MAKERERE UNIVERSITY

COLLEGE OF BUSINESS AND MANAGEMENT SCIENCES (COBAMS)

DEPARTMENT OF PLANNING AND APPLIED STATISTICS

COURSE NAME: BQE3106 RESOURCE AND ENVIRONMENTAL ECONOMICS1

Credit Units: 2CU Credit hours: 30hrs

John Paul Tugume Office: Room A10 –statistical methods

Email: tugumejopa@[Link]

Tel: 0701260687/0788051506(whatsapp)
Course Outline

The concept of sustainable development; Circular flow Model Vs Material

Balance model; Typology of natural resources (mineral, energy, water,
forestry, wildlife, arable and grazing land and water). [9hrs]
The valuation of natural resources: marginal opportunity cost; external and
user costs; willingness to pay. [4hrs]
Market failures; externalities: causes, social costs and benefits; markets for
externalities; taxes and externalities. [6hrs]

The common property problem: The coarse Theorem; inter-temporal

efficiency; intergenerational welfare and the rate of time preference. [9hrs]
Exhaustible resources; efficiency of inter-temporal extraction programmes;
taxes, royalties and the rate of extraction. [4hrs]
Renewable resources; optimal rates of exploitation; optimal regulation, taxes,
user fees and the rate of exploitation [4hrs]

Environmental pollution [2hrs]

Mass balance models, environmental bonds; pollution markets; pollution
control [4hrs]

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Application of economics of natural resources in LDCs [3 hrs]

Reference materials and Text books

1. Environmental Economics by Charles D Kolstad
2. Roger Perman , Yue Ma , Michael Common and David Maddison (2003)
Natural Resource and Environmental Economics (3rd Edition) Prentice
hall.
3. Environmental and Natural Resource Economics by Tom Tietenberg.
Fourth Edition.
4. Natural Resource Economics. Notes and problems by Conrad and Clark.

Mode of Delivery
Lectures (30 LH)

Assessment
Course work (in-class tests and course work assignments) 40%

Final examination 60%

RESOURCE AND ENVIRONMENTAL ECONOMICS

1. Definition
Natural resource economics is the study of the use of natural resources such
as energy, minerals, timber, fish and water as inputs in the production of
goods and services. It is concerned with the allocation of resources overtime
and space. Environmental economics focuses on how and why people make
decisions that have environmental consequences and the role of economic
institutions( organizations, public or private, laws etc) and policies in
influencing these decisions e.g cutting trees, overfishing, dumping garbage.

The primary objective of resource economics is to determine the efficient

allocation of scarce resources among the alternative uses.
Types of resources

Examples of Resource and Environmental problems include:

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 1. Pollution of the soil, water and air resources-chemicals, garbage, and car
fumes.
2. Global warming: it refers to changes in climate (rainfall and
temperature) caused by increased concentration of carbon dioxide and
other green house gases e.g. Nitrogen, Methane, chlorofluorocarbons
(CFC) in the upper atmosphere. Impacts of global warming include:
➢ Reduction in agricultural production
➢ Reduction in the forest biomass
➢ Property damages from coastral flooding due to the rise in the sea
level.
➢ Depletion of the ozone layer (layer in earth’s atmosphere
containing relatively high concentration of ozone)
3. Acid decomposition: a complex chemical and atmospheric phenomenon
that occurs when emissions of sulphur and nitrogen compounds and
other substances are transformed by chemical processes in the
atmosphere, often far from the original sources and then deposited on
earth in either wet or dry form. The wet forms, popularly called ‘‘acid
rain’’, can fall as rain, snow, or fog. The dry forms are acidic gases or
particulates. Some of the impacts of acid decomposition include:
➢ Damage of natural resources such as forests and water bodies.
➢ Increase in skin cancer
➢ It affects structures as buildings and bridges.

4. Over exploitation of renewable resources e.g. forests, fish, wildlife etc

example Nile perch, tilapia with disappearance of certain species.
5. Depletion of exhaustible resources e.g. oil, copper, cobalt, coal etc
6. Disposal of human and toxic waste. Human waste is found in solid
waste, needles and syringes from hospital.
7. Degradation of the general Eco-system-Community of living organisms
in conjunction with non-living components of their environment
interacting as a system.
8. Losses in biodiversity (variety of life on earth).

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The primary objective of resource economics is to determine the efficient
allocation of scarce resources among the alternative uses. Resource
economics provides the analytical framework for determining efficient
allocation of natural resources over space and time. Efficiency in this case is
defined as maximizing one or more objectives subject to technological and
physical limitations. Whereas maximization of profit is the key to the
conventional economic theory, resource economics emphasizes the objective
of maximizing resources.

Historical Background of Natural Resources

Resource and environmental economics can be traced way back to classical
economics. The classical Economists were particularly concerned with the
effect of population and land use on resource scarcity, economic growth and
quality of life.
Malthus argued that population grows at geometric growth rate and human
subsistence (food supply) grows at an arithmetic rate causing human
condition to decline overtime. It takes the concept of absolute scarcity of land
further by arguing that geometric growth in population in combination with a
fixed supply of land increases the intensity of land cultivation overtime
resulting in diminishing per capita returns to land at a higher food production
and labour force.

Taxonomy/Classification of Natural Resources

Private and public decisions regarding the use and management of natural
resources is influenced by a variety of social, economic, technical and other
environmental factors.
Natural resource management refers to the decision made by resource
owners, managers, interest groups and policy makers regarding the rate,
timing and methods of resource depletion, conservation and management.

Types of natural Resources

Household decisions regarding the use of natural and environmental

resources are influenced by physical and biological attributes of the resources.
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The difference in the biological and physical nature of resource may have
important economic implications for temporal use and management of
resources. Natural and environmental resources can be classified into two
broad categories namely: Renewable (Flow) and Non-renewable (stock)
resources.
Non renewable (exhaustible/stock) resources

These are resources whose stock is fixed. If the use rate is positive, then the
resource is being depleted. This implies that its future availability is reduced
e.g. metal, ore; coal, clay etc. suppose(S) is the initial stock of an exhaustible
resource due to the end of period t-1, the stock of the resource available at the
beginning of period t is determined by the equation St =S 𝟎 − St-1

For example, suppose the initial estimate of copper resource in Kilembe mines
is 600 tonnes and the cumulative use of copper to the beginning of period t-1
is 300 tonnes, we find that the current reserve St =600-300=300 tonnes. Given
that the current annual use of copper is 3 tonnes, the number of years of
copper in mining at the current usage will take us for more 100 years
=300/3=100. Physical exhaustion occurs when St =0.
And ut-1 is the total use of the resource due to the end of period [Link] stock
of the resource at the beginning of period t is St =S 𝟎 − ut -1.

Renewable resources (Flow)

Renewable resources are regenerated through natural growth. The time and
space required for regeneration varies according to the resources e.g seal
regeneration occurs at a slow rate compared to other resources such as fish,
plants, wild life etc. renewable resources have multiple uses and most of the
renewable resources are interconnected in nature and this makes it difficult to
manage them. Consider a biological resource such as a forest. The initial stock
of a forest resource is called biomass. Biomass at the beginning of period t is
given by S t =S𝟎 − Ht-1+Gt-1 − Lt-1
Where,

S0 Is initial biomass
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Ht-1 =cumulative harvest

Gt-1 =cumulative biomass growth

Lt-1 =cumulative biomass losses due to causes such as fire, diseases e.t.c. For
example if S0 =1000, Ht-1 =900, Gt-1=1000 and Lt-1 =100, then St =1000-
900+1000-100=1000. The resource stock decreases due to over exploitation.
If
Ht-1˂(Gt-1 − Lt-1 ) it implies the resource stock increases.

Static efficiency in resource use

This happens when resource decisions in different time periods are
independent. If the use of a resource in the current time period does not affect
the amount of the resource in future time periods, then the resource decisions
are time independent. The decision criterion for determining efficient
resource use in static framework is to maximize the consumer’s and the
producer’s surplus. These are derived from the market demand and supply
functions for the resource. The sum of the consumer surplus and producer
surplus gives us the Net Social Benefit (NSB).

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Graph showing Consumer Surplus, Producer Surplus and Net Social
Benefit:

Qn: Suppose the demand and supply functions are given by

Pd=50-0.5Qd, Ps=5+0.5Qs
(a) Find the Maximum Net Social Benefit
(b) Suppose the demand curve becomes Pd=60-0.5Qd. What will be the
Net Social Benefit?

Material Balance Model and Its Implication on Environmental

Economics
In the words of Ayres and Kneese, “If waste assimilative capacity of
the environment is scarce, the decentralized voluntary exchange
process cannot be free of uncompensated technological external
diseconomies unless all inputs are fully converted into outputs, with no
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 unwanted material residuals along the way and all final outputs are
utterly destroyed in the process of consumption.”
The functions of an economy are related to production, consumption
and distribution activities. These activities have a direct relation with
nature. Nature provides raw materials to the economy for its
production and consumption activities. Residuals from both the
production and consumption processes usually remain and they
usually render disservices like killing fish, reducing public health,
soiling and deteriorating buildings due to industrial pollution.
Some wastes (residuals) from production and consumption activities
are ultimately returned to nature. Remaining wastages are recycled.
Further, all emission of residuals do not cause pollution damage
because of assimilative capacity of the environment.
Further, energy that is taken out of the environment must reappear
somewhere else in the economic system. Its form may, however, be
changed so that it appears as waste products and gases. Moreover,
waste energy cannot be recycled but waste materials can be used up
to a point. It means that economic activity always affects
environment in a direct or indirect manner.
Thus the law of conservation of matter and energy holds that matter
can be transformed to other matter or into energy but can never
vanish. All inputs (fuels, raw materials, water and so forth) used in
the economy’s production processes will ultimately result in an
equivalent residual or waste. The model is explained in the Material
Flow Diagram.

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 The material flow diagram implies that mass inputs must equal mass
outputs for every process. Moreover, all resources extracted from the
environment must eventually become unwanted wastes and
pollutants. This means, among other things, externalities (market
failures) associated with production and consumption of materials
are actually pervasive and they tend to grow in importance as the
economy itself grows. Materials recycled can help but recycling is
energy intensive and imperfect, so it cannot fully compensate.
According to John H. Baldwin, the conventional model of production
and consumption omits important considerations. This omission
results in emphasizing and managing only those sectors of
production and consumption that are monetized.
Most real production and consumption of goods and services in the
world, especially in developing countries, occur even outside the
formal monetized economy. Hence, the materials balance model
provides a useful framework for analyzing alternative methods of
resource and residuals management.
Thus, economics of the environment may be defined as a study which
concerns allocation of resources among alternative uses in such a
way that there is an efficient reduction of the waste or residuals in
the environment, which lead to an increase in social welfare.
Its implications:
The material balance model has important implications:
1. Disposal activities may affect both consumers and producers. The
environment can act as a conduit for carrying the disposal activities.
Business firms generally smoke into the air and this may affect the
consumer’s welfare. The consumers may also litter the landscape;
produce vast quantities of trash and sewage.
Each of these activities may affect each other. Because there are no
markets regulating the flow of goods through disposal, there is also a
possibility that too much of these activities will be carried on. Each
will regard his disposal costs as zero and will use the environment so
long as this use permits him to improve his own welfare.
2. The environment has a large waste assimilation capacity, but this
is not infinite. Too much waste entering the environment rather than
being recycled or reused will put too much stress on the assimilative
capacity of the environment to handle such waste safety. The result
will be a range of pollution and resources degradation impacts, and
consequent economic damage cost.

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 3. With the application of the laws of thermodynamics, economic
production and consumption activities always generate some
pollution and waste. It requires proper disposal. Moreover, it is not
always possible to have 100 percent recycling. Nevertheless, society
does not have a choice over the total quantity of waste that its
economic system produces.
4. In a general sense, policy makers can weigh up the social benefits
of various productive activities and compare them with the social
costs (including disposal) imposed by these activities. Policy makers
may then decide to intervene in the economic process in order to
change or modify production processes.
5. If a balance can be reached between acceptable levels of materials
flows, there will be an increase in output and improvement in
environmental quality.
6. From the policy point of view, this approach emphasizes recycle
process and less residual-generating production process. It is only
possible by modifying an environmental medium through
investment in control facilities so as to improve its assimilative
capacity. Investments involving public goods such as transportation
systems, sewage disposal and river flow regulation are intimately
related to the amounts and effects of residuals and must be planned
in the light of them.
7. It is important to develop not only measures for the external costs
resulting from different concentrations and duration of residuals in
the environment but more systematic methods for forecasting
emissions of external cost-producing residuals, technical and
economic trade-offs between them, and the effects of recycle on
environmental quality.
8. The application of the law of thermodynamics to the problem of
waste is an important event in integrated residuals management.
Residuals are generated by all production and consumption
activities. This pervasive nature of the residuals problem, along with
the inter-relationships of residuals, economic activities and recycling
provides a physical system basis for environmental quality
management.
In other words it demonstrates that waste generation is pervasive to
the economy. In turn, if the capacity of the environment to assimilate
and degrade the waste into harmless form is limited, the externalities
arising from the waste will be pervasive.

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 9. The importance of the materials balance principle lies in the fact
that it provides a coherent framework in which an economic analysis
of resources use and its implications for the environment can be
placed. It draws one’s attention to the long-term implications of
economic activity, by focusing on the stock-flow relationships
implied by that behavior and its importance in this relationships.
Conclusion:
As suggested by S. Baker, to improve the analysis of environmental
economy interactions, the empirically relevant and up-to-date
knowledge of ecological and natural sciences needs to be used and
integrated into environmental economics in a more systematic way.

2. Distortions responsible for natural resource degradation/inefficiency

in allocation.

The basic concern in economics is efficient use of resources which will lead us
to welfare maximization (Pareto optimality). In Pareto optimality, the market
system should allocate resources in such a way that no re-allocation can
improve the welfare of any individual in the society without making the other
individual worse off. There are many situations which prevent us from
attaining Pareto optimality. These situations are thus responsible for natural
resource degradation. These include market failure, institutional and policy
failure.
MARKET FAILURE

Market failure is a situation in which the market mechanism fails to achieve

Pareto optimality. Market failure implies that the price generated by the
market does not reflect the true social cost and benefit of resource use. Such a
price conveys misleading information about resource scarcity and provides
inadequate incentives. Market failure situations include:

1. Inappropriate property rights

2. Externalities
3. Public goods
4. Asymmetric information

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 5. Common property and open access properties
6. Un-priced resources and absent/thin market
7. High transaction costs.

How does each situation lead to market failure?

1. Inappropriate property rights: property rights are a bundle of entitlements

defining the owner’s rights, privileges and limitations for use of a resource.
An appropriate property rights structure should have the following
characteristics:
i. Universality (comprehensively assigned): This means that resources
must be privately owned and all entitlements must be completely
specified.
ii. Exclusivity: All benefits and costs that accrue as a result of owning
and using the resource should accrue to the owner only either
directly or indirectly by selling to others.
iii. Transferability: All property rights should be transferable from one
owner to another in a voluntary exchange.
iv. Enforceability: Property rights should be secure from involuntary
seizure or encroachment by others.

Any property which does not meet the four characteristics above has an
inappropriate property rights structure and will therefore lead to inefficiency.
Most environmental resources are not governed by an appropriate property
rights structure. It is when the asset has appropriate property rights that the
owners have the incentive to use it efficiently. For example, rivers, forests,
oceans are used inefficiently or inappropriately.

2. Externalities: an externality occurs when the consumption or production

function of one individual or firm affects another person’s utility or another
firm’s production function and there is no payment for the external
benefits received or no price is paid for the imposition of external costs for
example a firm polluting a river.
Graph: Firm polluting a river
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MB is the Marginal Benefit to the producer

MC is the Marginal cost to the individual.

Marginal benefit to the firm/producer: This is the increase in benefit when

pollution increases by one additional unit. MB falls as amount of pollution
increases because of the law of diminishing returns. Increasing amount of
inputs increases the amount of output up to a certain point beyond which
increasing inputs will reduce output but even when the amount of output is
decreasing, amount of pollution will still increase thus MB will decrease.

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Marginal cost (Damage) curve to the individual: this is the damage to the
victim from one additional unit increases in pollution. At higher levels of
concentration, the increase of damage per unit of concentration is higher than
at lower levels.
𝑋𝑝 Is the optimal amount of pollution for the producer.

𝑋 ∗ is the optimal amount of pollution for society i.e. where MB=MC

The free market will cause 𝑋𝑝 amount of pollution while when there is
governmental intervention, amount of pollution will be 𝑋 ∗ . The free market
results in inefficiency. This is because the appropriate rights structure does
not exist in this case governing the use of the river. No one owns the river. We
can correct this inefficiency by giving the property rights to either the firm or
the consumer.

Assume the firm has the Property Rights to the River

The victim must pay the firm an amount P per unit of pollution. The firm will
be induced to stop polluting at 𝑋 ∗ . The benefit to the firm polluting beyond
𝑋 ∗ is 𝑋 ∗ A𝑋𝑝 . The benefit to the firm if the victim pays P per unit of pollution in
excess of 𝑋 ∗ AB𝑋𝑝 . Initially the firm’s benefit is the area under the MB curve
i.e. O𝑃0 𝑋𝑝 . When the victim accepts to pay P to the firm, the firm’s benefit will
be O𝑃0 𝐴𝑋 ∗ +A𝑋 ∗ 𝑋𝑃 𝐵. Thus the firm’s benefit beyond 𝑋 ∗ is A𝑋 ∗ 𝑋𝑃 𝐵 with
payment from the victim which is greater than 𝑋 ∗ A𝑋𝑝 when the firm works in
a free market. Thus the total benefit O𝑃0 𝐴𝐵𝑋𝑝 > O𝑃0 𝑋𝑝 .

What happens to the victim, is he better off paying p? If he does not pay p,
then his cost is area under the MC curve i.e. OC𝑋𝑝 . If he pays p so that the firm
produces 𝑋 ∗ (amount of pollution) then the cost reduces to OAB𝑋𝑝 which is
clearly less than the initial Marginal cost.

H/W: Assume the victim has the Property Rights to the River, work out what
happens to the polluter and the victim.

The Coarse Theorem:

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The coarse theorem is the notion that an efficient solution will be achieved
independently of who is assigned property rights, as long as someone is
assigned the rights and the transaction costs are zero. The transaction cost
being zero will make the market complete and thus efficient. Transaction
costs may prevent the people with property rights to go to the firm to
negotiate for compensation. In the absence of property rights, the market is
incomplete. Coarse implies that once property rights are established, no
government intervention is necessary. Note that the distribution of income in
the final outcome will vary based on who is assigned the rights. The coarse
theorem does not simply mean that assigning property rights to a polluter will
cause the pollution to continue. A deal could be struck among both parties to
bring about a more desirable solution. However, the decision on property
rights will affect the distribution of income in the final outcome.

Coarse’s main points:

1. Externalities are reciprocal in nature.
❖ Not only does pollution cause an externality, but also the presence
of the victims harms the polluter.
❖ If no one were harmed, there would be no problem.
2. The economic problem is to maximize the value of production. Thus,
you need to determine which activity has the higher value.
❖ Since externalities are reciprocal, coarse argues that the highest
value option should be preserved.
3. Victims should not be compensated
❖ Because of the reciprocal nature of externalities, compensation
would lead to too many people living in harm’s way.
3. Public goods:
A public good is one available to everyone and cannot be denied to anyone
else. The use of the good by one person does not diminish the amount of that
particular good provided to other people. A public good encompasses both
natural and environmental resources. A public good is different from common
property resource in that the use of a common property resource by one
person decreases its availability to other persons. It is generally unprofitable

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for a private party to invest in the provision or enhancement of a public good
because it is not possible to recover costs from the users (free riders).

Classification of goods: there are two ways of classifying goods

i. Rivalry (Non-rivalry) in consumption: this means one person’s
consumption prevents (does not prevent) the benefits from
simultaneously accruing to others.
ii. Excludability (Non-excludability) of non payers: this means that it is
possible (not possible) to exclude certain individuals from consumption
of the good.
✓ Private goods: are rivalry and exclusion of some people is possible
e.g. ice cream
✓ Club goods: partially non-rivalry and exclusion is possible e.g. a
swimming pool, sauna, common property e.t.c
✓ Local public goods: partially non-rival, exclusion not possible e.g.
community police station. Those in the locality can use it; can
exclude those outside the community.
✓ Pure public good: non rivalry and non excludability e.g. National
defence. Except for private goods, the rest do not have properly
defined property rights.
Why do public goods create problems?

1. Free rider problem: rational individuals would rather enjoy the good
free than pay for it because they cannot be excluded from consuming it.
2. Pricing: although different individuals consume the same quantity of the
public good, they will derive different levels of utility from consumption.
Hence the price they can be charged will be different while for private
goods, they are charged the same price.
3. Efficiency: given the property of non-rival and non excludability, the
marginal cost of one more individual consuming the public good is zero.
Therefore any pricing scheme which excludes any individual is
inefficient.
4. Preference revelation/information problem: since voluntary price can’t
be enforced, any price charged can be coercive e.g. a tax and since
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 individuals will be forced to pay, they will not voluntarily reveal their
preference i.e. their demand for a public good. As a result, a planning
agency will not have reliable information to determine the efficient level
of the public good which should be produced. Thus the efficient level of
the public good will not be produced.
Graph:

In private goods, same price is paid for different utilities therefore we have
horizontal summation. For public goods, we have vertical summation.

An example of an environmental public good in biodiversity (variety of life on

earth)

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Assume constant marginal cost of production. The amount that satisfies
person A is 𝑄𝐴 . The amount that satisfies person B is 𝑄𝐵 . If A was alone, he
would choose to provide 𝑄𝐴 to maximize his utility. If B was alone, he would
produce 𝑄𝐵 . But since they are two and A has already provided 𝑄𝐴 , B will
provide 𝑄𝐵 − 𝑄𝐴 . hence total quantity of the public good produced by both A
and B will be 𝑄𝐵 .
What quantity is required to maximize their welfare (social welfare)? This
would be Q where MC intersects the Total demand curve. The result is that
less of the public good is produced compared to the quantity required to
maximize welfare. To get the efficient level Q, government should charge A
and B differently according to their marginal benefits i.e A will be charged 𝑃𝐴
and B will be charged 𝑃𝐴 .The solution will be for government to produce the
quantity Q and charges A a price 𝑃𝐴 and B a price 𝑃𝐵 . In this case the
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government will get just enough revenue to cover the cost of providing the
public good. Revenue from B is O𝑃𝐵 𝐹𝑄, Revenue from A is O𝑃𝐴 𝑇𝑄. Total
Revenue is O𝑃𝐵 𝐹𝑄+ O𝑃𝐴 𝑇𝑄=OPMQ. In conclusion, when a market is left on
its own, the efficient level of a public good will not be provided.
iv) Common Property Resource:

This is a resource with property rights regime that allows for some collective
body to exclude others. They do not have property of exclusivity and
universality. There is a tendency of inefficient use of a common resource
because it has no appropriate rights structure. The basis is on ‘‘Tragedy of the
commons’’. Take an example of grazing land as a common property resource.
Any individual who adds one more cow gets all the benefits in the form of the
cattle added but bears only a fraction of the cost resulting from one more
additional cow. Once the marginal benefit is greater than the marginal cost,
there is an incentive for any additional rancher to add an additional cow. A
rational individual will keep on adding more cattle since MB to him is always
greater than MC. But all other individuals will also find it beneficial to add
more cattle. This eventually results in the destruction of the commons. Here
lies the tragedy.

Open access Resources

Open access resources are not owned by any one thus it is not practical to
exclude others from using them and there is generally no incentive for
individuals to limit his/her use of the resources. An example of open access
resource is the ocean fisheries because no one owns the resource and
therefore over exploitation occurs. The individual fishermen have no legal
entitlements to the section of the ocean e.g. fishing in Lake Victoria. Each
fisherman is more/less free to fish wherever he wishes. The result is part of
competition among fishermen. Good example of an over exploited resource is
the harvesting of whales because the whale products are very valuable and
there are no restrictions on harvest rates. Whale harvesting exceeds rates of

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regeneration as a result certain species of whales have almost been hunted to
extinction.

v) Asymmetric information:
One party in a transaction has some information that the other party does not
have. There are two basic forms of asymmetric information: moral hazard and
adverse selection.
Moral hazard: This occurs when the action of one party cannot be
observed by the second party. Example is insurance. Preferably
insurance companies should set the premium based on a given level of
care. However, once the consumer purchases insurance, there is a
tendency to reduce the level. The result is the offer of less insurance
than optimal. Too little insurance means people are taking more risks
than they would have liked.
Adverse selection: This is when one party cannot identify the correct
type of good or the character of the second person e.g. the market for
lemons (second hand cars). It is the bad car which will find market
because the sellers of the high quality cars cannot give away their cars
at the expected price. The problem is that there is an externality
between the sellers of good cars and the sellers of bad cars. The bad cars
affect the buyer’s perception and therefore the price they are willing to
pay for an average car. An environmental example is eco-products
(products produced in an environmental friendly way). It is very costly
to produce eco-products e.g. eco- tomatoes. The non- eco products will
be selling at lower prices and therefore the eco-products will remain
unsold since prices are higher. This is because of the problem of adverse
selection. The buyer cannot differentiate the eco products from the non -
eco products.

vii) Un-priced resources and absent/thin market

Other causes of market failure are that many natural resources cannot be
priced and as a result they cannot be traded. With a price zero and no market

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to register scarcity it is not surprising that natural resources are depleted at
rapid rates since demand is high and supply is low at zero price.

viii) High transaction costs

High transaction costs discourage otherwise beneficial exchange that would
conserve resources and improve social welfare. Transaction costs include
costs of information, costly negotiations and cost of monitoring and
enforcement.
POLICY FAILURE

The tendency of free market to fail in the allocation and efficient use of natural
resources and environmental resources opens an opportunity and provides a
basis for government intervention. Ideally government intervention aims at
correcting or at least mitigating market failures through taxation, regulation,
private incentives, public projects and macroeconomic management. In
practice however, government policies tend to introduce distortions in the
markets for natural resources rather than correct the existing ones. Thus
natural resources depletion results not only from over reliance on free market
which fails to function efficiently (market failure) but also government
policies that distort (through incentives)in favour of over exploitation and
against conservation of variable scarce resources(policy failure). Policy
failures may be classified into 4 basic types:
1. Distortions of otherwise well functioning markets through taxes,
subsidies, quotas and regulations. Inefficient state enterprises and
public enterprises will allow economic returns and high environmental
impact.
2. Failure to consider and internalize any significant environmental side
effects of otherwise warranted policy intervention example fertilizer
subsidies. These play a useful role in encouraging farmers to adapt new
high yielding crop varieties but have side effects e.g. contamination of
water resources. For example, we could internalize a fertilizer subsidy
as follows, offer subsidy for a short period of time which promotes soil

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 conservation, organic fertilizers and integrated pest management
programmes.
3. Government intervention that aims to correct/mitigate market failure
but ends up generating a worse outcome than a free and failing market
would have produced e.g. if the free market fails to contain
deforestation because forests are open access resources and the
negative externality of deforestation are internalized, a logging bond is
unlikely to be effective because high prices are likely to stimulate illegal
logging.
4. Lack of intervention in failing markets when such intervention is clearly
needed to improve the function of the market. This could be made at a
cost fully justified expected benefits e.g. nationalization of the process
for obtaining land titles (e.g. land tenure) is more than the cost.

Other factors causing environmental degradation in developing countries

1. Institutional failure: This relates to behavior and norms of the society,
religious beliefs, special interest groups etc. it is a combination of
various aspects within the sector e.g. political, social and economic.
2. International trade: Arises because LDCs earn a lot of income from
export of natural resource based products. For these exports, we
generally get low prices compared to industrial goods implying that we
have to produce more and more which leads to destruction of the
environment.
3. Economic growth: This degrades the environment in the absence of
appropriate policies. The World Bank (1990) commissioned a study to
show the relationship between growth and environment. These are
some of the results:
Some environmental problems increase as economic growth
increases e.g. municipal waste percapita, carbon emission
percapita. This is well elaborated using the Environmental
Kuznets Curve(EKC). The Kuznets hypothesis : postulates an
inverted-U-shaped relationship between different p ollutants and p er
capita income, i.e., environmental pressure increases up to a certain
level as income goes up; after that, it decreases

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 Some environmental problems initially worsen but later improve
as economic growth increases e.g. urban concentration of
particulate matter and urban concentration of Sulphur dioxide.
Some environmental problems decline as growth increases e.g.
population with safe drinking water, population with adequate
sanitation.
There are both positive and negative relationships between growth and
environment and therefore all we need to do is maximize the positive
synergies and minimize the negative ones.
4. Population growth

As population increases, more people will be using the same resources.

Evidence suggests that population growth is damaging to the environment,

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however, it is not a direct cost. Hence while population control may be
desirable, it is not a cure for environmental degradation.

5. Poverty
The poor rely very much on natural resources. Majority are farmers using
land. They lack resources to avoid environmental degradation and therefore
are forced to cultivate degraded land. The poor are concerned with day to day
survival so they do not think about sustainability of the environment. Their
rate of time preference is high.
QUESTIONS:

1(a) State Coase’s theorem and explain the main points

(b) Why is a natural forest or wilderness considered a public good and what
problems does it create?
(c) Distinguish between ‘‘Adverse selection’’ and ‘‘Moral hazard’’ as used in
environmental economics

(d) Explain the relationship between poverty and environmental

degradation.
2. Suppose that a wood pulp and a fishery are situated on the bank of
River Nile. The marginal benefit of producing wood pulp to the mill is
given by the function MB=40-2Y. Each tone of wood pulp produces
pollutant flows into the river which affects the fishery. The Marginal
Cost (MC) of producing wood pulp to the victim (fishery) is given by the
function MC=3Y, where Y is tons of pollution produced.

Suppose the pulp mill has the property rights to the river,
a) Draw a diagram illustrating the marginal cost and marginal benefit
curves.(clearly label the graph)
b) What will be the optimal amount of pollution to the pulp mill in a free
market
c) What will be the optimal (efficient)amount of pollution to society

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 d) Suppose the pulp mill accepts to produce the efficient level of pollution
on condition that the fishery pays for each foregone unit of pollution,
will the pulp mill be better off or worse off than when it is polluting at
its initial level?
e) Is the fishery better off paying the pulp mill to reduce
pollution?(explain)
[20 marks]

ENVIRONMENT AND SUSTAINABLE DEVELOPMENT

Sustainable development is that kind of development that meets the needs of
the present generation without compromising the ability of the future
generation to meet their own needs.
Under sustainability, we are mainly concerned with issues of efficiency and
equity, intergeneration and intrageneration. Environmental resources are
considered as a form of natural capital. For sustainable development, we can
make allowance for the natural capital we have used just as we make
depreciation allowance for used up man made capital.

In order to understand the use of environmental economics, it is important to

understand clearly the linkage between environment and sustainable
development. Prior to the 1960’s the models of economic growth focused on
capital and stressed that investment in machinery, factories and
infrastructure were needed if incomes were to be increased. However,
experience indicated that there were limitations to growth. It is for this reason
that environmental revolution shaped the current thinking of sustainable
development. The first revolution was 1960-1970 and was characterized by a
debate on environmental quality versus economic growth. Later 1980’s –
1990’s, the second revolution focused on how growth could be achieved in an
environmentally friendly manner.
There are two concepts to Sustainable development: the weak concept and
the strong concept. The weak concept assumes that man-made capital and
natural capital can be perfectly substituted for one another. This implies that
we can make use of natural capital provided we replace it with an equivalent

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amount of man-made capital. The strong concept assumes that manmade
capital and natural capital are not perfectly substitutable and therefore we
must keep each one constant.

Different Approaches to Sustainable Development.

At the minimum, future generations should be left no worse off than the
current generation. These approaches recognize the limited substitution
possibilities between physical and natural capital.
1. Hartwick-Solow Approach: This implicitly models sustainable
development as a non-declining consumption over time i.e. average
consumption from generation to generation remains constant. They saw
that the problem is that people derive utility from environment, not just
from consumption goods. We can therefore replace non-declining
consumption with non-declining utility. To ensure that utility remains
constant from generation to generation, capital stock should not decline
over time. And to ensure that capital stock does not decline over time, we
must re-invest all Hotelling rents (Hotelling rent is the difference between
the selling price of a resource and its marginal cost of
production/extraction) from non renewable resource extraction into
man-made capital. To ensure that utility does not decline over time, we
must maintain a constant means of production.
2. Non-declining Natural Capital Approach : This assumes that some
substitution is possible but there is also some natural capital for which we
cannot substitute. Hence some amount of natural capital stock must be
kept constant.
3. Safe minimum standard approach: Prevent reduction of natural capital
from going below the safe minimum standard identified for each
component of stock. The standard is set apriori. The difference between
safe minimum standard and non declining natural capital stock is that safe
minimum standard for any resource can be breached if society considers
preservation has created an opportunity cost.
4. Daly’s operational Principles: The principle rules are as follows:
i. Renewable resources: Set the harvest level less or equal to the
population growth rate for some determined population size. e.g.
for fish, the amount of fish caught each year must be less or equal
to the fish growth rate in the river.
ii. Non-renewable resource: Receipts from extraction should be
divided into an income stream and an investment stream. The

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 investment stream should be invested in renewable resources to
generate an identical level of consumption.
iii. Pollution: For degradable materials, maintain discharge of waste
below established assimilation capacities. For non degradable
materials, discharge should be set close to zero.
iv. Control in the use of Resources: There should be minimization in
the use of materials and energy. The use of materials and energy
is bringing more disorder in the economy.
Note: The old view of growth was: Growth= f (𝐾𝑝 ,𝐾𝑓 ) where 𝐾𝑝 is physical
capital and 𝐾𝑟 is financial capital.
Sustainable Development Concept:
Sustainable development= f (𝐾𝑚 ,𝐾𝑛 ,𝐾ℎ ,𝐾𝑖,𝐾𝑒 ) where 𝐾𝑚 is Natural capital, 𝐾𝑛
is man-made capital, 𝐾ℎ is human capital, 𝐾𝑖 is Institutional capital (e.g.
governance), 𝐾𝑒 is Cultural capital. Therefore sustainable development
incorporates economic elements (𝐾𝑓 and 𝐾𝑝 ), Social elements (𝐾ℎ , 𝐾𝑖 and 𝐾𝑒 )
and Ecological elements (𝐾𝑛).
Levels at which we look at sustainability Issues
There are four levels at which we look at sustainability issues:
1. Local level: We look at the firm/industry and its pollution levels and
observe their revenues.
2. National Level: Here we consider things like the lakes, watersheds or an
agro-ecological zone where problems of water pollution and
deforestation and biodiversity loss may be found.
3. Regional level: We look at trans-boundary lakes (e.g. Lake Victoria),
rivers (e.g. river Nile) and water shades where problems are very
similar to those of the national level.
4. Global Level: We look at worldwide impacts e.g. depletion of the ozone
layer, climatic change, air pollution and biodiversity loss.
It is important to look at environmental problems at the different levels:
i. So that we can trace the beneficiaries (benefits) and the losers
(costs) form a given economic activity/policy.
ii. Because the tools used and institutions involved will differ by the
level at which they address these issues.
Achieving Sustainable development through Policy reforms.
Policy reform simply means the restructuring of government intervention
from areas of policy failure to areas of policy success. A comprehensive policy
reform should have five components.

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 1. It should eliminate or at least reduce policy distortions that favour
environmentally unsound practices and at the same time
discriminate against the poor to reduce economic inefficiency and
waste budgetary resources.
2. It should correct or at least mitigate market failure such as
externalities and insecurity of land ownership through a system of
incentives and regulation.
3. It should include investment in human resources and rural industry
so as to provide employment to disadvantaged groups in order to
lessen the pressure on natural resources and their use.
4. It should apply broad social cost analysis by say avoiding projects
that lead to irreversible changes in the environment.
5. They should formulate and implement policies that have
environmental dimensions.
Policy success is government intervention that improves the allocation of
resources and reduces degradation of the environment. Policy success can be
classified into groups:
1. The reduction and eventual elimination of policies that distort well
functioning markets or worsen aspects of market failure such as taxes,
quotas, subsidies and public projects.
2. The correction or mitigation of market failure through intervention that
improve the functioning of the market or results in outcomes that are
superior to those of free markets.
3. Internalization of environmental, social and other environmental effects
of public projects and sectoral and macroeconomic policies.

Principles of Sustainable living

➢ Control population growth especially in environmentally critical areas.
➢ Ensure prices reflect both private and social costs
➢ Reduce reliance on fossil fuels. Burning coal is a health hazard because
they have been formed from organic remains of pre-historic plants and
animals.
➢ Reduce pollution emissions and waste.
➢ Slow rate of deforestation, soil erosion and fishery depletion.
➢ Develop new appropriate “green” technologies.-environmentally
friendly ways e.g. making briquettes instead of wood charcoal.
➢ Keep within the earth’s carrying capacity
➢ Change personal attitudes and practices
➢ Enable communities to care for their own environment.

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Sustainable Development and Economic growth
Sustainable development must benefit both current and future generations. It
is not simply a matter of temporal tradeoff and intergenerational transfers; it
is a matter of cost and efficiency rather than the right and speed of growth.
Sustainable development is not attainable without growth. The ultimate
source of environmental degradation on sustainability is not growth but
policy failure. The costs of economic growth include:
i. Resource depletion – ecological disturbance
ii. Environmental degradation – widening inequalities especially during
the take off stage.
How can the costs of Growth be minimized and fully paid for?
1. They must be borne by those who generate them and not by the general
tax payers, foreign lenders in future generations. The principle that the
polluter of the environment or the one benefiting from the natural
resource pays should be applied. The polluter pay principle?
2. A quest for sustainability can be made into patent force for efficient
productivity, innovation and growth as well as conservation.
3. The best hope is for state/government to eliminate policy induced
distortion of existing markets and to establish the foundation and
institutional arrangements necessary for the emergency of efficient
functioning markets in natural resources and environmental services.

Guidelines for designing projects.

In designing development projects, developing countries can find the
following guidelines useful for pursuing a goal of sustainable development.
1. Projects affecting renewable resources should not result in high rates of
use that exceed the regenerative capacity of these resources e.g.
fisheries project should not lead to over fishing, livestock projects
should not lead to overgrazing, irrigation projects should not lead to
destruction of water shades and agricultural projects should not lead to
ruining of the productivity and fertility of the soil, soil erosion and over
use of pesticides.
2. Projects should not lead to irreversible deterioration of the
environment e.g. they should not cause species extinction or habitat
destruction or loss of biodiversity.
3. Projects should not compromise public health and safety by using
chemicals such as asbestos or producing hazardous wastes.

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 4. No project should displace people or sections of disadvantaged groups
e.g. tribal groups without mitigation and compensation measures.
5. No project should significantly modify areas designated as national
parks or wild heritage sites.
6. Decision makers should balance short term development against long-
term environmental degradation. Short term development often leads
to environmental degradation which constrains long term sustainable
development.
7. 1Projects that protect, restore and enhance environmental benefits and
that are based on extended economic appraisal that fully internalize
these benefits as well as costs should be supported.
Decision makers should include environmental effects in the appraisal of all
public and large private projects by requiring extended economic analysis that
considers a wider set of inputs and output than is traditionally considered.
Financial analysis and commercial narrow economic analysis lead to

1 CDM----Clean Development Mechanism is one of the mechanisms defined

in the Kyoto Protocol (2007) that provides for emission reduction projects
to be set up in developing countries. The Clean Development Mechanism
(CDM), defined in Article 12 of the Protocol, allows a country with an
emission-reduction or emission-limitation commitment under the Kyoto
Protocol (Annex B Party) to implement an emission-reduction project in
developing countries. Such projects can earn saleable Certified Emission
Reduction (CER) credits, each equivalent to one tonne of 𝐶𝑂2 , which can be
counted towards meeting Kyoto targets.

The mechanism is seen by many as a trailblazer. It is the first global,

environmental investment and credit scheme of its kind, providing a
standardized emission offset instrument, CERs.

A CDM project activity might involve, for example, a rural electrification

project using solar panels or the installation of more energy-efficient
boilers.

The mechanism stimulates sustainable development and emission

reductions, while giving industrialized countries some flexibility in how
they meet their emission reduction or limitation targets.

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misallocation of resources when significant environmental impacts are
involved.

QUESTIONS
1. Apollo a student of environmental economics was asked to design a
project that aims at conserving the Crested Crane an endangered
species in Uganda. In light of this what guidelines would he need in
order to achieve his objectives?
2. a) Apollo a student of environmental economics was asked to carry out
a policy reform that aims at conserving the Crested Crane an
endangered species in Uganda. In light of this what components would
he need to include in order to achieve his objectives?
b) Sustainable development can be achieved through policy reforms.
Explain the five components of a comprehensive policy reform.
3. Write short notes on the following;
a) Hartwick-Solow Approach to sustainable development.
b) Explain the Hartwick-Solow Approach and Daly’s operational
principles to sustainable development
4. Explain the meaning of the following concepts:
(a) Environmental valuation and Clean Development Mechanism
(CDM)
5. Differentiate between the ‘‘weak’’ and ‘‘strong’’ concepts of sustainable
development.
RENEWABLE RESOURCES
These have the capacity to regenerate themselves.
The analysis and management of renewable resources can take any of the
following forms:
1. The resource is a private property with limited access i.e has exclusive
rights.
2. Common property with limited access.
3. The resource is common property with unlimited access.
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 4. Market for the natural resource is purely competitive.
Case Study: Fisheries resource
Fisheries resources are important not only because they are sources of
proteins but they also provide an introduction to problems of managing
biological common property resources. Schaefer model is used in analysis of
fisheries resources and it is based on the average relationship between
growth of fish population and the size of the fish population.

Fig 1: Relationship between the Fish population and Growth.

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𝑠−to 𝑠 ∗ : population growth increases as the population increases.
𝑠 ∗ to 𝑠 − : population growth decreases as the population increases.
𝑠 − is the carrying capacity of the fisheries, also known as the natural
equilibrium. It is the population size which would persist in the absence of
outside influences. This is the maximum stock of fish that the lake can hold.
Lakes have a carrying capacity beyond which fish can die. Reductions in the
stock due to mortality or outmigration would be exactly offset by increases in
the stock due to birth, growth of the fish in the remaining stock and in-
migration. This natural equilibrium is a stable equilibrium. If the stock is
above 𝑠 −, the movement will be towards 𝑠 − and growth rate is negative. If the
stock is less than 𝑠 −, the movement will be towards 𝑠 − because growth rate is
positive.

𝑠− is minimum viable population meaning that if you go below 𝑠−, the

population of fish will become extinct. This is the level of population below
which growth in population is negative (death and outmigration exceeds birth
and in-migration). This equilibrium is unstable. Population sizes to the right of
𝑠− lead to positive growth until 𝑠 −. Population sizes to the left of 𝑠− lead to
negative growth which leads to extinction.

𝑆 ∗ is known as the 2maximum sustainable yield population. It is the

population size which yields the maximum growth hence maximum sustained
yield equals maximum growth and it represents the largest catch that can be
perpetually sustained. Sustained yield growth is the growth in the 3biomass
defined by the intersection of growth line with the vertical axis e.g G (𝑆 𝑂 ) is
the sustained yield for population size 𝑆 𝑂. A catch is said to represent
sustainable yield whenever it equals the growth rate of the population since it
can be maintained forever.

2
Maximum sustainable yield is the largest yield(catch)that can be taken from a
species stock over an indefinite period maximum sustainable yield or MSY is
theoretically, the largest yield (or catch) that can be taken from a species' stock
over an indefinite period. Fundamental to the notion of sustainable harvest, the
concept of MSY aims to maintain the population size at the point of maximum
growth rate by harvesting the individuals that would normally be added to the
population, allowing the population to continue to be productive indefinitely.
3
Biomass is the mass of living biological organisms in a given area or ecosystem at
a given time.
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Static efficient sustained yield
Efficiency is associated with maximizing the net benefit from the use of the
resource. Therefore to define efficient allocation, we must include the costs of
harvesting as well as the benefits. Static Efficient sustainable yield is the catch
level which if maintained perpetually, would produce the largest annual net
benefit. Dynamic efficient sustainable yield incorporates discounting.

Assumptions
➢ Price of fish is constant and does not depend on amount sold.
➢ Marginal cost of a unit of fishing is constant.
➢ The amount of fish caught per unit of effort expended is proportional to
the size of fish population. The smaller the population, the fewer the fish
caught per unit of effort.
➢ The catches, population, effort levels and net benefits remain constant
over time.
The static efficient sustainable yield allocation maximizes constant net
benefits.

Fig 2: Efficient sustainable Yield for a fishery

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In figure 2, benefits (Revenue) and costs are portrayed as a function of fishing
effort. Increasing fishing effort results in smaller fish population sizes. As
sustained levels of effort are increased, eventually a point is reached (𝐸 𝑚 )
where further effort reduces the sustained catch and revenue for all years. 𝐸 𝑚
corresponds to the maximum sustained yield which involves identical
population and growth levels. Every effort level portrayed in figure 2
corresponds to a population level in figure 1.
Net benefit is the vertical difference between benefits (Revenue) and costs
(constant marginal cost of effort times the units of effort expended). The
efficient level of effort is 𝐸 𝑒 where the vertical distance between benefits and
costs is maximized. 𝐸 𝑒 is the efficient level of effort because it is where
Marginal Benefit=Marginal Cost i.e point where the slope of the total benefit
curve=slope of the total cost curve. Levels of effort higher than 𝐸 𝑒 are
inefficient because the additional cost associated with them exceeds the value
of the fish obtained.
Qn: Why are levels of effort lower than 𝑬𝒆 inefficient?
Maximum sustained yield would be efficient only if Marginal cost of an
additional effort were zero (why?). The efficient level of effort is less than that
necessary to harvest the maximum sustained yield. Thus the static efficient
level of effort leads to larger fish population than the maximum sustained
yield level of effort.
Qn: What would happen to the static efficient sustainable yield if a
technological change were to occur which lowers the marginal cost of fishing?
Qn: Is the maximum sustained yield synonymous with efficiency?

Limitations of Maximum Sustainable Yield (MSY) approach

➢ MSY is not always easy to apply in practice.
➢ Estimation problems arise due to poor assumptions and lack of reliable
data.
➢ Biologists do not always have enough data to make a clear
determination of the population size and growth rate.
➢ It treats all individuals in the population as identical e.g. age, size,
survival and reproduction.
Exploitation of the fishery by a competitive sole owner
A sole owner would want to maximize his/her profits. The owner can increase
profits by increasing effort until Marginal Revenue=Marginal Cost. This is the
effort level 𝐸 𝑒 which is the static efficient sustainable yield.
Exploitation of the fishery as a common Property or Open Access Resource

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If there are any profits, more people will enter the fishery until profits are
driven to zero. Common property exploitation is inefficient because more
effort than what is required for efficiency is used. Inefficiency arises because
there is an externality i.e each individual fisherman imposes costs on others
which he does not take into account. 𝐸 𝑒 will be the effort of open access or
common property resource.
Fishery Policy
How do we achieve efficiency in open access fisheries?
1. Pigouvian Tax
To achieve efficiency in open access fishery, government should impose
a tax per unit of catch. Such a tax is referred to as Pigouvian tax. This tax
leaves operational decisions such as how much to catch under the
control of individual fishermen. It is opposed by fishermen who suffer
the income effect of a tax and some of the less efficient fishermen may
be eliminated from the industry. This tax increases the total cost of
fishing. However, this policy is considered by some people as improper
because the fishermen are already poor. The problem with Pigouvian
tax is how to determine the appropriate level of tax.
2. Control Methods (Regulations)
➢ Shorter fishing seasons so that total annual effort is reduced
➢ Restrict right to own a fishing boat
➢ Control type of fishing equipment e.g fishing nets
➢ Close designated fishing areas.
These methods lead to a rise in total cost for example if someone was initially
using small fishnets which are cheaper and they are restricted, then the cost
will increase since he has to buy big size nets.
Note: if regulation is successful, stock will begin to rise and therefore harvest
and profits will rise.
3. Individual Quota Allocations:
There is a total number of quotas equivalent to the amount of fish that
the regulatory authority wishes to authorize. The total amount of fish
authorized by the quotas held by all fishermen should be equal to the
efficient catch for the fishery. The quotas entitle the holder to catch a
specified weight of a specified type of fish. The quota should be freely
transferable among fishermen. The transferability of quotas ensures
that fishing is done at minimum cost. If one’s operation is efficient then
he can be able to purchase the quota from another fisherman. It is those
fishermen who have least cost of fishing that will buy the quota. This
ensures efficiency at least cost.

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NON-RENEWABLE RESOURCES

These exhibit no growth or regeneration process. These include fossil fuel

energy supplies-oil, gas and coal-and minerals-copper, and nickel etc. we are
interested in three issues

1. Rate of extraction by firms: what is the rate of extraction by competitive

firms compared to non-competitive firms.
2. The price path of the resource.
3. How quickly the resource is economically exhausted.

Classification of exhaustible resources

1. Current reserves: known reserves that can be profitably extracted at
current prices.
2. Potential reserves: reserves that could be recovered at higher prices
3. Resources endowment: the entire geological supply of resources
including those not yet discovered.
The problem is that scientists and companies are not 100% certain of how
much reserves are in the ground.

Resource Depletion
Extraction involves dynamic decisions. As a resource is extracted, then less
can be extracted in the future. The present and future are tied together.

Cost of extraction

Extraction cost is the cost of removing the resource from the ground,
processing it and transporting it to the market. Producers extract when price
is greater or equal to Marginal Extraction Cost (MEC) e.g if marginal
extraction cost of extracting oil is equal to $60, producers will shut down
production when the price of petroleum drops below $60.

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The owner of a resource has two sources of money for next year:
1. He may decide to sell all the oil now, and invest the profits at interest
rate i,
2. Wait and sell all the oil next year.

The price of the resource has to be greater than the marginal extraction cost
because of the user cost. User cost is defined as the reduction in the Net
Present Value of future earnings caused by increasing present production by
one unit. Simply put, it is the opportunity cost of not having the resource to
sell in the future.
Inter-temporal arbitrage

Case A: Expected price next year rise less than the rate of interest. Here the
owner of the resource is better off selling the oil now and investing it. This
leads to lower prices now (greater supply) and higher prices next year (lower
supply).

Case B: Expected price next year rise faster than the rate of interest: here the
owner of the oil is better off waiting to sell oil next year. This leads to higher
prices now (lower supply) and lower prices next year (higher supply).
By using this arbitrage, the petroleum companies cause petroleum prices to
increase at the rate of interest.
Profit maximization of the firm

For a competitive firm, the minor chooses output where price=marginal

extraction cost + user cost. For a monopolist, market price is higher and thus
market quantity is lower. The miner could earn long run profits called
resource rent. Hotelling rent is profit created by a resource scarcity in a
competitive market, because the resource is fixed in nature. Why the Hotelling
rent? Because Prices keep increasing.

Hotelling’s Rule:

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Hotelling's rule states that the most socially and economically profitable
extraction path of a non-renewable resource is one along which the price of
the resource, determined by the marginal net revenue from the sale of the
resource, increases at the rate of interest. It describes the time path of natural
resource extraction which maximizes the value of the resource stock.

Hotelling’s formal analysis of nonrenewable resource depletion generates

some basic implications for how the finite availability of a nonrenewable
resource affects the resource price and extraction paths.

Hotelling’s rule primarily addresses one basic question of the owner or agent
involved in the exploitation of the non-renewable resource: How much of the
asset should I consume now and how much should I store for the future? In
other words, the agent has to choose between the current value of the asset if
extracted and sold and the future increased value of the asset if left
unexploited. This simple rule can be expressed by the equilibrium situation
representing the optimal solution.

when P(t) is the unit profit at time t and δ is the discount rate (the inverse of
rate of return).

The stock of a non-renewable resource, being an asset, holds a market value

which yields returns to its owner at a certain rate. This rate of return can be
determined by three components:

1. Flow of product generated by the marginal unit of the resource,

Marginal Productivity or Dividend rate.
2. Change in the physical characteristics of the asset over time.
3. The rate at which market value of the asset will change over time.

In year 0 the firm starts extracting a depletable resource. The market price
and quantity are 𝑃∗ and 𝑄 ∗.

In year 1, the firm extracts fewer resources because some of it has been used
up. The supply function decreases, the market price becomes higher and
market quantity is lower.
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Thus price should continuously increase for a depletable resource. The higher
prices represent economic rent due to scarcity.

Marginal Extraction Cost (MEC) should increase over time as the resource is
depleted. This is because the producers will extract the highest quality ores
first. As the high quality ores are depleted, the producers start to mine the less
pure ores. The MEC should increase over time because(i) energy cost may
increase (ii) higher costs to process the metal (iii) may create more toxic
waste.

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Problems with Hotelling Rule:

Hotelling Rule ignores three factors:

1. Technological improvements cause MEC to fall over time
2. Hotellings prices depend on the petroleum reserves being known and
fixed. Petroleum companies do not know the location of all reserves.
They also have strong incentive to explore and drill for new petroleum
reserves when petroleum prices are high.
3. Demand for petroleum can change: as petroleum prices increases,
consumers reduce their demand. They can buy more fuel efficient cars
or even move closer to their work places. Consumers can greatly reduce
their consumption of fossil fuels when market prices are high in the long
run.
Usually mineral and petroleum extraction and energy generation are
dominated by very large corporations. For a monopolist, profits are
maximized at MR=MC. A monopolist conserves natural resources by
extracting less over time than pure competitive markets. The higher market
prices force consumers to conserve more of the resource too.

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Why then are monopolists bad?
1. Little competition limits the options to consumers. You either buy the
product from the monopolist or you go without.
2. Reduced competition results in allocative inefficiency. Allocative
efficiency is when P=MC which implies that only competitive markets
are efficient.
3. Consumers are not able to direct monopolists to serve their interests.
The services are usually bad.
4. Monopoly power may encourage rent seeking behavior i.e government
officials take cash and assets from private companies and people.
5. Companies bribe public officials, then officials grant licenses to those
businesses, restricting competition.

Mineral policy

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Objectives of the mineral policy are optimal exploitation. General revenue and
maintaining environmental standards. How much to tax the extracting
company depends on whether the government is looking for social optimality
or looking for revenue. The basic consensus is that taxes should be different
from the general taxes in the economy because of the special characteristics of
the mineral sector. There should be a judicious use of multiple fiscal
instruments towards achieving the three objectives. We can group the
taxes/levies under three categories:

1. Taxes that are of general type:

Basic income tax: levied as part of the government‘s general tax source.
Import duty: imposed on equipment used in mineral sector
Property tax: levied on land and property charged by local government.
Stamp duty: applicable for mining leases or property transfers.
2. Taxes/levies to claim government’s share as the mineral owner e.g
royalties.
3. Taxes/levies towards achieving environmental objectives e.g royalty
tax/subsidy (profit tax) and revenue tax/subsidy.

Royalty tax/subsidy

A royalty tax or subsidy will have no effect on a resource owner’s extraction

decision for a reserve that is currently being extracted. The tax or subsidy will
alter the present value of the resource being extracted, but there can be no
change in the rate of extraction over time that can affect that decline or
increase in present value. The government will simply collect some of the
mineral rent (or pay some subsidies) and resource extraction and production
will proceed in the same manner as before the tax/subsidy was introduced.

Revenue tax/subsidy
A revenue Subsidy is equivalent to a decrease in extraction cost. A decrease in
extraction costs will lower the initial gross price, increase the rate at which
the gross price increases and shortens the time to complete extraction of the
stock. This leads to inefficiency.
QUESTIONS:
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1(a) Using illustrations, explain what is meant by efficient sustainable yield in
a fisheries resource.

(c) What would happen to the static efficient sustainable yield if a

technological change were to occur which increases the marginal
cost of fishing?
(d) Is the maximum sustained yield synonymous with efficiency?

ENVIRONMENTAL VALUATION
Valuation is a method of determining the relative importance of
environmental consequences of economic activities so as to help
environmental authorities to make informed decisions of natural resource
conservation.
1. It is a reminder that environment is not a free good even in cases where
markets do not exist.
2. It helps in balancing between quantifiable and not quantifiable effects of
costs and benefits.
3. Valuation provides a true indication of economic performance.
4. Quantification of environmental benefits and effects can provide a basis
for policies including better management of environmental resources.

The values of environmental resources

Economic values of environmental resources

Total Economic Value (TEV) =Use Value (UV) +Non Use Value (NUV)
Use Value=Direct Use Value+ Indirect Use Value + Option value
Non Use Value=Existence Value +Bequest Value +Altruistic Value

Use value is the value associated with the consumption of a good. This could
include current use e.g. visiting a park, fuel wood, recreation, expected use e.g.
one expects to visit a park. Examples of direct use value could be fuel wood,
recreation and timber; examples of indirect use value include flood control,
storm protection etc. An example of option value is insurance. Option value is
something you value because you think you will use it in future.

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Non use value is a gain in a person’s utility without the person actually using
the good e.g. you value a good(wilderness) 4 in a certain area not because you
plan to make use of the wilderness but because others may and that makes
someone feel good.

Existence value is the value a consumer attaches knowing something exists

e.g. the African elephant. Altruistic value derives not from my own
consumption but from the fact that I derive benefit when someone gains
utility. So if my neighbor derives benefits from my cleaning my front yard, I
obtain utility from the fact that my neighbor is better off. Bequest value is
similar, though associated with the wellbeing of the descendants. If I value
passing a wilderness area on to the next generation, that wilderness has a
bequest value to me even if I never use it or intend to use it.
Valuation techniques

For a good not traded in the market, its economic value cannot be directly
obtained from the market. Valuation takes two approaches: Reveled
preference and stated preference.

Stated preference methods draw their data from people’s responses to

hypothetical questions rather than from observations of the real world
choices. Revealed preference methods infer the value of a non market good by
studying actual behavior on a closely related market. Examples of the revealed
preference methods are indirect because they do not rely on people’s direct
answers to question about how they would be willing to pay/accept for an
environmental quality change.
Revealed preference Methods

1. Hedonic pricing:
The hedonic pricing method attempts to estimate an implicit price for
environmental attributes by looking at actual markets in which these

4Wilderness refers to natural environment not been significantly modified by

human activity.
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 characteristics are effectively traded. For example, clean air, peace,
quiet environment are effectively traded in property markets since
purchasers of houses and land do not consider environmental
dimensions. Different locations of assets will have different levels of
environmental attributes tend to affect the stream of benefits from such
assets. The variation in attributes results in different property values
and such differences can be taken as a proxy for such an environmental
attribute.
2. Travel cost method
This method uses observed expenditures on travel to the recreational
facilities to estimate the benefits arising from the recreational
experience. This approach is relevant in valuing ecotourism. It can also
be used to value the benefits of forest conservation, forest fuel wood
using travel time. Alternatively, travel time may be used as a proxy for
the value of improved water supply facilities. The travel cost approach
typically uses information on money and time spent by people getting to
the site to estimate the willingness to pay for the site attributes e.g.
beaches. Data for travel cost method is obtained by surveys on the
number of visits to the sites, their places of origin and basic social
economic information such as income, education level, and gender e.t.c
Limitations of the travel cost method:
Users are assumed to get the same total benefits from the use of a
given recreation site/ from the location of source of firewood and
water and that people from different places would make the same
number of visits at given monetary costs.
The travel cost method relies on collecting a considerable amount
of data which are expensive both to collect and organize and it is
difficult to aggregate different people.
The shadow value of opportunity cost (travelers’ time) is difficult
to estimate. The use of wage rate as value of the opportunity cost
born while travelling is difficult especially where trips take place
in leisure hours and involve people not active in formal labour
market (young, old and un-employed).

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 Some trips are multipurpose. It is very expensive because this
requires also data to be collected from several sites.
3. Avertive/preventive expenditures
This method measures people’s valuation of the ecological
functions/services of forests and other habitats by observing how much
people are actually spending to prevent its loss or defend themselves
from the consequences or its loss. E.g. farmers may invest in re-
afforestation, may defend against soil erosion through terracing, against
floods through construction of dykes and drainage systems.
4. Replacement method
Is where environmental services are lost and damages are done but
people attempt to replace/restore the original environmental services
by applying artificial inputs. For example in case of soil erosion, we can
directly observe how much people are spending to replace the lost
environmental services or reallocate themselves to avoid damage from
the loss.
5. Stated preference methods

These refer to any survey-based study in which the respondents are

asked questions that are designed to reveal information about

preferences or values in a hypothetical setting. Examples of the stated

preference methods include: contingent valuation method and choice

experiment.

Choice experiment

In choice experiment, individuals are given a hypothetical setting and asked to

choose their preferred alternatives among several alternatives in a choice set
and usually asked to perform a sequence of such choices.
Contingent Valuation Method

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Contingent Valuation Method (CVM) is a non market valuation method
commonly used to find the economic value of environmental commodities.

It is a method that uses hypothetical survey questions to elicit people’s

preferences for public goods by finding out what they are willing to pay for
specified improvements in them. The idea was first suggested by Ciriacy
Wantrup in 1947. He was of the opinion that prevention of soil erosion
generates extra market benefits that are public goods in nature and therefore
one possible way of estimating these benefits is to elicit the individuals’
willingness to pay (WTP) for these benefits through a survey.
Elicitation Methods in CVM

1. Bidding game: the bidding game is essentially a series of dichotomous

questions starting with the initial lower (higher) bid that nearly all
respondents who have WTP>0 would be (not be) willing to pay. The
respondents would then say ‘‘yes’’ or ‘‘no’’ to the assigned bid, and the
process would continue until the highest positive response is recorded.
It is modeled on an English auction, in which individuals accept or reject
the bid amount and this determines whether they would be willing to
acquire the good at the bid price.
Advantages of the method

It captures the highest price consumers are willing to pay, thereby

measuring full consumer surplus.
It provides relatively better results since it gives a ‘‘market like’’
situation to respondents.

Disadvantages of the method

Cost of implementing the bidding game is higher because it involves the
presence of interviewers during the interview (can’t be used in mail
surveys and self completed questionnaires)
The starting points used in the bidding game may influence the final
value of the stated willingness to pay.

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 2. Payment card method: the payment card approach contains a range of
willingness to pay values (0 to some large amount) of the public good
under question from which the individuals have to choose the maximum
willingness to pay. The question asked is as follows: what amount on the
card is the most that you are willing to pay for the level of the good
being proposed? This approach has the advantage of being able to elicit
the maximum willingness to pay value. The disadvantage of the
approach is that of the range bias.
3. Open-ended: open-ended elicitation technique involves asking the
respondents directly what their maximum willingness to pay amount is
for a public good or service. The question is as follows: what is the
maximum you are willing to pay for good Z?
Advantages of this method
➢ Data gained from open-ended value questions are the simplest to
interpret.
➢ It does not require an interviewer.
➢ Data is used much more frequently.
➢ Absence of starting –point and yea-saying bias.
Disadvantages of this method

➢ The open-ended approach tends to create a large number of non-

responses or protest bids since respondents either find it difficult to
answer or do not have an incentive to provide true answers.
➢ The open-ended questions may attract strategic bias and people may
tell the cost rather than the true value.
4. Closed –ended or referendum Elicitation Format
The closed-ended approach also known as referendum approach is where
respondents are presented with a specific bid amount from a range of
predetermined bids and asked whether they would be willing to pay that
amount. The typical question of a Dichotomous Choice (DC) format is: would
you be willing to pay $X for good Z? (Yes/No). The respondents are required
to respond with a simple ‘‘yes’’ or ‘‘no’’ to the stated bid amount.

Advantages
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 ➢ Referendum approach is preferred because it places respondents
in a relatively familiar social context. In other words, it mimics the
decision making task that individuals face in everyday market
transactions. It is typically viewed as being easier to respond to.
➢ It minimizes strategic bias.
➢ Because only ‘ ‘yes’’ or ‘ ‘no’’ answer is required, dichotomous
choice poses a relatively simple decision for individuals and this
helps in minimizing protest bias and refusals to participate in the
survey.

Disadvantages
➢ Relatively large survey sample sizes are required to precisely
characterize a population’s WTP, which may in turn make the cost of the
CVM study prohibitive.
➢ This approach is also prone to starting point bias.
Biases in Contingent Valuation Methods

1. Embedding / scope effect

Embedding refers to a phenomenon in which a wide range of
variation is found to occur in WTP value for the same good
depending on whether the good is valued on its own or valued as
part of more inclusive package. Embedding occurs if the same good is
assigned a lower value if WTP for a more inclusive good rather than
if the particular good is evaluated on its own.
2. Hypothetical Bias
Hypothetical bias is defined as the potential divergence between the
real and hypothetical payments. Hypothetical bias can arise due to:
a. The respondents in a hypothetical situation may not fully
consider their budget constraint and
b. The goods that are being valued in CVM studies are not
commonly sold on the markets and therefore the
respondents can be uncertain about their true
valuations.
3. Strategic bias
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 Strategic bias occurs when respondents deliberately shape their
answers to influence the study’s outcome in a way that serves their
personal interest. Strategic bias can be classified into two forms; free
riding and over pledging. Free riding occurs if an individual
understates his/her true WTP for a public good on the expectation
that others would pay enough for that good, and therefore, he/she
need not have to pay. On the other hand, over pledging occurs when
an individual assumes that his /her stated WTP value would
influence the provision of the good/service under question, provided
that the stated WTP would not form any basis for future pricing
policy.
4. Information effect
The validity of the CVM results depends mainly on the level and
nature of information provided to the respondents and it affects the
results both positively and negatively. The influence of the additional
information on the WTP value depends on the level of information
possessed by the individuals. Additional information provided in
CVM studies should influence the WTP value if there exists
asymmetric information across individuals.
5. Payment Vehicle Bias
In CVM questionnaires, a payment vehicle is usually specified as a
means of securing an environmental or other outcome. The payment
vehicle is a crucial element in any CVM study because it provides the
context for payment. The payment vehicle affects the way
respondents answer the elicitation question. Respondents’ choice
may depend on when payment is due and the way in which it is
collected. Payment vehicle bias occurs where the payment vehicle is
either misperceived or is itself valued in a way not intended by the
researcher.
6. Starting point bias
While the use of starting point may reduce non-response and
variance in open-ended questionnaires, such ‘‘bidding hints’’ lead
respondents to take cognitive short cuts to arrive at a decision rather
than thinking seriously about their true WTP. Suggestion of an initial

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 starting point in a bidding game can significantly influence the final
bid.
7. Protest bids and bias in Contingent Valuation
Protest bias occurs whenever individuals who oppose or do not
approve of the survey fail to respond, give invalid but positive bids
(outliers) or place a zero value on a good that they actually value.

QUESTIONS:
1 (a) Why is valuation of environmental and natural resources necessary?

(b) Discuss the different components of value of an environmental good

(c) Differentiate between open ended elicitation method and the closed
ended elicitation methods.

2. Explain the Travel cost method as used in environmental valuation and

also state its limitations.

ENVIRONMENTAL POLLUTION

The ability of the environment to absorb pollutants is called absorptive

capacity. If the emission loads exceeds the absorptive capacity, then the
pollutant accumulates in the environment.

Taxonomy of pollutants
Stock pollutant: These are pollutants for which the environment has little or
no absorptive capacity. Examples of stock pollutants include non-
biodegradable bottles thrown by the roadside; heavy metals e.g. lead which
accumulates in the soils near the emission source.
Fund pollutant: Pollutant for which the environment has some absorptive
capacity. So long as the emission rate does not exceed the absorptive capacity
of the environment, the pollutants do no accumulate e.g. carbon dioxide is
absorbed by plant life and the oceans

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Local pollutant: Those for which the damage is experienced near the source of
pollution.

Regional pollutant: Those for which the damage is experienced at a greater

distance from the source of emissions. It is possible for a pollutant to be both
local and regional e.g. sulphur oxides and nitrogen oxides.

Surface pollutant: damage caused by a pollutant is determined mainly by

concentrations of the pollutant near the earth’s surface e.g. water pollutants.
Global pollutants: damage caused by a pollutant is mainly related to
concentration in the upper atmosphere e.g. air pollutant.

Graph of Efficient allocation of pollution

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A movement from right to left refers to greater control and less pollutants
emitted. Points to the left of 𝑄 ∗ (greater degree of control) are inefficient
because the further increase in avoidance costs would exceed the reduction in
damages. Points to the right of 𝑄 ∗ (lower degree of control) would result in a
lower cost of control but the increase in damage costs would be even larger
yielding an increase in total cost. Hence 𝑄 ∗must be efficient. Thus optimal
level of pollution is not zero. Note: in the absence of externality, MB=MSB
Graph of Private producers

For private individuals, optimum pollution level is at 𝑞𝑝 . If there is an

externality, there is an external cost to the society (in addition to the private
costs). The optimal level of pollution from society’s view will be 𝑞𝑠 .
How do we move from 𝒒𝒑 to 𝒒𝒔 ?

Assume the private producer internalizes the external cost. Assume the
amount of pollution is directly proportional to the output. Let the damage of

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the pollutant be represented by D(𝐵𝑞 ) where q is output and B is pollution
emission coefficient.

Without internalization, the problem is

𝑑𝜋
Max π=pq-c(q) where c(q)is private cost. Condition for maximization is =0,
𝑑𝑞
therefore p=𝑐 𝑖(q).

With internalization, the problem is

Max π=Pq-C(q)-D(𝐵𝑞 )

D(𝐵𝑞 )is what the firm is abating =cost of increased pollution

If the private producer takes account of the cost he imposes on the society,
then the optimal amount would be 𝑞𝑠 .
How do we get the firm to internalize the cost?

1. Impose Pigouvian Tax

With a tax, the producer’s problem becomes
Max π=pq-c(q)-tq
P= 𝑐 𝑖(q)+t

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 With this tax, the firm will produce at socially optimal level. The
effectiveness of the Pigouvian tax method depends on knowledge of the
marginal benefits and marginal damage curves.
2. Quantity rationing
Trade-able (market pollution permits)
➢ Specify a predetermined total level of emission concentration
within an area.
➢ Permits equal to the permissible total emissions are distributed
among polluters in the area.
➢ Permits can be traded.
➢ Producers who keep their emission levels below their allowed
permits level can sell or lease the surplus permit.
➢ Total emission level and hence total permits are limited to that
scarcity will create incentive to trade.
3. Liability Rules
Rules set to provide incentives to the firms to reduce the level of
avoidance by raising the cost of misbehavior. Types of liability rules
include:
a. Deposit refund systems: Here purchasers of potentially polluting
products pay a surcharge which is refunded when they return the
product or its container e.g. beverage bottles.
b. Performance bonds: A producer posts a bond before operations
begin. He forfeits the bond if he causes environmental harm or if
he pollutes above acceptable levels.
c. Non compliance fees: if the total ambient concentration exceeds
or is greater than the standard, the regulator imposes a fine.
4. Product charges: these are fees or taxes levied on inputs or outputs that
are potentially hazardous. The objective is to encourage substitution of
safe inputs and outputs e.g. leaded gasoline, batteries and cigarette.
Command and control methods (emission standards)
This has been the traditional approach. Regulators set a legal limit on
the amount of the pollutant an individual source is allowed to emit. The
amount should be set equal to what the regulator deems efficient level
of pollution. Because of lack of information on the efficient levels, the

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 firms are simply commanded to abate by equal amount. The approach is
inefficient because in equilibrium, marginal abatement cost will not be
equal among firms

POLLUTER PAYS PRINCIPLE

In environmental law, the Polluter Pays Principle is enacted to make the

party responsible for producing pollution responsible for paying for the
damage done to the natural environment. It is regarded as a regional custom
because of the strong support it has received in most Organization for
Economic Co-operation and Development (OECD) and European Community
(EC) countries.

The polluter pays principle underpins environmental policy such as an eco-

tax, which, if enacted by government, deters and essentially reduces
greenhouse gas emissions. Some eco-taxes underpinned by the polluter pays
principle include: the Gas Guzzler Tax, in US, Corporate Average Fuel Economy
(CAFE)- a "polluter pays" fine. The U.S. Superfund law requires polluters to
pay for cleanup of hazardous waste sites, when the polluters can be identified.

Polluter pays is also known as Extended Producer Responsibility (EPR).

This is a concept that was probably first described by Thomas Lindhqvist for
the Swedish government in 1990. EPR seeks to shift the responsibility dealing
with waste from governments (and thus, taxpayers and society at large) to the
entities producing it. In effect, it internalized the cost of waste disposal into
the cost of the product, theoretically meaning that the producers will improve
the waste profile of their products, thus decreasing waste and increasing
possibilities for reuse and recycling.

OECD defines EPR as:

A concept where manufacturers and importers of products should bear a

significant degree of responsibility for the environmental impacts of their
products throughout the product life-cycle, including upstream impacts
inherent in the selection of materials for the products, impacts from
manufacturers’ production process itself, and downstream impacts from the
use and disposal of the products. Producers accept their responsibility when
designing their products to minimize life-cycle environmental impacts, and
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when accepting legal, physical or socio-economic responsibility for
environmental impacts that cannot be eliminated by design.

QUESTIONS:

1. Write short notes on the following concepts:

a) Public goods
b) Deposit refund systems
c) Marketable pollution permits
d) Common property resource
e) Polluter pays principle.
f) Pigouvian tax
g) Hedonic pricing as used in environmental valuation
h) Altruistic value and existence value concepts in environmental
valuation.

2. By means of a graph illustrate the efficient allocation of pollution.

END

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