefit of abatement curve is [Link], note that we
have truncated the two curves in Figure 5.5 at Z = W, where W is identical in magnitude to M.

46
Confirm for yourself the reason for doing this. Finally, note that Z* = M − M*, and so the
distance from the origin to Z* in Figure 5.5 is equal to the horizontal distance between M and M*
along the emissions axis in Figure [Link] the absence of an emissions tax (or an abatement
subsidy), firms have no economic incentive to abate pollution. (In terms of Figure 5.5, the
marginal benefit of abatement lies at zero along the Z axis.). Profit-maximisingbehaviour implies
that firms would then undertake zero abatement, corresponding to emissions M. However, when
an emissions tax is levied (or, equivalently, when an abatement subsidy is available) an incentive
to abate exists in the form of tax avoided (or subsidy gained). It will be profitable for firms to
reduce pollution as long as their marginal abatement costs are less than the value of the tax rate
per unit of pollution (or less than the subsidy per unit of emission abated). If the tax/subsidy is
levied at the level μ* the efficient pollution level is attained without coercion, purely as a result
of the altered structure of incentives facing firms.
In the language of externalities theory, the tax eliminates the wedge (created by pollution
damage) between private and socially efficient prices; the tax brings private prices of emissions
(zero) into line with social prices (μ*). The tax ‘internalises the externality’ by inducing the
pollution generator to behave as if pollution costs entered its private cost functions. Decisions
will then reflect all relevant costs, rather than just the producer’s private costs, and so the profit-
maximising pollution level will coincide with the socially efficient level. Not only will the tax
instrument (at rate μ*) bring about an efficient level of pollution but it will also achieve that
target in a cost-effective way. Remember that cost-efficiency requires that the marginal
abatement cost be equal over all abaters. Under the tax regime all firms adjust their firm-specific
abatement levels to equate their marginal abatement cost with the tax rate. But as the tax rate is
identical for all firms, so are their marginal costs.
Our discussion in this section so far has dealt with the case in which the EPA wishes to attain the
economically efficient level of emissions, M*. Suppose that the EPA does have an emissions
target, M, set perhaps on health grounds. To attain this (or indeed any other specific) emissions
target, knowledge of the aggregate (economy-wide) marginal emissions abatement cost function
would be sufficient. This should be clear by looking at Figure 5.5 again. For any target M,
knowledge of the aggregate marginal cost of abatement function allows the EPA to identify the
tax rate, say µ, that would create the right incentive to bring about that outcome. Even though the
target is not an efficient target, the argument used above about cost-efficiency remains true here:
the emissions tax, levied at µ, attains the target M at least total cost, and so is cost efficient.
This result is rather powerful. Not only does the EPA not need to know the aggregate marginal
pollution damage function, it does not need to know the abatement cost function of each firm.
Knowledge of the aggregate abatement cost function alone is sufficient for achieving any
arbitrary target at least cost. Compare this result with the case of command and control
instruments; there, knowledge of every firm’s marginal abatement cost function is required – a
much more demanding information requirement.
Finally, let us deal with the third of the listed cases where an emission reduction of some
unspecified amount is sought. Without knowledge of anything about abatement costs and
benefits, the EPA could select some arbitrary level of emissions tax, say µ. Faced with this tax
rate, profit-maximising firms will reduce emissions up to the point where marginal abatement
costs are brought into equality with this tax rate. As all firms do this the emissions reduction is
achieved at least cost, once again. Although the government cannot know in advance how much
pollution reduction will take place, it can be confident that whatever level of abatement is

47
generated would be attained at minimum feasible cost. Taxes (and subsidies by an equivalent
argument) are, therefore, cost-efficient policy instruments.
We stated earlier that an emissions tax and an emissions abatement subsidy (at the same rate)
have an identical effect in terms of pollution outcome in the short term. However, the two
instruments do have some very important differences. Most importantly, the distribution of gains
and losses will differ. Taxes involve net transfers of income from polluters to government, while
subsidies lead to net transfers in the other direction. This has important implications for the
political acceptability and the political feasibility of the instruments. It also could affect the long-
run level of pollution abatement under some circumstances.
Marketable emissions permits
Marketable permit systems are based on the principle than any increase in emissions must be
offset by an equivalent decrease elsewhere. There is a limit set on the total quantity of emissions
allowed, but the regulator does not attempt to determine how that total allowed quantity is
allocated among individual [Link] are two broad types of marketable emission permit
systems – the ‘cap-and-trade’ system and the emission reduction credit (ERC) system.
A cap-and-trade marketable emission permits scheme for a uniformly mixing pollutant involves:
 A decision as to the total quantity of emissions that is to be allowed (the ‘cap’). The total
amount of permits issued (measured in units of pollution) should be equal to that target
level of emissions.
 A rule which states that no firm is allowed to emit pollution (of the designated type)
beyond the quantity of emission permits it possesses.
 A system whereby actual emissions are monitored, and penalties – of sufficient deterrent
power – are applied to sources which emit in excess of the quantity of permits they hold.
 A choice by the control authority over how the total quantity of emission permits is to be
initially allocated between potential polluters.
 A guarantee that emission permits can be freely traded between firms at whichever price
is agreed for that trade.
Marketable permit schemes differ from tax or subsidy schemes by working in terms of quantities
rather than prices. But this feature is also true for command and control instruments such as
quotas, licences and standards. The distinguishing feature is the transferability of permits
between individual sources in the marketable permits case. Permit trading is not allowed in
command and control licence systems. It is the exchange process that generates the attractive
qualities of the marketable permit system. In effect, tradability creates a market in the right to
pollute. In that market, the right to pollute will have a value, given by the prevailing market
price. So the decision to pollute generates an opportunity cost. By emitting an extra unit of the
pollutant, one unit of permit is used up and so cannot be sold to another firm. The firm incurs a
cost in emitting each unit of the pollutantthat cost being the current market permit price.
Intuitively, this suggests that a marketable permit system should be equivalent (at least in some
ways) to a tax or subsidy system, provided the permit price is equal to the tax or subsidy rate. Let
us consider how an equilibrium price might emerge in the market for permits. Suppose that
permits have been allocated at no charge to firms in some arbitrary way. Once this initial
allocation has taken place, firms – both those holding permits in sufficient number to cover their
desired emission levels and those not holding sufficient for that purpose – will evaluate the
marginal worth of permits to themselves. These valuations will differ over [Link] firms
hold more permits than the quantity of their desired emissions (in the absence of any control).
The value of a marginal permit to these firms is zero. Others hold permits in quantities

48
insufficient for the emissions that they would have chosen in the absence of the permit system.
The marginal valuations of permits to these firms will depend upon their emission abatement
costs. Some will have high marginal abatement costs, and so are willing to pay high prices to
purchase emissions permits. Others can abate cheaply, so that they are willing to pay only small
sums to purchase permits; their marginal permit valuation is [Link], it is not necessarily the
case that a firm which holds fewer permits than its desired emissions level will buypermits. It
always has the option available to reduce its emissions to its permitted level by undertaking extra
abatement. The firm may find it preferable to sell permits (rather than buy them) if the price at
which they could be sold exceeds its marginal abatement cost.
In any situation where many units of a homogeneous product are held by individuals with
substantially differing marginal valuations, a market for that product will emerge. In this case,
the product is tradable permits, and the valuations differ because of marginal abatement cost
differences between firms. Therefore, a market will become established for permits, and a single,
equilibrium market price will emerge, say μ. Notice that trading does not alter the quantity of
permits in existence, it merely redistributes that fixed amount between [Link] equilibrium
marginal abatement costs will be equal over all firms. It is this property of the system which
ensures that transferable marketable permits, like taxes and subsidies, achieve any given target at
least cost. Moreover, another equivalence arises. If the total quantity of permits issued is M*
andthat quantity is identical to the level of emissions which would emerge from an emissions tax
(or an abatement subsidy) at the rate μ* then a marketable permit scheme will generate an
equilibrium permit price μ*. In effect, the marketable permit system is an equivalent instrument
to either emissions taxes or emissions abatement subsidies.
The initial allocation of permits
The implementation of a marketable permits system requires that the EPA select a method by
which the total allowable quantity of permits (the cap) is initially allocated among sources.
Simplifying matters somewhat, we can envisage that it must choose one of the following:
 TheEPA sells all permits by auction;
 TheEPA allocates all permits at no charge (which in turn requires that a distribution rule be
chosen).

Figure 5.6 the determination of the market price of emissions permits

We shall now investigate how the market price of permits is determined in each of these two
cases.

49
Determination of the equilibrium market price of permits
Case 1: Auctioned permits
Suppose that the permits are initially allocated through a competitive auction market. Individual
firms submit bids to the EPA. When ranked in descending order of bid price, the resulting
schedule can be interpreted as a market demand curve for permits. Assuming that no strategic
behaviour takes place in the bidding process, this demand curve will be identical to the aggregate
marginal abatement cost [Link] market equilibrium permit price is determined by the
value of the aggregate marginal abatement cost at the level of abatement implied by the total
number of issued permits. This is illustrated in Figure 5.6. The demand curve for permits is the
aggregate marginal abatement cost function for all polluting firms. The total number of permits
(allowed emissions) is M*. Given this quantity of permits, the market price for permits will be
μ*. Firms collectively are required to reduce emissions from M to M*.
Case 2: Free initial allocation of permits on an arbitrary basis
Alternatively, the EPA may distribute the permits at no charge, and allow them to be
subsequently traded in a free market. The initial allocation is unlikely to correspond to the
desired (that is, profit-maximising) holdings of permits (and in aggregate, of course, is likely to
be less than total desired emissions). Some firms will try to buy additional permits from others,
while others will try to sell some of their initial holding. Buyers will typically be firms with
relatively high marginal abatement costs, who hope to purchase additional quantities at a price
less than their marginal abatement cost. Sellers will be those in an opposite position, hoping to
sell some permits at a price greater than their marginal abatement cost

Figure 5.7. The determination of the market price of emission

permits: free initial allocation case
In a well-functioning competitive market, the market price that would emerge in this case would
be identical to that which would be established if permits were sold at a competitive auction.
This is portrayed in Figure 5.7. Note that the quantity traded, EP*, is less than the number of
permits issued by the EPA (M*), because trades only take place as holdings are adjusted to
desired levels.
It is clear that the method by which permits are initially allocated has no bearing on the amount
of abatement that takes place; that depends only on the total number of permits issued. What is,
perhaps, less evident is that the method of initial allocation also has no effect on the equilibrium
permit price. There is one important qualification to these remarks about permit price
determination. We have assumed that the market behaves as if it were perfectly competitive. But
if the polluting industry in question is dominated by a small number of firms, or if for any reason

50
the quantity of trading is small, strategic behaviour may take place. This could happen both in
permit auctions and where firms are adjusting permit holdings from their initial allocations to
their profit-maximising levels. Strategic behaviour may cause the market price of permits to
diverge from its competitive level.
A simple numerical illustration will help to strengthen understanding about the way that this
instrument operates. Consider the information shown in Table 5.2. We suppose that the EPA
selects an emissions cap – and so a total permit allocation – of 50 units. The pollutant is emitted
by just two firms, A and B, and emissions abatement can only be undertaken by these firms. The
EPA decides arbitrarily to allocate half of total permits to each firm, so prior to trading A and B
are each allowed to emit 25 units of the pollutant. As in our earlier discussion, we assume that in
the absence of any control system A would choose to emit 40 units and B 50 units.
Table 5.2 emissions abatement data for firms A and B
A B A+B
Uncontrolled emissions 40 50 90
Uncontrolled abatement 0 0 0
Efficient emissions 15 35 50
Efficient abatement 25 15 40
Initial permit allocation 25 25 50
Final permit allocation 15 35 50

Given the initial permit allocations, A must reduce emissions by 15 units and B by 25 units. It
can be seen from Figure 5.8 that A has a marginal abatement cost of 45 and B a marginal
abatement cost of 125. The fact that firm A has lower marginal abatement cost than firm B after
the initial permit allocation implies that the total abatement of 40 units of emission is not being
achieved at least cost. Moreover, B places a much higher value on an incremental permit than
does A (125 as compared with 40). Thus the two will find it mutually beneficial to trade with one
another in permits. What will be the outcome of this trade? If the market behaved as if it were a
competitive market, an equilibrium market price of 75 would emerge. At that price, firm B (the
high-cost abater) would buy permits and A (the low-cost abater) would sell permits. In fact, A
would buy 10 permits from A at 75 each, because for each of those 10 permits, it would be
paying less than it would cost the firm to abate the emissions instead. Conversely, B would sell
10 permits to A at 75 each, because for each of those 10 permits, it would be receiving more than
it would cost the firm to abate the emissions instead.

Figure 5.8. Efficient abatement with two firms and marketable permits

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Trading finishes at the point where A has 15 permits (10 less than its initial allocation) and B has
35(10 more than its initial allocation). Marginal control costs are equalised across polluters, and
the total cost of abating emissions by 40 units has thereby been minimised. The permit system
will, therefore, have identical effects on output and emissions as an optimal tax or subsidy
system, and will be identical in terms of its cost-effectiveness property. One other feature shown
in Figure 5.8 should be noted. The line labelled MC (Industry) is the industry-wide (or
aggregate) marginal cost of abatement schedule. It is obtained by summing horizontally the two
firm’s marginal abatement cost functions, and is given by

The equilibrium permit price is found as the industry marginal cost (75) at the required level of
industry abatement (40). Note that as the required abatement rises, so will the equilibrium permit
price.
5.3. Pollution policy with imperfect information
The words risk and uncertainty are often used to characterise various situations in which less
than complete information is available. Risk is usually taken to mean situations in which some
chance process is taking place in which the set of possible outcomes is known and probabilities
can be attached to each possible outcome. However, it is not known which possible outcome will
occur. Alternatively, all that may be known is what could occur (but not probabilities), a
situation often described as uncertainty.A more extreme case – sometimes called radical
uncertainty – concerns circumstances in which it would not be possible even to enumerate all the
possible outcomes.
Difficulties in identifying pollution targets in the context of limited information and
uncertainty
In discussing efficiency-based pollution targets, we implicitly assumed that the policy maker was
well informed, and so either knew – or by an investment of resources could discover – the
relevant cost and benefit functions. Is this assumption reasonable? To try and answer this
question, it is useful to begin by listing what the policy maker needs to know (or have reliable
estimates of) in order to identify economically efficient emission or pollution [Link]
environmental agency must know the functional forms, and parameter values, of all the relevant
functions for the pollution problem being considered. In particular, knowledge of the benefits
and damages of pollution (or the costs and benefits of pollution abatement) is required.
Moreover, as we showed in our treatment of convexity, it is not sufficient to know the values of
such things near the current position; they have to be known across the whole range of
possibilities. Further, while it is pedagogically convenient to write about ‘pollution’ as if it were
a single, homogeneous thing, it is clear that ‘pollution problems’ come in many distinct forms.
Clearly, knowledge is required about a large number of functions, and it is not evident that
knowledge about one case can easily be transferred to other cases.
In a world of certainty, the word ‘estimation’ is not really appropriate: identification of marginal
costs would be a simple matter of collating and processing known information, and the standard
error of the resulting quantities would be zero. Estimation per se only becomes necessary where
the information available to the regulator is imperfect. This, of course, is the normal state of
affairs. Relevant information is decentralised, and those who possess it may have incentives not
to truthfully reveal it. There are costs in acquiring, collating, validating and processing
information, and these costs imply that it will not be efficient to search for information until all
uncertainties are resolved.

52
The benefits of pollution abatement are principally avoided damages. Identifying abatement
benefits typically involves a two-step process. First, the impacts of abatement have to be
established. Second, monetary valuations are put on those impacts. These processes are, once
again, normally done in the context of imperfect information. This is most evident in the first
stage. Scientific knowledge about pollution impacts is far from complete, and arguably can never
be complete because of the stochastic, complex nature of ecosystem functioning. Hence we
cannot be sure about the biological, ecological, health, physical and other impacts of a pollutant.
Knowledge of those impacts is not sufficient for an EPA to establish efficiency-based targets:
these ‘physical’ units need to be given monetary values. The available evaluation procedures
yield statistical estimates; point estimates are intrinsically uncertain. Valuation of environmental
services is beset by a host of theoretical and practical problems, and there is no consensus about
the validity of current valuation techniques.
Three further complications beset policy makers. First, the relevant costs and prices (on both
benefit and cost estimation sides) needed for evaluation should be those that correspond to a
socially efficient outcome; these may bear little relation to observed costs and prices where the
economy is a long way from that optimum. Second, difficulties are compounded by ‘second-
best’ considerations. If the economy suffers from other forms of market failure too, then the
‘first-best’ outcomes we investigated earlier are not efficient. Finally, limited information and
uncertainty do not simply mean that decisions should be taken in the same way (but have less
‘accuracy’) as under conditions of full information. There can be profound implications for
appropriate decision making under conditions of risk or uncertainty.

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Chapter six: Natural resource exploitation
6.1. The theory of optimal non-renewable resource extraction:
Non-renewable resources include fossil-fuel energy supplies – oil, gas and coal – and minerals –
copper and nickel, for example. They are formed by geological processes over millions of years
and so, in effect, exist as fixed stocks which, once extracted, cannot be renewed. These types of
resources areclassified in three basic concepts. These are:
Current reserves are defined as known resources that can profitably be extracted at the current
prices. The magnitude of these current reserves can be expressed as a number.
Potential reserves, on the other hand, are most accurately defined as a function rather than a
number. The amount of reserves potentially available depends upon the price people are willing
to pay for those resources- the higher the price, the larger the potential reserves. Take for
example, a country has some extractable resource that can be utilized with high technology that
the current demand condition does not allow the cost of extraction to be recovered. This
technology which costs tremendously high can be used if and only if the price that resource users
are willing to pay is able to cover at least the cost of extraction. As a result, we say that reserve is
a potential reserve.
Resource endowment represents the natural occurrence of resources in the earth’s crust. Since
price has nothing to do with the size of the resource endowment, it is a geological rather than an
economic concept.
One question is of central importance: what is the optimal extraction path over time for any
particular non-renewable resource stock?
6.1.1. Efficient Intertemporal Allocation of depletable non-recyclable resources
The Hotelling rule is a necessary efficiency condition that must be satisfied by any optimal
extraction programme. The chapter begins by laying out the conditions for the extraction path of
a non-renewable resource stock to be socially optimal. It then considers how a resource is likely
to be depleted in a market economy. The extraction path in competitive market economies will,
under certain circumstances, be socially optimal. It is usually argued that one of these
circumstances is that resource markets are competitive. We investigate this matter by comparing
extraction paths under competitive and mono-poly market structures against the benchmark of a
‘first-best’ social [Link] help understanding, it is convenient to begin with a model in
which only two periods of time are considered. Even from such a simple starting point, very
powerful results can be obtained, which can be generalized to analyses involving many periods.
Then, having analyzed optimal depletion in a two-period model, a more general model is
examined in which depletion takes place over T periods, where T may be a very large number.
A non-renewable resource two-period model
Consider a planning horizon that consists of two periods, period 0 and period 1. There is a fixed
stock of known size of one type of a non-renewable resource. The initial stock of the resource (at
the start of period 0) is denoted R. Let Rt be the quantity extracted in period t and assume that an
inverse demand function exists for this resource at each time, given by:

WherePt is the price in period t, with a andb being positive constant numbers. So, the demand
functions for the two periods will be:

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A linear and negatively sloped demand function such as this one has the property that demand
goes to zero at some price, in this case the price a. Hence, either this resource is non-essential or
it possesses a substitute which at the price a becomes economic-ally more attractive. The
assumption of linearity of demand is arbitrary and so you should bear in mind that the particular
results derived below are conditional upon the assumption that the demand curve is of this form.
Algebraically, the integral of P with respect to R over the interval R = 0 to R = Rt)shows the total
benefit consumers obtain from consuming the quantity Rt in period t. From a social point of
view, this area represents the gross social benefit, B, derived from the extraction and
consumption of quantity Rt of the resource.1 We can express this quantity as

Where the notation B (Rt) is used to make explicit the fact that the gross benefit at time t (Bt ) is
dependent on the quantity of the resource extracted and consumed (Rt). However, the gross
benefit obtained by consumers is not identical to the net social benefit of the resource, as
resource extraction involves costs. Fully borne by the resource-extracting firms, and so private
and social costs are identical. This assumption will be dropped in the following chapter. Let us
define c to be the constant marginal cost of extracting the resource (c ≥ 0). Then total extraction
costs, Ct, for the extracted quantity Rt units will be
Ct = cRt
The total net social benefit from extracting the quantity Rt is
NSBt = Bt – Ct
Where NSB denotes the total net social benefit and B is the gross social benefit of resource
extraction and use. Hence

A socially optimal extraction policy

Our objective in this subsection is to identify a socially optimal extraction programme. This will
serve as a benchmark in terms of which any particular extraction programme can be assessed. In
order to find the socially optimal extraction programme, two things are required. The first is a
social welfare function that embodies society’s objectives; the second is a statement of the
technical possibilities and constraints available at any point in [Link] the general two-period
social welfare function
W = W (U0, U1)
takes the particular form

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Where is the social utility discount rate, reflecting society’s time preference? Now regard the
utility in each period as being equal to the net social benefit in each period. Given this, the social
welfare function may be written as

Only one relevant technical constraint exists in this case: there is a fixed initial stock of the non-
renewable resource, R. We assume that society wishes to have none of this resource stock left
at the end of the second period. Then the quantities extracted in the two periods, R0 and R1, must
satisfy the constraint:
R0 + R1 =
The optimization problem can now be stated. Resource extraction levels R0 and R1 should be
chosen to maximise social welfare, W, subject to the constraint that total extraction of the
resources over the two periods equals . Mathematically, this can be written as

Subject to
R0+ R1 =
There are several ways of obtaining solutions to constrained optimization problems of this form.
We use the Lagrange multiplier method, a technique. The first step is to form the Lagrangian
function, L:

in which  is a ‘Lagrange multiplier’. Remembering that

R0 and R1 are choice variables – variables whose value must be selected to maximise welfare –
the necessary conditions include:

Since the right-hand side terms of equations 1 and 2 are both equal to zero, this implies that

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 Using the demand function Pt= a – bRt , the last equation can be written as

WhereP0 and P1 are gross prices and P0 – c and P1 – c are net prices. A resource’s net price is
also known as the resource rent or resource royalty. Rearranging this expression, we obtain

If we change the notation used for time periods so that P0 = Pt-1, P1 = Pt and c = ct= ct-1, we
then obtain

: This is called Hotelling’s rule or it is called “r” percent rules of

extraction.
Exercise: There is a single fixed stock of a non-renewable resource; the magnitude of this stock
is 2500 tones. The inverse demand functions for this resource is Pt = 700-0.25q t and the constant
marginal cost of resource extraction is $200. Based on this information answer the following
questions. Use r= 5%
A. Calculate the optimal level of output in each period?
B. Calculate the value of price in each output?
C. Calculate the scarcity rent in each period and check your work using the “r” percent rule
of extraction?
Efficient Intertemporal Allocation of depletablerecyclable resources
Not all depletable resources are non-recyclable. There are resources that exist in such a form that
once they are used for one particular purpose, they can be re-used or recycled in the production
of same or other goods. The efficient allocation of depletable but recyclable resources follows
the same route as that of depletable and non-recyclable resources. However, as it is pointed out
above recyclable resources lend themselves to multiply the flow of services that they render.
A recyclable resource is one which, although currently being used for some particular purpose,
exists in a form allowing its mass to be recovered once that purpose is no longer necessary or
desirable. They retain their physical and chemical properties during use and under the proper
conditions can be recycled or reused.
Recycling and virgin ore depletion
As long as the resource can be recycled at a marginal cost lower than that of the substitute, the
market tends to rely on the recyclable resource longer than it does on a non-recyclable resource
with an identical cost curve. This should not be surprising, since one effect of recycling is simply
to add more of the resource.
Example
Suppose 100 units of a resource are contained in a product with a useful life of one year.
Suppose further that 90% of the resource could be recovered and reused after one year. During
the first year, the full 100 units could be used. at the end of the first year only 90% of 100 (which
is 90 units) are recovered. At the end of the second year, 90% of the remaining 90 units could
once be recovered, leaving 81 units for the third year, and so on. The total amount of resource
available by recycling is the sum of these recovered amounts, which are 1000 units.

57
Algebraically;
If we let the original stock be A, and the recovery rate be a, then the total amount used be an
infinite sum of the form A + Aa + Aa2+ Aa3 + Aa4 + ……..
It turns out that the sum of this series as time becomes infinitely long is A/(1 - a).
How? Let us see
Let A + Aa + Aa2+ Aa3 + Aa4 + …….. = X
Then Aa + Aa2+ Aa3 + Aa4 + …….. =Xa
If we subtract the later from the above we get
A = X – Xa
=> A = X (1 - a)
=> X = A/(1 - a), which is what we have above.
Exercise: If the initial stock is 100 units, find the potential amount if the recycling rate were only
30 %?
6.2. Efficient allocation of renewable resource
Renewable resources are resources that their supply can be increased with in reasonably shorter
time period. Besides they are use dependent; they are significantly affected by human action. If
they are excessively utilized or improperly managed, they might even come to extinction.
Sometimes they are also called interactive resources, wherein the size of the resource stock
(population) is determined jointly by biological considerations and by actions taken by society.
The size of the population, in turn, determines the availability of the resource for the [Link]
our exploration of issue of renewable resources we seek to answers for questions like what is the
efficient rate of use of interactive renewable resources? In the absence of outside influences, can
the market be relied upon to achieve and sustain this rate?
Efficient allocation of renewable resource: Fishery resource
The population of biological resource at any given point in time depends on their natural growth
rate and the human interaction to it. The characterization of fishery resource, which is presented
below, rests on a biological model originally proposed by Schaefer (1957). This model posits a
particular average relationship between the growth of fish population and the size of the fish
population. This is an average relationship in the sense that it abstracts from such influences as
water temperature and the age structure of the population. The model therefore, does not attempt
to characterize the fishery on a day-to-day basis, but rather in terms of some long-term average
in which these various random influences tend to counterbalance each other.

Figure 6.1

58
In figure 6.1: the size of the population is represented in the horizontal axis and the growth of
the population on the vertical axis. Beyond the critical limit, S, we will see what it means later,
as population increases the growth of population is positive up to point S*. The growth of the
population declines as population increases above S*. Eventually, it ceases to grow at population
stock of S’, which is known as the natural equilibrium.
Have you observed that there are two points where the function intersects the horizontal axis,
which, therefore, means growth in the stock is zero? These points are indicated, on the figure, by
S and S’, the natural equilibrium is maintained if there are no outside influences. Reductions in
the stock due to mortality or out-migration would be exactly offset by increases in the stock due
to births, growth of the fish in the remaining stock, and in-migration. Hence, it is a stable
equilibrium in the sense that movements away from this population level set forces in motion to
restore it. If, for example, the stock of population temporarily exceeds S’, it would be exceeding
the capacity of the habitat. As a result mortality rate and out migration would increase until the
stock was once again within the confines of the carrying capacity of the habitat at S’. However,
unlike the stable equilibrium, the other point on the curve, S, which is known as the minimum
viable population is not stable. This point represent the level of population below which growth
in population is negative (deaths and out-migration exceed births and in-migration). When the
population moves to the right of S, population growth will be positive and a movement along the
curve to S and away from S’. And when the population moves to the left of S, the population
declines until it eventually becomes extinct. And In the region below S no forces act to return the
population to a viable level, Hence, point S’ is unstable.
Whenever a catch level is equal to the growth rate of the population it is said to represent a
sustainable yield, since it can be maintained forever. As long as the population size remains
constant, the growth rate (and hence the catch) will remain constant as well. The maximum
sustainable yield is, therefore, the peak of the curve which is indicated by G(S*). Hence, S* is
known in biology as the maximum sustainable yield population, defined as that population size
which yields the maximum growth. The sustainable yield for any population size between , say
So, is determined by drawing a vertical line from the stock size of intersect on the horizontal axis
to the point where it intersect the function, and drawing a horizontal line over to the vertical axis

59
(the population size of So gives us G(So) sustainable yield). Now, it becomes clear that why
G(S*) is the maximum sustainable yield.
Static efficient sustainable yield
In static efficiency we maximize net benefit from the use of the resource. Therefore, defining the
efficient allocation requires us to include the costs of harvesting as well as the benefits.
The static efficient sustainable yield is the catch level which, if maintained perpetually, would
produce the largest annual net benefit. We shall refer to this as the static efficient sustainable
yield, which does not worry about discounting, to distinguish it from the dynamic efficient
sustainable yield, which incorporates discounting.
Assuming that price of fish is constant, is the maximum sustainable yield the efficient level of
production? In our examination of the issue, we further assume that the marginal cost of a unit of
fishing effort is constant, and the amount of fish caught per unit of effort expended is
proportional to the size of fish population (the smaller the population, the fewer fish caught per
unit of effort). These assumptions would simplify our analysis without sacrificing too much
realism.
In any sustainable yield, catches, population, effort levels, and net benefits remain constant over
time. The static efficient sustainable yield allocation maximizes the constant net benefit.
Figure 6.2

The benefits and costs are portrayed as a function of fishing effort and can be measured in vessel
years, hours of fishing, or some other convenient metric. Do you observe that the shape of the
revenue function is similar to the curve indicating the growth and population relationship
portrayed in figure 6.2? It is dictated by the shape of the function in figure 6.1because the price
of fish is assumed constant. Observe also that increasing fishing effort in figure 6.2 would result
in smaller population sizes and would be recorded as a movement from right to left. Therefore, a
movement from left to right in figure 6.2 indicates a decrease in population size along that
movement.
As sustained levels of effort are increased, eventually a point is reached (E m) where further effort
reduces the sustainable catch and revenue for all years. Note that, every effort level in figure 6.2

60
corresponds to a population level in figure 6.1. Hence, point (E m) corresponds to the maximum
sustainable yield indicated on figure 6.2.
As usual, the net benefit is presented by the difference, or vertical distance, between benefits
(prices times the quantity caught) and costs (the constant marginal cost of effort times the unit of
effort expended). The highest vertical distance between cost and revenue curves is attained at the
level of effort denoted by E e. Ee is, therefore, the efficient level of effort because it maximizes the
net benefit. Put in another way, Ee is the level of effort where the marginal benefit (which
graphically is the slope of the total benefit curve) is equal to the marginal cost (the slope of the
total cost curve, which is constant in this case).
Why other points are not efficient? Because levels of effort higher than E eadds more to the cost
than to the revenue and levels of efforts less than E e deprives revenue which is higher than the
cost if the level of effort were to increase.
Is the maximum sustainable yield the efficient level of production?’The maximum sustainable
yield is not the efficient level of output. Since the marginal cost has positive slope, which is
greater than zero, the marginal revenue also need to be positive in order for this magnitudes to be
equal. This happens to the left of Em (to the right of G(So)) but not on Em (note that the slope of
total revenue at Em is equal to zero). Thus the static efficient level of effort leads to a larger fish
population than the maximum sustainable yield level of effort.
Now, let us see the effect of technological improvement (for example, sonar detection) in fishing
industry that lowers the marginal cost of fishing. The lower marginal cost would result in a
rotation of the total cost curve to the right. With this new cost structure, the old level of effort is
no longer efficient. The marginal cost of fishing is now lower than the marginal benefit. The
equality of marginal cost and marginal benefit (which is the requirement of maximization in
static efficiency) can result only from a decline in marginal benefits. This implies an increase in
effort. The new static efficient sustainable yield equilibrium implies more effort, a lower
population level, a larger catch, and a higher net benefit for the fishery.
Dynamic efficient sustainable yield
The static analysis we introduced above is the special case of the dynamic efficient sustained
yield where the discount rate is zero. This is so because in static efficient sustained yield the
allocation maximizes the identical net benefit in every period. Any higher effort levels than this
would yield temporarily larger catches and net benefit, but this would be more than offset by a
reduced net benefit in the future as the stock reached its new lower level. Thus the undiscounted
(zero discount rate) net benefits would be reduced.
Recall the introduction of a positive discount rate on the efficient level of mineral extraction that
we have covered above-the higher the discount rate, the higher the cost (in terms of foregone
current income) to the resource owner of maintaining any given resource stock. In a similar way
when positive discount rate are introduced, the efficient level of effort would be increased
beyond that suggested by the static efficient sustained yield with a corresponding decrease in the
equilibrium population level.
The increase in yearly effort beyond the efficient sustained yield level would initially results in
an increased net benefit from the increased catch. However, since this catch exceeds the
sustained yield for that population size, the population of fish would be reduced and future
population and catch levels would be lower. Eventually, as that level of effort is maintained, a

61
new lower equilibrium level would be attained when the size of catch once again equals the
growth of the population.
What does an assumption of infinite discount rate have on the dynamic efficient level of fish
catch? It moves the level of effort towards E c, where at that level of effort the net benefit equals
to zero.
It is easy to see why the use of infinite discount rate will drive the effort level up to point E c. in
dynamic allocation of depletable resources we have seen that interdependent allocations over
time give rise to a marginal user cost measuring the opportunity cost of increasing current effort.
This opportunity cost reflects the forgone future net benefits when more resources are extracted
in the present. For efficient allocations, the marginal willingness to pay is equal to the marginal
user cost plus the marginal cost of extraction. But with an infinite discount rate this marginal
user cost is zero. Why? This is because no value is received from future allocation. Put
differently, as the interest rate, which is part of the denominator in discounting (∑NB/(1+r) t),
increased the present value of net benefit decreases. In an extreme case where the discount rate is
infinity the present value of the net benefit approaches to zero. Therefore, the foregone net
benefit when more resources are extracted in the present (marginal user cost) is zero.
The implication of zero marginal user cost are, therefore, one, the marginal cost of extraction
equals the marginal willingness to pay, which equals the constant price, and two total costs equal
to total benefits. Unlike the static efficient sustained yield which implies larger population than
the maximum sustained yield, the introduction of discount rate may possibly, though not
inevitable, would lead the sustained catch be smaller than the maximum sustained yield.
However, we know for sure that the dynamic efficient sustained yield implies lower population
than the static efficient sustained yield. Notice that the likelihood of the population being
reduced below the level supplying the maximum sustainable yield depends on the discount rate.
Of course, the extraction cost has also its own effect on driving the total cost curve downward.
The lower the extraction cost and the higher the discount rate, the more likely it is that the
dynamic efficient level of effort will exceed the level of effort associated with the maximum
sustainable yield. Thus, with zero marginal costs and a positive discount rate, the dynamic
efficient level of effort necessarily exceeds the static efficient level of effort and the level of
effort associated with the maximum sustainable yield.
The other important question we need to address is that whether a dynamically efficient
management scheme leads to extinction or not. What do you think? Would extinction be a
possibility? It would not be with the condition described above! The highest dynamically
possible in this model is Ec, and that level falls well short of the level needed to drive the
population to extinction.
If the benefits of extracting the very last unit exceeds the cost of extracting that unit (including
the costs on future generations) extinction would be possible. As long as the population growth
rate exceeds the discount rate, this will not be the case. If, however, the growth rate is less than
the discount rate, extinction can occur in an efficient management scheme if the costs of
extracting the last unit are sufficiently low.
But why does the biomass rate of growth determine extinction in dynamic efficient management
of fish? Rates of growth determine the productivity of conservation efforts. With high rates of
growth, future generation can be easily satisfied. On the other hand, when the rate of growth is
very low, it takes a large sacrifice by current generations to produce more fish to the future

62
generations. In the limiting case, where the rate of growth is zero, we have a resource with fixed
supply and therefore no different from an exhaustible resource. Total depletion would occur
whenever the price commanded by the resource is high enough to cover the marginal cost of
extracting the last unit. This is the reason why the biomass rate of growth is one of the
determining factors in the possibility of extinction in dynamic efficient management of fishery
resource.
Market solution
Now we characterize the normal market allocation and contrast it with the efficient market
allocation of renewable resources we have defined above. Where they differ we indicate some
policy measures to correct the misallocation.
Consider the allocation resulting from a fishery resource owned and managed privately. A sole
owner has a well defined property right where all the benefits and costs are accrued to him/her
only. The owner of the resource would maximize his/her profit (static) by increasing the fishing
effort until the marginal revenue equals the marginal cost. This level of effort is E e, which
provides the static efficient sustainable yield. This will give positive profits equals to the
difference between R(Ee) and C(Ee).
However, sole ownership of fishery resource in ocean and lakes are not normal. In such cases,
usual case, since the property rights are not conveyed to any single owner, no single fisherman
can exclude others from exploiting the resource. Hence, the property right is said to be ill
defined. In this open access resource-access to the fishery is unrestricted- two kinds of
externality appears; a contemporaneous externality and an intergenerational [Link]
contemporaneous externality is resulted from the over commitment of resource to fishing. As a
result, fishermen earn a substantially lower rate of return on their efforts. This reduction in profit
is borne by the current generation; hence, contemporaneous externality is associated with the
current [Link] intergenerational externality, as the name implies transcends to the next
generations; hence, the external effect is borne by the future generations. It occurs because over
fishing reduces the stock which, in turn, lowers future profits from fishing.
Let us see how these externalities arise. In privately owned resource the owner chooses not to
expend more efforts than Eebecause to do so would reduce the profits, which is a personal loss.
When access to the resource is unrestricted, a decision to expend effort beyond E ereduces profit
to the fishery as a whole but not to that individual fisherman. Most of the decline in profits falls
on the other fishermen. Therefore, an individual fisherman in an open access fish resource has an
incentive to expend more effort until profits are zero. In figure 2.3 that point is at effort level E c,
where the average benefits and average costs are equal.
Figure 6.3 market allocation of fishery

63
Do you remember that in a well defined property right the owner of the resource balances the use
value and the asset value. Yes he should if he has to maximize the net benefit. But when access
to the resource is unrestricted exclusivity, which is one of the basic characteristics of a well
defined property right, is lost. As a result, it is rational for a fisherman to ignore the asset value,
since he/she cannot appropriate it, and simply maximize the use value. In the process all the
scarcity rent is dissipated. Do see any similarity between allocation that results from open access
to the fishery and that resulting from dynamic efficient sustainable yield when an infinite
discount rate is used?
Public policy toward fisheries
Open access resources generally violate both the efficiency and sustainability criteria. Hence,
there need to be some restructuring in the decision making environment is necessary. Here are
some policy measures that may help to fulfill the efficiency and sustainability criteria.
 Aquaculture
We have understood that the source of the inefficient management of fishery resource is lack or
incomplete existence of property right; treating it as common, rather than private, property. The
obvious solution could be allowing some fishery resource to be owned privately. This approach
may work when the fish are not mobile, when they can be confined by artificial barriers, or when
they instinctively return to their place of birth to spawn. In addition to precluding over fishing,
this approach has an advantage of encouraging the private owner to invest in the resource and
undertake measures that will increase the productivity of the fishery. (For example, adding
nutrients to the water or controlling the temperature can markedly increase the yield of some
species.) This movement toward controlled raising and harvesting of fish is called aquaculture.

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Another market approach to aquaculture involves fish ranching rather than fish farming.
Whereas fish farming involves cultivating fish over their lifetime in a controlled environment,
fish ranching involves holding them in captivity only for the first few years of their lives.
Do you observe that fish ranching relies on the strong homing instincts that only few fish species
have and fish farming also requires specific behavior of the fish , indicating that this approach,
aquaculture, is not applicable to all fish types. Furthermore, fish farming create environmental
problems, ranging from pollution caused by the fish wastes, to the destruction of ecologically
valuable sites to develop fish farms.
 Raising the real cost of fishing
To address the overexploitation problem in fishery resources one way is by preventing the use of
sophisticated fishing equipments and traps. And designating fishing areas and suspend fishing in
other areas for certain period of time. Raising the real cost of fishing measure can be depicted in
the following figure (figure 6.4). This measure can be reflected as a rotation of the cost curve to
the left until it intersected the benefits curve at a level of effort equal to Ee. The aggregate of all
these regulations had the desired effect of curtailing the yield of fish. But are these policies
efficient? They were not and would not have been even had they resulted in the efficient catch!
Efficient implies not only that catch must be at the efficient level, but it must also be extracted at
a lower possible cost. This later condition is violated by these policies.

Figure 6.4 effect of regulation

Let us see further the impact of raising the cost of fishing using figure 6.4. In the figure 6.4 the
total costs, TC1 (total cost in an efficient allocation) and TC 2(total cost after these policies are
imposed)are indicated. The net benefit received from an efficient policy is shown graphically as
a vertical distance between total cost and total benefit. After the policy, however, the net benefit
was reduced to zero; the net benefit (represented by vertical distance) was lost to society. This is
because the use of excessively expensive means to catch the desired yield of fish. Larger
expenditure on capital and labour were required to catch the same number of fish. This additional
capital and labour represent one source of the waste. Time restriction also has a similar effect.
These policies are guided by a narrow focus on the maximum sustainable yield which ignored
costs. As a result these policies led to a substantial loss in the net benefit received from the
fishery. Costs are an important dimension of the problem, and when they ignored, the incomes of

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fishermen suffer. When incomes suffer, further conservation measures become more difficult to
implement, and incentives to violate the regulations are intensified.

 Taxes
In figure 6.4 taxes on effort would also be represented as a rotation of the TC line, and after-tax
cost to the fishermen would be adequately represented by line TC 2. Since the after tax curve
coincides with TC2, the cost curve for all those inefficient regulations, does not imply that the tax
system is just as inefficient? No! The key to understanding the difference is the distinction
between transfer costs and real-resource costs. Real resource costs involve utilization of
resources. But transfer cost involves transfers of resources from one part of society to another,
rather than their use. Transfers do represent costs to that part of society bearing them, but are
exactly offset by the gain received by the [Link] the calculation of net benefit, therefore,
one should subtract real cost, but not transfer cost, from benefits. For society as a whole, transfer
costs are retained as part of the net benefit. Hence, the net benefit under a tax system is identical
to that under an efficient [Link], this discussion should not obscure the fact that, as
far as the individual fisherman is concerned, these are very real costs.
 Individual transferable quotas (ITQs)
A properly designed quota that has the following identifiable characteristics would result an
efficient allocation: (1) the quotas entitle the holder to catch a specified share of total authorized
catch of a specified type of fish; (2) the catch authorized by the quota held by all fishermen
should be equal to the efficient catch for the fishery; and (3) the quotas should be freely
transferable among fishermen.
Each of these three characteristics plays an important role in obtaining an efficient allocation. If
the quota were defined in terms of the right to own and use fishing boat rather than in terms of
catch, it may lead to inefficient level of catch because there is an incentive to build larger boats.
The role of transferability of the quota would lead to cost efficiency. Those who have quotas but
also have high costs find they make more money selling the quotas than using them. Meanwhile,
those who have lower costs find they can purchase more quotas and still make money.
Transferable quota also encourages technological progress.

The harvesting decision (Algebraic presentation): fisheries

Defining the efficient sustainable yield for a fishery begins with characterization of the
biological relationship between the growth for the biomass and the size of the biomass. The
standard representation of this relationship is:
S
g=rS (1− ),
k
---------------------------------------- (1)
Where
g = the growth rate of the biomass,
r = the intrinsic growth rate for this species,

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S = the size of the biomass, and
k = the carrying capacity of the habitat.
Since we want to choose the most efficient sustained yield, we must limit the possible outcomes
we shall consider to those that are sustainable. Here we define a sustainable harvest level, hs, as
one that equals the growth of the population. Hence:
S
hs=rS (1− )
k
------------------------------------- (2)
The next step is to define the size of the harvest as a function of the amount of effort expended.
This is traditionally modeled as:
h=qES
---------------------------------------------------- (3)
Where
q= a constant (known as the “catchability coefficient”), and
E = the level of effort.
The next step is to solve for sustained yields as a function of effort. This can be derived using a
two-step procedure. First we express S in terms of E. then we use this newly derived expression
for S along with the relationship in (3) to drive the sustained yield expressed in terms of effort.
To define S in terms of E, we can substitute (3) in to (2):
S
qES=rS (1− )
k
----------------------------------------- (4)
Rearranging terms yields:
qE
S=k (1− )
r
----------------------------------------------- (5)
Using S = h/qE from equation (3) and rearranging terms to solve for hyields:
q2 kE 2
h s=qEk−
r
----------------------------------------- (6)
It is now possible to find the maximum sustainable effort level by taking the derivative of the
right hand side of (6) with respect to effort (E) and setting the result equal to zero.
The maximum condition is
q2 kE
qk −2 =0
r

----------------------------------------------- (7)
r
Emsy =
So: 2q
----------------------------------------------- (8)

Where:
Emsy = the level of effort that is consistent with the maximum sustained yield.

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Can you see how to solve for maximum sustainable yield, hmsy? (hint: Remember how the
maximum sustained yield was defined in terms of effort in (6)?)
To conduct the economic analysis, we need to convert this biological information to a net
benefits formulation. The benefit function can be defined by multiplying (6) by P, the price
received for a unit of harvest. Assuming a constant marginal cost of effort, a, allows us to define
total cost as equal to aE. Subtracting the total cost of effort from the revenue function produces
the net benefits function:
Pq 2 kE 2
PqEk− −aE .
Net benefits = r
---------------------------------( 9 )
Since the efficient sustained effort level is the level that maximizes (9), we can derive it by
taking the derivative of (9) with respect to effort (E) and setting the derivative equal to zero:
2 Pkq 2 E
Pqk− −a=0
r
--------------------------------------------------( 10 )
Rearranging terms yields:

E=
r
2q
1− (a
Pqk )
-----------------------------------------------------( 11 )
Can you see how to obtain the efficient sustained yield?
Note that effort level is smaller than that needed to produce the maximum sustained yield. Can
you see how to find the efficient sustainable harvest level? Finally we can derive the free-access
equilibrium by setting the net benefits function (9) equal to zero and solving for the effort level.
Rearranging terms yields:

E=
r
q (
1−
a
Pqk )
-------------------------------------------------( 12 )
Notice that this is larger than the efficient sustained level of effort. It may or may not be larger
than the level of effort needed to produce the maximum sustained yield. That comparison
depends on the specific values of the discount rate.

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