WOLLEGA UNIVERSITY

SCHOOL OFECONOMICS
ECONOMICS PROGRAM

Lecture Note on: Natural Resource and

Environmental Economics

By: Mekonnen Bersisa 

December, 2010


Lecture at Wollega University, School of Economics, Economics program
Lecture Note on: Natural resource and environmental economics

Chapter One
1. Introduction
1.1 Concepts of the resource
What is Environment?
According to Encarta Dictionary:
Environment is
Surrounding influences: all the external factors influencing the life and activities of
people, plants, and animals
Natural world: the natural world, especially when it is regarded as being at risk from the
harmful influences of human activities
Set of conditions: a set of external conditions, especially those affecting a particular
activity (usually in combination)
the home environment
a stimulating learning environment
General definition
Environment: is the surroundings of an organism, including the physical world and other
organisms. Firms and governments are very sensitive to the environment and the impact of
businesses on it. Such an impact can be regularly analyzed in an environmental audit or
environmental impact assessment.
Natural resource and Environmental economics has two parts; viz: Natural resource economics
and Environmental economics.
Natural resource economics is concerned with allocation of resources in the present as well
as in the future, i.e. intertemporal resource allocation.
It also deals with distribution of the outcomes of resource and decisions related to it
What are natural resources?
Natural resources: is a part of the environment considered as a factor of production and able to
be used commercially (forest, natural gas, minerals, fishery, water and etc). They are:
are gifts of nature
living and non-living things

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Lecture Note on: Natural resource and environmental economics

exploited or potentially can be exploited by human beings as a source of food, raw

materials, energy and etc.
Classification of natural resources
Natural resources are classified in two broad categories. These are:
1. non-renewable resources
2. renewable resources
Non-renewable resources are depletable (exhaustible) resources. Their supply cannot be
increased in at least in the short run. They exist as stocks.
E.g. Oil, natural gas, minerals, metals, clay and etc
Renewable resources are non depletable or non exhaustible resources. Their supply can be
increased or decreased with time.
E.g. Forest, wildlife, Rainfall, solar energy and etc

Use dependent Use independent

Their existence is in the form of flows, i.e. no accumulated resources for usage and there is a circular
flow.

Environmental economics is concerned with regulation of pollution activities and valuation of

environmental activities.
Summary
Narrowly defined environmental economics is distinct from its sister discipline natural resource
economics. In their narrow sense:

Environmental economics is concerned with welfare economics, i.e.,

the economics of pollution
valuation theory and Brown issues
environmental policies

Natural resource economics is concerned with optimal utilization of natural resources ( Green issues)
Broadly defined environmental economics is concerned with both Green and Brown issues. Hence, in
the broad sense environmental economics is not distinct from its sister, discipline natural resource
economics.

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Lecture Note on: Natural resource and environmental economics

1.2 Historical development of the subject matter

We now briefly examine the development of resource and environment economics from the
time of industrial revolution in European. Generally the following highlights how the issue of
resource and environmental economics came to vision from early classical writings to
welfare economists.

i. Classical economics
While the emergence of natural resource and environmental economics as a distinct sub-
discipline has been relatively recent event, concerns with the substance of natural resource
and environmental issue has much earlier antecedents. A central interest of classical
economist was the question of what determine standards of living and economic growth.
Natural resource was seen as important determinants of national wealth and its growth.
ii. Neoclassical economics: marginal theory and value
The introduction of natural resource in to neoclassical models of economic growth occurred
in the 1970s, when some neoclassical economists first systematically investigated the
efficient and optimal depletion of resources. This body of work, and the developments that
have followed from it, is natural resource economics.
iii. Welfare economics
The problem of externality and market failure challenged the writings of welfare economists.
The problem of pollution is a major concern of environmental economics. It first attracted
the attention of economists as a particular example of the general class of externalities.
Important early work in the analysis of externalities and market failure is to be found in
Marshal (1890). The first systematic analysis of pollution as an externality is to be found in
Pigou (1920). However, environmental economics did not really ‘take off’ until the 1970s.
The modern sub-disciplines of natural resource economics and environmental economics
have largely distinct roots in the core of modern main stream economics. The former
emerged mainly out of neoclassical growth economics and the latter out of welfare
economics and the study of market failure.

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Lecture Note on: Natural resource and environmental economics

1.3. Economic activity and the environment

Economic activity takes place within, and is part of, the system which is the earth and it
atmosphere.
In economics the environment is viewed as a composite asset that provides a variety of
services. It is a very special asset, to be sure, since it provides the life support systems that
sustain our very existence, but it is an asset nonetheless. It provides the following services for
the economy.
It provides the economy with raw materials, which are transformed in to
consumers’ products by the production process, and energy, which fuel this
transformation.
It absorb waste products from the economy or serve as sink of wastes/ residuals of
production and consumption, i.e. the raw materials and energy used in the
production process return to the environment as waste products.
The environment also provides services directly to the consumers. The air we
breathe, the nourishment we receive from food and drink and the protection we
drive from shelter and clothing are all the benefits we receive either directly or
indirectly from the environment.
It provides us aesthetic values. The environment provides us with varieties of
amenities for which no substitute exists (recreational service etc).

NB: If the environment is defined broadly enough, the relationship between the
environment and the economic system can be considered as a closed system. For our
purpose, a closed system is one in which no inputs (energy, matter and so on) are received
outside of the system and no outputs are transferred outside the system. An open system, by
contrary, is one in which the system imports and exports matters or energy.

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 Lecture Note on: Natural resource and environmental economics

Fig. 1.1 the Economic system and the environment

THE ENVIRONMENT

AIR
ENERGY POLLUTION
Firms SOLID WASTE
AIR (Production)

THE ECONOMY Output

Inputs s

WASTE
Households HEAT
WATER
(Consumption)
WATER
POLLUTION
AMENITIES

RAW
MATERIALS
.4. The prospect
The knowledge of the relationship between the environment and the economy help us to design
an appropriate policy that prevents undue depreciation of the value of these special assets, the
environment, so that it may continue to provide aesthetic and life sustaining services.
In line with this fact, modern ecologists have the stand point saying that the environment
possesses a unique “carrying capacity” to support humans, and once that capacity is exceeded
widespread ecological destruction occurs with disastrous consequence for humanity. The focus is
no longer on individual societies but on the survival of the planet.
For several decades economists have been concerned with topics such as exhaustible resource
and pollution, but during the last decades it has become a researchable area. As a consequence,
we have come to better understand the relationship between humanity and the environment and
how that relationship affects, and is affected by economic and political institutions.
With regard to the relationship between natural and environmental resources and economic
activities there are two view points (prospects). These are Optimistic view point and Pessimistic
view point which are discussed briefly as under.

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Lecture Note on: Natural resource and environmental economics

1. The Basic pessimist model

One end of the spectrum is defined by an ambitious study published in 1972 under the title “The
limit to Growth”. Based on techniques known as System dynamics a large scale computer model
was constructed to simulate likely future outcome of the world economy. The most prominent
feature of system dynamics is the use of feedback loops to explain behavior. The feedback loop
is a closed path that connects an action to its effect on the surrounding conditions, which in turn,
can influence further actions.
The model concluded that:
With in a time span of less than 100 years with no major changes in the physical,
economic or social relationship that have traditionally govern world development,
society will run out of the non-renewable resources on which the industrial base
depends. This implies when the resources have been depleted, a precipitous collapse of
the economic system will result, manifested in massive unemployment, decreased food
production, and a decline in population as death rate soars. There is no smooth
transition, no gradual slowing down of activity; rather, the economic system consumes
successively larger amount of the depletable resources until they are gone. The
characteristic behavior of the system is overshoot and collapse. (See fig. 1.2 below)
Piecemeal approaches to solving the individual problem will not be successful. The
authors suggested that if the depletable resource and pollution problem were somehow
jointly solved population would grow unabated and the availability of food would
become the binding constraint. In this model the removal of one limit merely causes the
system to bump subsequent in to another one, usually with more dire consequence.
Overshoot and collapse can be avoided only by an immediate limit on population and
pollution, as well as a cessation of economic growth. The portrait pointed shows only
two possible outcomes: the termination of growth by self-restraint and conscious
policy- an approach that avoids the collapse or the termination of growth by a collision
with the natural limits, resulting in societal collapse. Thus, according to this study, one
way or the other, growth will cease. The only issue is whether the conditions under
which it will cease will be congenial or hostile.

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Lecture Note on: Natural resource and environmental economics

Figure 1.2 the Limits- to- Growth Standard Run (State of the world model)

Resource
Population

Food
per
capita Pollution

Industrial
output
per capita

1900 Time 2100

NB: The model relied heavily on exponential growth patterns and feedback effects. Exponential
growth occurs when population, economic production, resource use, or pollution increases by a
certain percentage each year. Feedback effects occur when two variables interact, for example,
when capital accumulation increases economic output, which in turn leads to a more rapid
accumulation of capital. Positive feedback effects strengthen growth trends, whereas negative
feedback effects moderate them. Negative feedback effects, however, may be undesirable, for
example, when limits on food supply cause population decline through malnutrition and disease.
Exponential growth in population, industrial output, and food demand generate declines in
resources and increasing pollution, which force a catastrophic reversal of growth by the mid-
twenty-first century. The report also emphasized that aggressive policies to moderate population
growth, resource consumption, and pollution could avoid this disastrous result, leading instead to
a smooth transition to global economic and ecological stability. This conclusion received far less
attention than the catastrophic predictions. The report was widely criticized for failing to

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Lecture Note on: Natural resource and environmental economics

recognize the flexibility and adaptability of the economic system and for overstating the danger
of resource exhaustion.
2. The Basic Optimistic Model
As a reply for the limits to growth model, Herman Khan and his associate presented an
alternative vision in a book titled The Next 20 years: A Scenario for America and the world. This
vision is an optimistic one based in large part on the continuing evolution of a form of
technological progress that serves to push back the natural limits until they are no longer
limiting. For the most part, the optimists placed faith in future technological progress to tap new
sources of energy, overcome any resource limitations, and control pollution problems.
The model concluded that:
The future path of population growth is expected by Khan and his associates to
approximate an S-shaped logistic curve. (See figure 1.3 below)
Fig. 1.3 the Khan perspective on prospective of Humanity (in fixed 1975 dollars)

2176:
15 million people
$300 trillion GNP
1976: $20,000 per capita
4.1 billion People
$3.5 trillion GNP
$1300 per capita

1776:
750 million people
$150 billion GNP
$200 per capita

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Lecture Note on: Natural resource and environmental economics

Chapter Two
2. Environment and some developmental issues
2.1 Introduction
In earlier 1950’s and 1960’s the main emphasis was on economic growth and the environment.
E.g. the increase in per capita income. There was no concept of environment. In the late 1960’s
and 1970’s the concept of development was established such as health, nutrition, education and
freedom but environment was not included.
Around 1980’s environment issues were considered as development issues. This is very good
reason. The good must be scarce, utility and market too become economic goods. But the
environment goods didn’t have such like economic good.
For a long period of time development economics ignores the issues of environment. This is
partly because of the special futures of the environmental goods. For a good to be considered as
economic good, it must be marketable, i.e. tradable. It must be related with scarcity. However,
because of the problem of market failure natural resources were not considered as economic
good.
Hence even in the 1950’s and 1960’s environmental and natural resources were considered as
free goods. Because of this a number of problems have arise on free goods.
Forms of Environmental Degradation
There are various environmental degradations. This are:
Rapid deforestation
Air pollution
Land degradation
Excessive soil erosion
Fuel, wood and water shortage
Water shade degradation These and the like undermine the
Over grazing effort of economic development

Over fishing
Loss of bio diversity

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Water contamination
Urban congestion
In the late 1960’s and 1970’s concepts of environmental degradation began in industrialized
countries and was extended to less developed countries by the 1980’s.
Regardless of the economics status of countries and their geographical location, currently all
countries in the world is in sever environmental problem. But the degree of the problem may
vary from country to country depending on geographical location and economic status. But do
developed countries and developing countries face the same environmental problem?
The main concerns of developing countries are:
Deforestation (inadequate forest)
Water contamination (unsafe water)
Over fishing
Soil depletion
Indoor smoke (burning fire woods)
Outdoor smoke (pollution)
The main concerns of developed countries are:
Global warming
Air pollution
Depletion of ozone layer
Global warming which is related to carbon dioxide emition, depletion of ozone layer, acid rain
and hazardous waste materials. Most of environmental problems are linked with economic
growth. The reason environmental problems differ so substantially between less and more
developed countries result few if any forms of environmental degradation and to remain constant
with economic growth, i.e. only few economic growth remains constant.
The environmental problems of less and more developed countries are ofcourse not completely
independent of each other. If the CO2 emitions that come primarily from rich countries are
causing green house warming which affects less developed countries.
Loss of Biodiversity due to destruction of tropical rain forests in less developed countries is a
problem for more developed countries as well.

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Lecture Note on: Natural resource and environmental economics

Industrialized countries need to solve their own problems but they also have their crucial role to
play in helping to improve the environmental of developing countries.
1. Developing countries need to have access to less polluting technologies and to learn from
the success and failures of industrialized countries on environmental policies.
2. Some of the benefit from the environmental policies in developing countries (e.g. the
protection of tropical forests and biodiversity) accrue to rich countries which act,
therefore to bear on equivalent part of the costs.
3. Some of the benefits from the environmental problems facing developing countries
(particularly global warming and ozone depletion) steam from high consumption levels in
rich countries. Thus the burden of finding and implementing solutions should be on the
rich countries.
4. The strong and growing evidence of the links between poverty reduction and
environmental goals makes a compelling case for greater support for programmes to
reduce poverty and population growth.
5. The capacity of developing countries to enjoy sustainable economic growth will depend
on industrial countries economic policies.

2.2 Poverty and the Environment

There is a strong link between poverty and environmental degradation. Environmental
degradation cause poverty and poverty also causes environmental degradation. It has an
effect on health, productivity, water pollution. It results in water pollution and shortage of
potable water. Similarly for health part air pollution is witnessed to result in death, illness
and poor hygiene.
Summary of relationship between poverty and the environment
Problems Health Productivity
Air pollution - death, illness, poor hygiene - decrease fisheries, increase
life span
- Premature death - to search for it
- Child hood chronic
- coughing
Soil degradation - decrease nutrient for poor family - decrease land
productivity

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Lecture Note on: Natural resource and environmental economics

Deforestation - localized flood death - decrease ecosystem

adaptability

2.3 Population and the environment

Human population and economic activity have remained fairly stable during much of recorded
history. Prior to the Industrial Revolution of the nineteenth century, Europe’s population grew
slowly and standards of living changed little. The advent of the market economy and rapid
technological progress altered this pattern dramatically. Populations in Europe entered a period
of rapid growth that led British classical economist. As Thomas Malthus to theorize that
populations would outgrow food supplies, keeping the mass of people perpetually at a
subsistence standard of living. Malthus’s Essay on the Principle of Population as It Affects the
Future Improvement of Society, published in 1798, and initiated a long and continuing debate on
the impact of population growth. History has proved the simple Malthusian hypothesis wrong:
both population and living standards in Europe rose rapidly throughout the two centuries
following Malthus’s Essay. But if we consider a more sophisticated argument, that a growing
human population and economic system will eventually outrun its bio- physical support systems,
the debate turns out to have strong current relevance. The controversy over population growth is
intimately intertwined with resource and environmental issues. In the twenty-first century these
issues, rather than the simple race between population and food supply, will strongly affect the
course of economic development. It is unlikely that we will see major shortfalls in food supply
on a global scale. But it is highly likely that the environmental stresses associated with a growing
population and rising resource demands will require sweeping changes in the nature of economic
systems.
Certainly a focus on productive capacity alone is insufficient. Resource and environmental
factors, as well as issues of equity, will be central in responding to the challenge of feeding much
larger populations with limited resources. As a consequence of rapid population growth the
demand for land to a larger extent increases. Pressure on land increases and the productivity
of land will be unquestionably decreased.
In addition to agricultural land requirements, expanding populations require more space for
urban, residential, and industrial development. These needs will tend to encroach on farmland,
forests, and natural ecosystems. This population pressure on land is acute in countries such as
India (794 people per square mile) or Bangladesh (2,320 people per square mile). In less densely

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Lecture Note on: Natural resource and environmental economics

populated areas such as the United States (74 people per square mile), land use remains a central
environmental issue, with ever-increasing pressure from suburban developments on farmland and
natural areas, and continual conflict between large scale agriculture or forestry and wilderness
preservation.

Population pressure worsens environmental degradation. There are two views on this stand.
a. Increased population leads to rise in food and increased demand for arable land
b. Population increase leads to increased physical waste materials.
Policy to control population pressure
1. Access to family planning should be encouraged
2. Educate people to benefit from having low households
3. legal law that specifies the minimum age for marriage
4. Economic incentive and disincentive

2.4 Economic growth and the environment

Factors Essential to Economic Growth
Before showing the link between economic growth and the environment, let us briefly attempt to
answer the following question.
What determinants of increased productivity make steady growth possible?
One is accumulation of capital. Indeed, investment allows growth of capital stock over time: as
capital stock per worker increases, the productivity of each worker increases. On top of this,
technological innovation raises the productivity of both capital and labor. Standard economic
growth models place no limits on this process. Provided investment continues at adequate rates,
productivity and per capita consumption can continue rising far into the future.
Besides these, the ecological economics perspective focuses on three additional factors as
essential to economic growth.
i. Energy supply:
Europe’s economic growth in the nineteenth century depended heavily on coal as an energy
source, and some writers at the time expressed concern that coal supplies might run out. In
the twentieth century, oil displaced coal as the prime energy source for industry. Currently

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Lecture Note on: Natural resource and environmental economics

oil, natural gas, and coal provide more than 85 percent of energy supplies for the United
States, Europe, Japan, and other industrial economies, and about the same proportion of
industrial energy for the world as a whole. To a great extent, economic growth both in
agriculture and industry has been a process of substituting fossil fuel energy for human
labor. This substitution has important resource and environmental implications, which in
turn affect projections of future growth.
ii. Supply of Land and Natural Resources (Natural Capital)
Almost all economic activities require some land use. As these activities grow, pressures
increase to convert land from a natural state to agricultural, industrial, and residential uses.
Some uses conflict: housing may compete with farming for rural land, and industry or road
building may make land less suitable for either residential or agricultural use. Land, of course,
is fixed in supply. Except in limited cases such as the dike areas of the Netherlands, human
technology cannot create more land. Natural resources vary in abundance, but mineral
resources and the regenerative capacity of forests and other living resources have physical
limits.
iii. Absorptive capacity of the environment for the waste products of industrial
development
This issue is not so critical when the scale of economic activity is small relative to
the environment. But as national and global economic activity accelerates the flow of
waste products increases and may threaten to overwhelm environmental systems.
Flows of solid wastes, sewage and liquid wastes, toxic and radioactive wastes, and
atmospheric emissions all pose specific environmental problems that require local,
regional, and global solutions. On top of this economic growth inevitably results in a
number of consequences, of which the followings are some.
a. Dwindling Resources
Worldwide pressure on renewable resources such as forests and fisheries has become
increasingly evident. Over-harvesting of renewable resources has caused serious
environmental losses. World forest cover has declined, with particularly rapid loss of tropical
forest during the past several decades. After many years of steady increase, global fish catch
appears close to a maximum, with major fisheries now in decline. Exploitation of natural
resources is also causing an increasing rate of species loss, posing unknown ecological hazards

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Lecture Note on: Natural resource and environmental economics

and diminishing the natural “inheritance” of future generations. Clearly, these pressures will only
increase with rising demands for food, fuel, wood products, and fiber. Economic theory offers an
explanation for the over-harvesting phenomenon. Prescribing solutions is more difficult. Such
prescriptions will certainly require a conceptual shift from regarding forests and fisheries as
unrestricted open-access resources to perceiving them as part of a global commons1. Future
economic development cannot simply take advantage of “free” resources such as undeveloped
land and open oceans, but must be adjusted to ecological limits. In some cases, private property
rights can create incentives for individual owners to conserve resources. Other situations require
the development of effective regional or global common-property management policies.

b. Pollution
Economic growth also brings the problem of growing volumes of cumulative pollutants
(pollutants that neither dissipate nor degrade significantly over time) and of toxic and nuclear
wastes. Controls on emissions, the traditional focus of pollution policy, are of limited use in
dealing with these more insidious problems. When we deal with cumulative pollutants such as
chlorofluorocarbons (CFCs), organochlorides such as DDT, or radioactive wastes, we must
grapple with the legacy of all previous pollution and waste production as well as consider how
our present activities will affect the future environment. This greatly complicates any economic
evaluation of costs and benefits.
Air and water pollutants that are not cumulative can be controlled through specific regulatory
policies. But economic growth often leads to an increased volume of such pollutants.
In general, some of environmental problems decline with economic growth. E.g. sanitations, lack
of safe water, urban congestion etc while others keep on increasing up to a point with economic
growth.

1
“Commons” refers to resources not privately owned but managed for the social good

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Lecture Note on: Natural resource and environmental economics

Environmental
Problems

PCI

Some problems initially worsen but then improve as income rises. E.g. most forms of air
pollution and water pollution

EKC= environmental
Kuznet curve
Environmental
degradation

PCI

EKC is a curve which shows the relationship between PCI and environmental degradation. It
shows at the initial stage of increase in PCI environmental problem gets worsen and after some
point of growth the problem will decline. This relationship can be explained from optimism and
pessimist as follows:
Optimist- argue that pollution initially increase because at the early stage of economic growth
they worry to increase their PCI and do not worry about the environment. They always worry to
become industrialized and to sustain life but at certain point they tried to think about fresh air,
entertainment and conserving wild life. They tried to think about to become worth for their
environment. This makes the curve to slope down.

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Pessimist- according to pessimist view there is no real argument. None of the environmental
problems are inevitable and static. They contend the persistency of environmental problem of the
world.

2.5 Sustainable development and Economic policies

In 1987 the World Commission for Environment and Development (WCED) prepared a
document entitled Our Common Future, also known as the Brundtland Report, after the
coordinator of the commission, Gro Harlem Brundtland. It was the first occasion on which the
concept of sustainable development was introduced. Its definition says in a few words the
following: sustainable development is development that meets the needs of the present without
compromising the ability of future generations to meet their own needs (WCED, 1987).
Evidently this definition does not speak about the environment per se, but refers to the well-
being of people as an environmental quality. From this originates a fundamental ethical
principle: the responsibility of present generations to future generations.

An Ecological Approach to Economic Growth and the Environment

In reviewing these major environmental and resource challenges of the twenty-first century, we
should not necessarily lean toward either an “optimistic” or “pessimistic” perspective. While
analysts differ greatly regarding appropriate responses, few dispute the importance of global
environment and resource issues. As we will see, both the market-oriented approaches stressing
economic system adaptability and the ecological assessment of biophysical problems have
important roles to play in devising policy responses.
Although in each case specific policies may address individual problems, the issues together
suggest a common need for a different kind of economic analysis, one that addresses a global
economy in which resource and environmental considerations are much more prominent than in
the past.
Rather than approaching environmental questions as an afterthought once we have dealt with the
basic economic issues of production, employment, and output growth, our concept of economics
must consider the environment as fundamental to the productive process. Of course, economic
production has always depended on the environment, but the scale of economic activity makes a

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difference. So long as human activity remained on a small scale relative to the ecosystem, we
could do with an economic theory that analyzed production and consumption without regard to
their environmental impacts. Now that economic production produces such widespread
environmental effects, it is essential to integrate our views of economics and environment. If we
adopt a broader perspective, we must adapt the goals of economic activity themselves to
ecological realities. Traditionally, the main goals of economic activity have been seen as
increased production and rising per capita consumption. But in the many ways as presented
above, these goals pose a threat to the environmental sustainability of our economic system.
The effort to balance economic and environmental goals is addressed in the theory of
sustainable development—economic development that provides for human needs without
undermining global ecosystems and depleting essential resources. Sustainable Development
Recall that the standard view of economic growth is defined in terms of per capita GDP,
meaning that total GDP must raise faster than population. Sustainable development requires
different measures. Increased output of goods and services can certainly be part of the desired
outcome, but equally important is the maintenance of the ecological base of the economy—
fertile soils, natural ecosystems, forests, fisheries, and water systems. Even so, sustainable
development means more than simply a different yardstick. It also implies a different analysis of
the process of production and consumption.

Sustainable Development versus Standard Views of Economic Growth

On the production side, it is important to differentiate between renewable and nonrenewable
resources. Every economy must use some nonrenewable resources, but sustainable development
implies conservation or recycling of these resources and greater reliance on renewable. On the
consumption side, an important distinction must be drawn between wants and needs. In contrast
to the standard economic paradigm, in which “dollar votes” command the market place and
determine which goods are to be produced, sustainable development implies putting a priority on
supplying basic needs before luxury goods. Also in contrast to standard economic growth theory,
sustainability implies limits to macroeconomic scale. Rather than projecting rates of growth
indefinitely into the future, some maximum level is postulated based on the carrying capacity of
the area (and ultimately of the planet). This in turn implies a maximum level of population above

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Lecture Note on: Natural resource and environmental economics

which carrying capacity—the level of population and consumption that can be sustained by the
available natural resource base—will be exceeded and living standards must fall.

Population and Sustainable Development

This introduction of population as a key variable in determining the limits of economic growth
has implications for both developing and currently industrialized economies. For developing
economies with rapid population growth rates, it means that limiting population growth is a
critical element in successful development.
For industrialized economies, the role of population is different. In much of Europe and in Japan,
population has stabilized, and for countries such as Germany and Russia concern has shifted to
an emerging pattern of population decline. In the United States, however, population increase
continues to put pressure on both national and global ecosystems. Although the U.S. population
growth rate is less dramatic than that in many developing nations (0.6 percent per annum as
opposed to 2–3 percent in much of Latin America, Africa, and Asia), the much larger U.S. per
capita consumption means that each additional U.S. resident creates several times the additional
resource demand of, for example, an additional resident of India. This means that population
policy must be an essential element of sustainable development.
Population policy must include elements of education, social policy, economic policy, and health
care, including contraceptive availability, and often runs into conflict with established religious
and social mores. Still, this difficult area, generally little considered in standard economic
development models, is crucial for sustainability.

Energy and Sustainable Development

A similar issue arises as to whether renewable energy sources (including solar energy) have
the capacity to replace fossil fuel dependence. The challenge is a daunting one, because
renewables now supply less than 10 percent of energy in the industrialized nations. The picture is
different in developing nations, where a large portion of current energy supply comes from
biomass (wood, plant, and animal wastes). Efficient use of biomass and maintenance of forest
resources can thus play an important role in energy policy. Technological advances in solar,
wind, and biomass energy systems have lowered the prices of these renewable sources, and their
potential for future expansion is significant both in developed and developing nations.

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Lecture Note on: Natural resource and environmental economics

A huge, often unrecognized, potential lies in conservation and improved efficiency—by some
estimates the developed world could reduce its energy use by about 30 percent through these
techniques with little or no effect on living standards.
The traditional emphasis on energy supply augmentation (such as building new power plants)
could thus give way to a focus on demand-side management (increasing efficiency and
reducing energy consumption). Because the industrialized nations now account for three-quarters
of global energy use (though only one-quarter of global population), increased energy
consumption in developing nations could possibly be offset by reductions in rich nation energy
use. Negotiations over global climate policy suggest that such a tradeoff may be essential to
reduce overall human impacts on the world’s climate.

Objectives of sustainable development

1. Economic objective:-promoting growth and efficiency e.g. income redistribution,
employment, targeted assistance, increase of PCI of poor and decrease uncompensated
future cost
2. Social Objectives:- fulfilling people’s cultural, material, and spiritual needs in equitable
manner (e.g. popular participation, consultation, pluralism)
3. Environmental objectives:- maintaining and improving long term validity of the
ecosystem

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Lecture Note on: Natural resource and environmental economics

In general sustainable development has the role of balancing between:

 Human needs and capacity of the environment
 Poor and rich
 Present and future generation

Types of sustainable development

We have got two arguments of sustainable development based on the substitutability of different
forms of capital. Viz: Weak and Strong sustainable development.
1. Weak sustainable development
In the weak sustainable development the sum of capital asset must be constant. K = Km + Kn+
Kh where K is total capital stock which is assumed to be constant, Km = man made capital, Kh
= human capital and Kn = natural capital.
As to weak sustainable development if the decrease of one is sustained by the increase in the
other it is sustainable development.
The overall stock of capital assets (Km + Kh + Kn) should remain constant overtime. Reduce
in one form of capital asset may be tolerated as long as there is an increase in the other form of
capital asset that offset the other reduces.

2. Strong sustainable development

Some forms of capital asset must be constant overtime. Strong sustainability argues that
sustainability requires that the level of natural capital (Kn) be non-declining. There should be
lack of inversibility in Kn (constant Kn).
Pre-requisite for sustainable development
1. Respect for people
2. respect for the ecosystem:- for the development to be sustainable it must improve the
quality of life for a long time

better nutrition

Adequate health

Social freedom
It must protect the diversity, the structure and action of the natural environment

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Lecture Note on: Natural resource and environmental economics

Signs of unsustainable development

1. Poverty- a billions of population lives under absolute poverty. The level of poverty is
getting most horrible overtime
2. Increasing world population and consumption of resources: - the world population
increased from 4.4 billion in 1940 to 5.6 in 1970 and to 6.2 billion in 2000.
3. Resource depletion: - in less than 200 years, the planet has lost 6 million km2 of forests.
4. Pollution:- an increase in industrialization leads to an increase in pollution which in turn
leads to increase in cancer in developed countries
5. Global climate change: - because of depletion of Ozone layer the world temperature has
been increasing; rain fall decreases by 20% to 40% and world temperature has increased
from 0.4% to 0.8%.

2.6. Macroeconomics and the environment

National income Accounting Practice and Macro-economic performance
System of National Account (SNA): is an aggregate GDP/GNP
The major limitation of GDP
a. double counting
b. it doesn’t account for informal sector or black economies, none marketed
assets
c. it doesn’t account for the service to be provided by the natural resources

fell its forest

erase its wild life
Illusion

loss of fertile land by erosion

loss of some species by polluting the water

Development that ignores this environmental factor is an illusionary development. Expenditure

is more harmful. GDP indicates welfare only partially. Thus contemporary the issue of green
accounting comes to vision to circumvent this problem. This means:

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Lecture Note on: Natural resource and environmental economics

Green accounting incorporates environmental assets and their source and sinks functions
into national and corporate accounts.
It is the popular term for environmental and natural resource accounting.
Conventional national accounts largely ignore:
New or newly observed scarcities of natural resources, which threaten to undermine the
sustainability of economic performance and growth, and
Environmental degradation as an ‘external’ (social) cost of economic activity
Further critique refers to a possible distortion from counting environmental protection
expenditures as an increase in national income, despite the fact that such ‘defensive
expenditure’ tends to maintain, rather than increase, the welfare of society.
In response, the United Nations issued in 1993 and revised in 2003 a handbook on a
System for integrated Environmental and Economic Accounting (SEEA).
Thus in response to this the national income account can be computed by making
adjustment in the form of:
1. Physical Resource Accounting Approach (PRA)
Adjustment in physical terms using some physical indicators
Deforestation:- 2Km2 per years
Soil degradation in Ethiopia 3.5 million tone fertile soils is lost by erosion per year.
2. Monetary Accounting
Aggregate values for losses and gains computed and obtain environmentally adjusted GDP
(EDP)
NDP = GDP – Dmc (depreciation of manmade capital)
EDP = GDP – Dmc – Dnc (depreciation of natural capital)
Such adjustment of GDP for natural resource depletion and environmental degradation is known
as “Green National Accounting”.
Genuine Saving
Net saving = gross saving – Dmc
Genuine saving = Gs – Dmc – Dnc
Those who are largely depends on natural resources will have low Genuine saving. If there is
low genuine saving there is no sustainable development.

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Lecture Note on: Natural resource and environmental economics

2.7. Policy for development and the environment

1. Win-win policy
It is a policy that increases economic efficiency. It is the policy that improves the economic
efficiency and the environment. It improves the gain of both current and future generation.
This can be achieved by
i. Correcting (preventing) policy failure: - e.g. elimination of subsidy in chemical
fertilizers
ii. By improving access to resource and technology:- e.g. providing property right
(decrease over grazing, decrease over fishing);
Introduce less polluting technology
It is a policy related to poverty reduction
It results in social distribution
It is not only as attacking poverty as a moral imperative but also as
environmental protector
Win-win policies may be in the form of:
i. Investment in human capital
ii. Investment in a better sanitation and water
iii. Improves research and extensions but, these policies are not enough. Thus there should
be alternative
2. Forgotten policies
We have to live more on the market and less on the government but in the case of public
goods market fails to allocate resources properly.
Environmental aspect which needs high government intervention may result in temporarily
loss of income but may result in permanent (sustainable) gain in future income.
The world has learned over the past decades to relay more on market and less on government
to promote development. But environmental protection is one area in which government
must maintain a central role. This is basically emanates from the fact that the government
cares the environment than private sector. Here there may be a tradeoff between income loss
and environmental protection, requiring a careful assessment of both the benefit and costs of
alternative policies as they affect both today’s population and future generation.

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Lecture Note on: Natural resource and environmental economics

Example
Change the behavior of polluters
Protect the environment
Forgotten policies include
Policies based on incentive:- taxation based on the level of pollution released by a
farmers, subsidies for less polluting technologies
Policies based on quantitative restrictions: setting emission standard

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Lecture Note on: Natural resource and environmental economics

Chapter three
3. Efficiency, Property right, market failures and the
environment
3.1 Efficiency
The concept of efficiency was developed by Vilfered Pareto. It is called Pareto efficiency (Pareto
optimal).
Pareto optimality states that “a situation is efficient or a Pareto optimal if it is impossible to make
one person better-off without making someone else worse off.
Pareto inefficiency or pareto improvement is a situation where it is possible to make at least one
individual better-off without making someone else worse-off.
Why efficiency is needed?
a. Resources are scares (limited quantity)
b. The complex environmental system that provides numerous benefit

Static efficiency: optimum allocation of

resource in a given period of time
Efficiency

Dynamic efficiency: an optimum allocation of

resources over a period of time. It is an
allocation of resource between generations
(intertemporal allocation of resources)

Pareto efficiency (SE) requires the fulfillment of the underneath three assumptions
Two goods (X, Y)
Two inputs (L, K)
Two individuals (A, B)
1. Efficiency in consumption: all individuals face the same relative values on margin
from all goods consumed. i.e.

MUx A = MUx B

MUy MUy

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Lecture Note on: Natural resource and environmental economics

Y OB

IB4
C D

IA1
IB3
B Edge worth
box
IA2
IB2

X
A
Z IB1 Contract curve

IA3
IA4

OA

NB: Efficiency in consumption lies on the contract curve.

2. Efficiency in production
It requires the equalization of marginal productivity of inputs in similar products. This requires
the marginal rate of substitution between factors be the same in all industries.
x y
 MpL   MpL 
    
 Mpk   Mpk 

 MRTS LK    MRTS LK   ( MRsxy ) A  ( MRsxy ) B

x y

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Lecture Note on: Natural resource and environmental economics

Graphically efficiency in production can be represented as

K
Iy1 Oy

Iy2
Ix4
Ix3
Iy3

Ix2
Iy4 L

Ix1

Ox K

3. Efficiency in production mix

This requires subjective values of X in terms of Y should be equal to its marginal cost. i.e

Mcx Mpx Mu x Mpk y

  
Mc y Mp y Mu y Mpk x
X

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Lecture Note on: Natural resource and environmental economics

Social welfare function and optimality

All efficient configurations may not constitute a social optimum. To obtain a social optimum we
need a utility frontier of the economy known as Grand Utility Frontier and a social welfare
function. To get grand utility function (GUF) we will take each feasible output mix from the
transformation curve and construct its utility frontier. This process gives a family of utility
frontier and the overall utility frontier is the outer envelope of all these frontiers.

Utility frontier of (x,y)

X Grand Utility function (GUF) of Optimal points

Y
The social welfare function can be written as

W = w (UA, UB) this function relates social welfare to individuals’ utility.

UB

Iso- welfare curve (IWC)

at different level of utility
of individuals A and B.

UA

W
U A
The slope of IWC is given as: Slope of IWC= W
U B

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Lecture Note on: Natural resource and environmental economics

To obtain the social optimum point (constrained or bliss point) we use the social welfare function
to peak the preferred utility mix as depicted by the following graph.
UB
Constrained or blessing point

Grand utility function

Iso-welfare function

UA
Similarly dynamic efficiency or intertemporal economic efficiency and optimality can be
represented as shown by the underneath graph.
UG1

ISC3

ISC2
Intertemporal utility possibility frontier (IUPF)
ISC1

UG2
Intertemporal optimum can be represented mathematically as: W = w (UG1, UG2)
On top of this, there are different approaches to measure the optimum social welfare, viz:
1. Rawlsian social welfare
This approach attempts to maximize the minimum of the function.
W = min(UG1, UG2)
Example W = min(10, 15)  W = 10
2. Utilitarian Social function
This method of measuring social welfare attaches weights to utility of each individual or
generation and take the average.
W = 1UG1 + 2UG2, where  represents weights attached to current and future generations.

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Lecture Note on: Natural resource and environmental economics

Does market economy lead to efficiency? Yes, but it requires the fulfillment of many
conditions. These assumptions are:
1. There must be market for all goods and services
2. No externality
3. No public goods
4. Absence of transportation cost
5. The existence of perfect information
6. Absence of government intervention in the system
7. All resources must have value
Efficiency, dynamic and static, is the maximization of net benefit.
Static efficiency aims at maximizing net benefit, which is the difference between total benefit
and total cost. This happens when the first order condition is satisfied, i.e.

NB TB TC

0  0
Q Q Q
MB  MC  0  MB  MC

Dynamic efficiency on the other hands maximizes net benefit over time, i.e. maximizes

NB1 ---------- for two time periods

TNB  NBo 
(1  r )1
NB1 NB2 NBn ---------- in the case of time period run to n.
TNB  NBo    ... 
(1  r )1 (1  r ) 2 (1  r ) n

How do measure benefits and costs?

The traditional method of measuring the cost and benefit is measurement based on their effect on
humanity. This approach is known as anthropocentric- human centered.
Benefits are derived from the demand curve.
P
Consumer surplus

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Lecture Note on: Natural resource and environmental economics

Q
Points on the demand curve show the individuals willingness to pay for different quantity. An
area under the demand curve shows individuals total willingness to pay for a given amount of
goods. Total benefit is directly measured from total willingness to pay.
Cost
The cost of environmental goods is measured by their opportunity cost which means the second
best alternative of using that resource.
MC is equal to the supply in the perfectly competitive market. TC is the summation of MC.

MC (SS Curve)
A B P

MC2
E MC1 MC2 C
D Q1 Q2 Q3 Quantity demanded

Area ABCD is total revenue where as EBCD is total cost. Hence the producer’s surplus is area
(ABE).
Any decision is said to be justified iff the net benefit is maximized, i.e. the sum of Producer
surplus (PS) and Consumer surplus (CS) is maximized.
P

PS +CS
MC (SS curve)

MR = dd curve

Q
Allocation is said to be efficient iff the total net benefit is maximized. The implication of the
above analysis is what initially called the first equi-marginal principle.
“The first equi-marginal principle (the efficiency equi-marginal principle) says that net benefits
are maximized when the marginal benefits from an allocation equal the marginal costs”

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Lecture Note on: Natural resource and environmental economics

In dynamic efficiency we should consider costs and benefits of the present and future generation.
How do we calculate this? It is analyzed from the concept of present value which discounts the
future values. Present value of one time net benefit received n years from now is given by:

Bn
PvBn 
(1  r ) n
The process of finding the present value is called discounting with discount rate (r). The net
present value of a stream of net benefits {Bo,B1,…,Bn} received over a period n years is
computed as:

n
Bi
NPV  Bo , B1 ,..., Bn   
i 0 (1  r ) i

Example if the time period is say two (i=2)

B1
NPV  Bo 
(1  r )1
An allocation of resource across n time period satisfies the dynamic efficiency criteria iff it
maximizes the present value of net benefits that could received from all the possible ways of
allocation of those resources over n periods.
The simple mathematics of dynamic efficiency assumes that the resources under consideration
are depletable resources with linear and stable demand function.

Pt  a  bqt 1 where t stand for time period

Total benefit of using the resource is the integration of the demand curve. Total benefits from
extracting an amount qt in year t are the integral of this function.
qt
  0
( a  bqt )dq 2
(Total benefit)  b 2 
  aqt  q t 3
 2 

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Lecture Note on: Natural resource and environmental economics

Further assume that the marginal cost of extracting the resource is constant (C), and therefore,
the total cost of extracting qt is:
(Total cost)t = Cqt --------------------------------------------------------------------------- 4
Net benefit is the difference between total benefit and total cost. If the total available amount of
these resource is Q , then the dynamic allocation of a resource over n years is the one which
satisfies the maximization problem, i.e.
b
n aqt 

Maximize
 ( (1 
i 1 r)
2 q 2  cq )
i 1 t t

n
s.t .Q  q
i 1
i 5

From the objective function and the constraint form the composite function using the Lagrangian
multiplier, i.e.

bqt 2
n aqt   cqt  n

 2    Q   qi 6
i 1 (1  r )i 1  i 1 

At the maximum the first order conditions must be satisfied. That is the partial derivative of the
composite function with qi and λ must be zero.

 a  bqi  c
0   0 7
qi (1  r )i 1
 a  bq1  c
   0
q1 (1  r ) 0
 a  bq2  c
   0
q2 (1  r )1

 n
 Q   qi 8
 i 1

Equation (7) and (8) are called necessary conditions.

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Lecture Note on: Natural resource and environmental economics

If the reserve is greater than what is demanded by every generation, there is no need for
maximization.

Illustration
Let the inverse demand function for the depletable resource is Pt = 8 – 0.4qt and the marginal
cost of supplying it is $2.
a) If 20 units are to be allocated between two periods, in a dynamic efficient allocation how
much would be allocated to the first period and how much to the second period when the
discount rate is 0.1.
Soln
Given

Q  q1  q2  20
qt

TB   (8  0.4q
0
t ) dq

TB  8qt  0.2qt 2 , TC  2qt

NB  TB  TC
8qt  0.2qt 2  2qt
NB 
(1  r ) i 1

Using equation (7), we obtain

8  0.4q1  2    0 9
8  0.4q2  2
  0 10
(1  r )1

20  q1  q2  0 11

From the above equation (10) q1 + q2 =20, solving for q2 we get q2= 20 – q1 .Moreover
rearranging equation (9) and (10) we get

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Lecture Note on: Natural resource and environmental economics

8 – 0.4q1- 2 = λ
8 – 0.4q2- 2 = λ
(1.1)
1.1(8 -0.4q1 - 2) = 8 -0.4q2 – 2
 8.8 – 0.44q1 – 2.2 = 6 -0.4q2
 6.6 – 0.44q1 = 6 – 0.4q2
 6.6 – 0.44q1 = 6 – 0.4(20 –q1)
 6.6 – 0.44q1 =6 -8 + 0.4q1
 8.6 = 0.84q1
 q1 = 8.6 = 10.238
0.84
q2 = 20-q1  q2 = 20 -10.238 = 9.762

λ= 6 – 0.4(q1) = 6 – 0.4 (10.238) = 1.905

PVNB in each periods are equal to each other.
b) What would the efficient price be in the two periods?
Soln
Pt = 8 – 0.4qt , thus
P1= 8 – 0.4 (10.238) = 3.9
P2 = 8 – 0.4(9.762) = 4.1
c) What would the marginal user cost be in each period?
The value of λ obtained from equation (9) and (10) is the present value of marginal user
cost. That is λ = 1.905
In the case of natural resource (depletable) price is equal to the MC plus marginal user
cost.
d) Check that PVMNB1= PVMNB2
PVMNB1 = 8 – 0.4(10.238) – 2 = 1.905
PVMNB2 = 8 - 0.4(9.762) – 2 = 1.905
1.1

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Lecture Note on: Natural resource and environmental economics

What does marginal user cost measures?

Marginal user cost measures the opportunity cost of producing an extra unit of the
resource against the future generation.
MUC = PVMNB = λ
Social marginal cost is the sum of marginal extraction cost and marginal user cost.
SMC = MEC + MUC
e) From the above equation compute MBs and MCs of each generation
MB1 = 8 – 0.4(10.238) = 3.905
MB2 = 8 – 0.4(9.762) = 4.095
MC1 = $2 + $1.905 = 3.905
MC2 = $2 + $2.095 = 4.095
To compute the present value divide for the discount rate (1 + r)i-1

3.2. Market failure

Definition
Market failure is the system where the market conditions do not reflect the true social values. It
is the condition in which the prices do not reflect the true costs and benefits. This is basically
because of the
Existence of monopoly power
Existence of externality
Existence of public goods
Existence of common property

3.3. Environmental externalities

In the case of perfectly competitive market the costs and benefits of producing and consuming is
reflected by demand and supply. An externality occurs whenever welfare of an individual
depends not only on his/her activity but also on the activity of some other individuals. The
implication is that the utility of an individual depends not only on his or her but also on the
activity of others.
It occurs when the utility of one individuals affects the utility of some other individuals and
hence do not compensate.

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Lecture Note on: Natural resource and environmental economics

Externality occurs when market price do not reflect the social value.
Distinction between social and private value
Private costs: the cost that is born in undertaking an activity by the individual (agent)
who undertakes the activity.
Social costs: all other costs related to the production of some activity. It includes
private costs and other associated costs. It is costs born to undertake the activity plus
costs imposed on all other economic agents.
Private benefits: benefits obtained from production or realization of an activity by
economic agents undertaking the activity.
Social benefits: are benefits obtained from production of an activity by economic
agents undertaking the activity plus benefits to all other economic agents.
Thus externality will exist only if
SC > PC or SB > PB
Types of Externality
1. Negative externality: it is the cost that the producer and consumer of that
commodity do not take in to account. It is a cost of resource not reflected in price of
the resource. It causes additional costs to other members of the society that the
consumer and producers of a good will not take in to account. In case of negative
externality social cost exceeds the private. SC = PC + EC, e.g. pollution, noise
2. Positive externality: all benefits are not reflected in the price. Additional benefit to
the society that the producers do not take in to account. SB > PB
e.g. education: if the individual educated, it has benefit to him/herself, the society
will be beneficial to the benefit.
Example of Negative Externality

River
Still factory
Hotel

Pollution

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Lecture Note on: Natural resource and environmental economics

Example of Positive Externality

Benefits Beekeeper
Flower
cultivation

Pollination

3. Pecuniary externality (pseudo externality): we cannot call it purely externality (no

market failure)
When one individual’s activity level affect the financial circumstance of other but
which need not produce a miss allocation of resource in a world of pure competition.
For example, if farmers migrate to certain farmland, the financial capacity of the
existing farmers is affected but this is reflected in the increasing in rent of land
which shows scarcity of land.
4. Unidirectional externality
Occurs when externality are in one direction/unilateral. The case where the activity the
activity of individual A affects B but that of B do not affect A.
5. Reciprocal externality
It occurs when externalities are bilateral. The case when the activity of individual A affects that
of individual B and vice versa. Example: Acid rain in industrialized countries affects both DCs
and LDCs.
6. Technological externality
This type of externality exists when at least one of the variables in the production or utility
function of one agent falls under the control of an external economic agent.
i.e. U1 = U(X, Y)
U2 = U(X, Y2, Y)
Externality and Economic efficiency
In case of perfectly competitive market, MC = MB and thus there is efficiency, but in the
presence of externality MPC ≠MSC and MPB ≠ MSB.
When there external benefits: unregulated market would under produce the desired quantity of a
given good. Qs > QM, MSB > MPB

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Lecture Note on: Natural resource and environmental economics

Price
MEs Dead weight loss due to externality (welfare loss)
Ps

Pm

MSB

MPB

Qm Qs Education

Where Qs indicates social optimum output

Qm indicates market optimum output

When there are negative externality

 unregulated market would over produce the undesired quantity of a given good.

Price MSC
MPC

Ps

Pm

MB

Qs Qm Pollution

Summary of the impact externality on the market system

Negative Externality Positive externality

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Lecture Note on: Natural resource and environmental economics

Quantity produced Too much costs greater than Too little benefits, less than
Costs/ Benefits the socially optimum socially optimum
Stimulus to innovation Little incentive to reduce Little incentive to expand
social costs social benefits

3.4. Property Right

Definition
Property right is a bundle of entitlement that defines the right, privileges and limitations
to use a resource. In a free market structure a property right brings efficiency in
production, distribution and consumption of goods and services.

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Lecture Note on: Natural resource and environmental economics

Chapter Five
5. The Economics of Pollution Control and environmental policy
5.1. Why is pollution an example of market failure? (Taxonomy of pollution)
Pollution is a side effect of production. Pollution is defined as the introduction of waste and
harmful products in to an environment that is classed as undesirable. Let us use the example of
so-called greenhouse gases. Assume that a company engages in production and in doing so it
generates waste products that escape into the atmosphere. These waste products could be in the
form of carbon dioxide. Carbon dioxide contributes to the buildup of greenhouse gases. The
build-up of greenhouse gases traps ultra-violet radiation from the sun within Earth's atmosphere.
This causes the average temperatures to rise and has effects such as melting polar ice caps. As
these ice caps melt, sea levels rise and weather patterns can be affected. The resultant increase in
extreme weather conditions can affect people in all sorts of ways. The increase in flooding,
storms, tornados and drought that results might affect millions of people around the world.
It should be noted that there are those who would dispute the links between greenhouse gases
and global warming. However, let us assume, for the sake of this analysis that carbon dioxide
emissions do translate to global warming and the extremes of weather we hear about.

The effects on the residents who suffered from the pollution represent a cost to them. To the
business that is generating carbon dioxide, this cost is not considered as part of their private
costs. It is a cost borne to people in society at large.

Now, let us further assume that there were 10 residents whose houses were badly damaged. The
cost to each resident was £60,000. That represents a total cost to them of £600,000. This is a cost
(we are assuming) that is a direct result of Firm X's output of carbon dioxide but which they do
not take into consideration. This is the social cost. Such case is generally represented as on the
following diagram.

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Lecture Note on: Natural resource and environmental economics

The supply curve is upward sloping as usual and represents the marginal cost of production. This
is also the private cost of generating output. The true cost of generating each unit of output,
however, ought to take into consideration the cost imposed on society. For each unit of output
the true cost would be larger than the private cost. This would be represented by a supply curve
positioned to the left of the MPC curve as shown. If we look at output level OQ2, the private cost
of this output is shown as £250,000 but the true cost is shown as £300,000. This is reflected
throughout the output range.

The demand curve represents the sum of the benefits received by consumers from production.
We use money as a means of measuring the value of these benefits. The total benefit of
consuming OQ2 units is shown as the area under the demand curve as shown below.

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Lecture Note on: Natural resource and environmental economics

The demand curve slopes down from left to right because each additional unit consumed
represents a slightly lower level of utility than the previous one (the marginal utility). As a result,
consumers are willing to pay less to consume more units since they confer lower levels of utility.
The total value of the benefits however does not take into consideration the fact that consumers
have to pay a price to gain those benefits. We need, therefore to subtract the value of the sum
paid from these benefits to get the net benefit from consumption. This is shown by the shallowly
shaded area in the diagram below. This is the area of consumer surplus.

If we look at the area of consumer surplus when private costs are considered only, we can see
that the consumption of OQ2 units is associated with a consumer surplus equal to the value of
the triangle x y z. The area of producer surplus is shown by the area abc.

Let us now compare this to the situation when we take into account the social costs. The
consumption of OQ2 units is now associated with a higher cost. If the market price was the

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Lecture Note on: Natural resource and environmental economics

intersection of the demand curve and the MSC curve the price paid by consumers would be
higher - reflecting the true cost of production. The area of consumer surplus, therefore, would
now be less than before. The area of producer surplus would now be a 1b1c1. What this
demonstrates is that the market has failed. It has failed because price did not provide the right
signals for both producers and consumers.

What this led to was overproduction of this particular good. If the market price had been a more
accurate reflection of the costs and benefits of production and consumption then there would
have been less produced and the price would have been higher. Going back to our scenario, if
company X had factored in the social cost into their production then they would have produced
less, generated less carbon dioxide and the pollution would not have been so devastating. The
less devastating pollution would have had less of an impact on the homes of the residents and
their costs for repair would have been lower.

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Lecture Note on: Natural resource and environmental economics

This concluding analysis does, of course, require a leap of faith to really come to terms with.
However, it does illustrate the basic concept. People all over the world are being affected by the
external costs of production. We are consuming items at a price lower than it should be and as a
result are consuming amounts that we would not if price were higher and we were made more
aware of the true costs. Equally producers would behave differently if they had to factor in the
true costs of production into their decision making.

5.2. Efficient allocation of pollution

The solution is relatively simple in theory but more difficult to implement in practice. What
needs to happen is that price needs to be more reflective of the true costs and benefits of
production. Both producers and consumers need to be more aware of the relative costs and
benefits of production. The main way of solving the problem of pollution is to make businesses
that generate the pollution take account of it in their costs. If they do so they will produce less
and also have incentives to change their behavior to find ways of cutting the pollution or
producing without generating pollution. In some cases, it could be that a business will look to
find ways of recycling or using the waste product and gaining some form of competitive
advantage that might generate future profit.

For consumers, it is a case of making them recognize that the price they pay is a more accurate
reflection of the true benefits from consumption and that over consumption might be associated
with negative externalities. We might feel we are getting a good deal out of consumption and the
price is such that we are tempted to buy it. However, if we, as consumers, are not fully aware of
the costs that our consumption is creating then price is not accurately reflecting the value of the
benefits - because they are not, ultimately, benefits!

A higher price might make consumers think more carefully before buying the product concerned.
It helps send a signal about the value of the product. The problem in many cases with market
failure is that consumers want cheaper prices but are very concerned by issues like global
warming. As consumers we are not always prepared to pay for production and for protecting the
things we might hold dear!

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Lecture Note on: Natural resource and environmental economics

The main way of trying to deal with pollution is through taxation, some form of pollution permit
(carbon trading permits for example) or through some form of pricing policy that makes
consumers more aware of the true costs of consumption such as road pricing. Road pricing's
main target is to try and reduce congestion but if car use falls as a result there will also be
reductions in the amount of pollution emitted from vehicles.
The ideal level of pollution is the level at which the marginal costs to society of polluting equal
the marginal benefits to society that come from polluters producing goods and services. Without
some degree of regulation, corporations will not take all marginal social costs into account, and
will thus produce at a level that is excessively damaging to the environment.
Putting in other words, the efficient (optimal) level of pollution control occurs where the
marginal abatement cost is equal to the marginal damage cost due to pollution.
i.e. MAC = MDC

Definition
The marginal abatement cost (MAC) is the cost of abatement or controlling an extra unit
of pollution. It is also known as the marginal control

cost.
Cost of pollution

MAC

Pollution
There is a negative relationship between MAC and the quantity of pollution. The higher
the MAC, the lower will be the quantity of pollution and vice versa.

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Lecture Note on: Natural resource and environmental economics

The marginal damage cost (MDC) is the health or environmental damage caused by an
extra unit of pollution. It is also known as the marginal pollution cost.
Cost of pollution

MDC

P relationship
There is a positive Quantitybetween
of pollution
MDC and the quantity of pollution. The higher
the MDC, the higher will be the quantity of pollution and vice versa.
Graphically, the MDC does not start at zero, but at positive amount of pollution because
of the ability the environment to assimilate certain pollution without any danger. Thus
point p indicates ecologists’ optimum point.
Optimum pollution level
As we indicated earlier optimum pollution occurs where the marginal abatement cost is
equal to the marginal damage cost due to pollution. This is depicted by the following
graph.

MAC MDC
of tax
Amount
money
Extra

spent

Qp

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Lecture Note on: Natural resource and environmental economics

O P A Q* B Qk (capitalists optimum)

To achieve maximum economic efficiency, the government should allow pollution up to the
point where marginal benefits equal marginal costs, as shown by the intersection of the two
curves above. Of course, these are only theoretical curves, and are difficult to derive in real life.
Drawing a line straight down from this intersection point leads to the level of allowable pollution
that maximizes economic efficiency, Q*. This is the optimal level of pollution.

If the allowable level was left of that point, polluters would lose less than society would gain, but
this net gain could be taken further. If we move to the right of the optimal level, the costs to
polluters would outweigh the gains to society. As the level of pollution prevented goes up,
meaning that you move to the right in the graph, the marginal cost increases. This is because
eliminating small to medium amounts of pollution may be relatively easy, but total elimination
of pollution may cost considerably more. Also, those companies that have great difficulty in
reducing pollution, and incur great costs in removing it, will be forced to reduce pollution so that
the economy can achieve extremely high levels of pollution prevented.

5.3. Environmental policy instruments

Free market transactions are usually unregulated in the sense that there is no mechanism for
charging polluters a fee to correct for the damage done by their emissions. Once society has
decided on an acceptable level of environmental quality, it is necessary to adopt measures that
will change the behavior of producers and consumers. This could be achieved through
government intervention, by setting command and control regulations and market-based
incentives.

For example, air pollution episodes in major cities across the United States, led to the United
States government to the establishment of strong emission standards for industry and
automobiles. The Clean Air Act of 1970 empowered the federal government to set emission
standards that each state was required to enforce. The Clean Air Act was revised in 1977 and in
1990 to include incentives to encourage companies to lower emissions of chemicals responsible
for the production of acid rain. The Act today identifies 189 pollutants for regulation.

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Similarly, by early 1970s water pollution had reached crisis proportions in the United States.
Congress responded in 1972 by passing the Clean Water Act, whose main objective was "to
restore and maintain the chemical, physical and biological integrity of the Nation’s waters." "In
order to achieve this objective it is hereby declared that, consistent with the provisions of this
Act —

1. it is the national goal that the discharge of pollutants into the navigable waters be
eliminated by 1985;
2. it is the national goal that wherever attainable, an interim goal of water quality which
provides for the protection and propagation of fish, shellfish, and wildlife, and provides for
recreation in and on the water be achieved by July 1, 1983;
3. it is the national policy that the discharge of toxic pollutants in toxic amounts be
prohibited."

It should be noted that in the case of air and water pollution, the damage is done because they
are open access resources, i.e., no-one owns them, and there is no individual incentive to
restrict pollution. This is why the phenomenon of global climate change has come about, which
has motivated governments to act.

Regulatory and Incentive-based Policies

The techniques used by regulatory agencies, such as the Environmental Protection Agency
(EPA), to control pollution range from charges for the right to pollute to regulations that impose
limits to the amount of a pollutant. Among these are the following:

1. Emission Charges

Emission Charges are prices established for the right to emit a unit of a pollutant.

Example: In the United Sates industrial polluters pay effluent fees for the right to dump waste
in municipal water treatment plants.

Advantage: Directly internalizes a negative externality by pricing the use of the environment to
dispose of waste.

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2. Emission Standards

Limits established by government on the annual amounts and kinds of pollutants that can be
emitted into the air or water by producers or users of certain products.

Example:

EPA places limits on the number of grams/mile of hydrocarbons, nitrogen dioxide and carbon
monoxide emitted per automobile. The automobile industry satisfies these standards by
equipping cars with catalytic converters. In turn, this device raises the cost of cars.

Disadvantages:

- Allow emission of less than the standard free of charge

- Firms are restricted in the method of compliance
- Does not take into account differences among firms
- Does not take into account differences among regions

3. Command and Control Regulation

A system or rule that requires the use of specific pollution control devices on certain sources of
pollution or applies strict emission standards to specific emitters

Example: All newly produced automobiles are required to have catalytic converters to meet
EPA emission standards.

Disadvantages:

- All emitters are treated equal

- Provides no incentive for emitters to seek less expensive ways of reducing emissions
- Provides no incentive to reduce emissions more than the required amount

4. Pollution Rights

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Lecture Note on: Natural resource and environmental economics

A government issued permit allowing a firm to emit a specified quantity of polluting waste.

Example: Michigan's Air Emissions Trading Program

Advantages:

- Pollution permits are tradable at free market prices

- Regulatory authorities can control the amount of pollution by limiting the number of
certificates
- Provides a choice: purchase permits and pollute or reduce pollution and save the cost of permits
- Provides an incentive to reduce emissions in order to sell previously purchased pollution rights
Disadvantage:

- A firm in a much polluted region is allowed to buy emission permits from a firm in a region
where there is no pollution.

Failure of Government Intervention and alternatives

Although there are good reasons for government to intervene, they are often no better at
managing natural resources than the free market. Some of the reasons for this are:

1. They may favor the interests of some part of the community rather than the community as
a whole. If government acts to please some particular pressure group, it may not act to
protect the environment, especially if environmental protection would impose costs on
members of a particularly powerful pressure group.
2. Governments are not very good at obtaining the right information about the full
consequences of a particular action. This is mostly true because of the tendency of
governments to compartmentalize issues.
3. They may have problems translating good intentions into practice because of lack of
competence among the government bureaucracy.

An alternative to government intervention is proposed by Coase (1960), who argues in favor of

market bargaining underpinned by appropriate property rights in order to achieve the social
optimum of pollution. Given the existence of an appropriate property rights system (guaranteed

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ownership of resources via the force of law), Coase argued that polluter and those affected by
pollution should be left to bargain in an unregulated situation. The Coase theorem states that
regardless of who holds the property rights, there is an automatic tendency to approach the social
optimum via bargaining. If this analysis is correct, then government regulation of externalities is
redundant, the market will take care of itself, with bargaining representing an efficient process.
Coase’s approach also has its disadvantages and limitations. In reality, a combination of a
property right system, regulations and economic incentives may be the best approach to
protect the environment.

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Lecture Note on: Natural resource and environmental economics

Chapter six
6. Valuation of environmental resources
6.1 Concepts of Economic value

Economic value is one of many possible ways to define and measure value. Although other types
of value are often important, economic values are useful to consider when making economic
choices – choices that involve tradeoffs in allocating resources.

Measures of economic value are based on what people want – their preferences. Economists
generally assume that individuals, not the government, are the best judges of what they want.
Thus, the theory of economic valuation is based on individual preferences and choices. People
express their preferences through the choices and tradeoffs that they make, given certain
constraints, such as those on income or available time.

The economic value of a particular item, or good, for example a loaf of bread, is measured by the
maximum amount of other things that a person is willing to give up to have that loaf of bread. If
we simplify our example “economy” so that the person only has two goods to choose from,
bread and pasta, the value of a loaf of bread would be measured by the most pasta that the person
is willing to give up to have one more loaf of bread.

Thus, economic value is measured by the most someone is willing to give up in other goods and
services in order to obtain a good, service, or state of the world. In a market economy, dollars
(or birr) are a universally accepted measure of economic value, because the number of dollars
that a person is willing to pay for something tells how much of all other goods and services they
are willing to give up to get that item. This is often referred to as “willingness to pay”
In general, when the price of a good increases, people will purchase less of that good. This is
referred to as the law of demand—people demand less of something when it is more expensive
(assuming prices of other goods and peoples’ incomes have not changed). By relating the
quantity demanded and the price of a good, we can estimate the demand function for that good.
From this, we can draw the demand curve, the graphical representation of the demand function.

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It is often incorrectly assumed that a good’s market price measures its economic value.
However, the market price only tells us the minimum amount that people who buy the good are
willing to pay for it. When people purchase a marketed good, they compare the amount they
would be willing to pay for that good with its market price. They will only purchase the good if
their willingness to pay is equal to or greater than the price. Many people are actually willing to
pay more than the market price for a good, and thus their values exceed the market price.

The economic benefit to individuals is often measured by consumer surplus. This is graphically
represented by the area under the demand curve for a good, above its price.

The economic benefit to individuals, or consumer surplus, received from a good will change if
its price or quality changes. For example, if the price of good increases, but people’s willingness
to pay remains the same, the benefit received (maximum willingness to pay minus price) will be
less than before. If the quality of a good increases, but price remains the same, people’s
willingness to pay may increase and thus the benefit received will also increase.
Producers of goods also receive economic benefits, based on the profits they make when selling
the good. Economic benefits to producers are measured by producer surplus, the area above the
supply curve and below the market price. The supply function tells how many units of good
producers are willing to produce and sell at a given price. The supply curve is the graphical
representation of the supply function. Because producers would like to sell more at higher
prices, the supply curve slopes upward.
If producers receive a higher price than the minimum price they would sell their output for, they
receive a benefit from the sale—the producer surplus. Thus, benefits to producers are similar to

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benefits to consumers; because they measure the gains to the producer from receiving a price
higher than the price they would have been willing to sell the good for.

When measuring economic benefits of a policy or initiative that affects an ecosystem,

economists measure the total net economic benefit. This is the sum of consumer surplus plus
producer surplus, less any costs associated with the policy or initiative.

Why environmental valuation and analysis?

Environmental resources often have the characteristics of public goods and externalities
are common; market prices cannot be relied on.

The need to obtain values of environmental resources to identify (or at least approximate)
a socially optimal decision (optimal pollution tax rate, project appraisal)

The need to demonstrate the importance of environmental policy (many of the net gains
from environmental policy do not show up as immediate monetary gains)

Components (dimensions) of value of a resource

Economists classify ecosystem values into several types. The two main categories are use values
and non-use, or “passive use” values. Whereas use values are based on actual use of the
environment, non-use values are values that are not associated with actual use, or even an option
to use, an ecosystem or its services.
Thus, use value is defined as the value derived from the actual use of a good or service, such as
hunting, fishing, bird watching, or hiking. Use values may also include indirect uses. For
example, an Alaskan wilderness area provides direct use values to the people who visit the area.

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Other people might enjoy watching a television show about the area and its wildlife, thus
receiving indirect use values. People may also receive indirect use values from an input that
helps to produce something else that people use directly. For example, the lower organisms on
the aquatic food chain provide indirect use values to recreational anglers who catch the fish that
eat them.
Option value is the value that people place on having the option to enjoy something in the future,
although they may not currently use it. Thus, it is a type of use value. For example, a person
may hope to visit the Alaskan wilderness area sometime in the future, and thus would be willing
to pay something to preserve the area in order to maintain that option.
Similarly, bequest value is the value that people place on knowing that future generations will
have the option to enjoy something. Thus, bequest value is measured by peoples’ willingness to
pay to preserve the natural environment for future generations. For example, a person may be
willing to pay to protect the Alaskan wilderness area so that future generations will have the
opportunity to enjoy it.
Non-use values, also referred to as “passive use” values, are values that are not associated with
actual use, or even the option to use a good or service. Existence value is the non-use value that
people place on simply knowing that something exists, even if they will never see it or use it.
For example, a person might be willing to pay to protect the Alaskan wilderness area, even
though he or she never expects or even wants to go there, but simply because he or she values the
fact that it exists.
It is clear that a single person may benefit in more than one way from the same ecosystem.
Thus, total economic value is the sum of all the relevant use and non-use values for a good or
service.

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Total economic value = Use value + Non-use value

Components of value of a resource (the environment) (one possible categorization)

Total economic value

Use value Non-use value

Bequest value
Direct use value Indirect use value Option (use) value Altruism
(for others)

Existence value
Components of value of a forest
Total economic
value

Use value Non-use

value

Direct use value Option (use) Indirect use Bequest value

Timber value value Altruism
And non-timber
products
Greenhouse Recreation (for others)
impact Biodiversity Biodiversity
Biodiversity Watershed
Existence value

6.2. Economic valuation technique

There are three generally accepted approaches to estimating dollar values of ecosystem services.
Each approach includes several methods. They are:
1. Market Prices – Revealed Willingness to Pay

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The values of some ecosystem goods or services can be measured using market prices. Some
ecosystem products, such as fish or wood, are traded in markets. Thus, their values can be
estimated by estimating consumer and producer surplus, as with any other market good. Other
ecosystem services, such as clean water, are used as inputs in production, and their value may be
measured by their contribution to the profits made from the final good.

Some ecosystem or environmental services, like aesthetic views or many recreational

experiences, may not be directly bought and sold in markets. However, the prices people are
willing to pay in markets for related goods can be used to estimate their values. For example,
people often pay a higher price for a home with a view of the ocean, or will take the time to
travel to a special spot for fishing or bird watching. These kinds of expenditures can be used to
place a lower bound on the value of the view or the recreational experience. These methods
include:

Market Price Method

Productivity Method

Hedonic Pricing Method

Travel Cost Method

3. Circumstantial Evidence – Imputed Willingness to Pay

The value of some ecosystem services can be measured by estimating what people are willing to
pay, or the cost of actions they are willing to take, to avoid the adverse effects that would occur
if these services were lost, or to replace the lost services. For example, wetlands often provide
protection from floodwaters. The amount that people pay to avoid flood damage in areas
similar to those protected by the wetlands can be used to estimate willingness to pay for the
flood protection services of the wetland. These methods include:

Damage Cost Avoided,

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 Lecture Note on: Natural resource and environmental economics

Replacement Cost, and

Substitute Cost Methods

3. Surveys Expressed Willingness to Pay

Many ecosystem services are not traded in markets, and are not closely related to any
marketed goods. Thus, people cannot “reveal” what they are willing to pay for them
through their market purchases or actions. In these cases, surveys can be used to ask people
directly what they are willing to pay based on a hypothetical scenario. Alternatively, people
can be asked to make tradeoffs among different alternatives, from which their willingness to
pay can be estimated. This group includes:

Contingent valuation method

Contingent choice method

Contingent experiment method

Contingent ranking

Contingent rating

Environmental valuation techniques

Valuation technique

Stated (expressed) Revealed preference

preference methods (behavioural methods)
(Direct) (Indirect)

Contingent valuation Choice modelling-- Travel cost Hedonic pricing Others (Production
method (CVM) choice experiment, method (TCM) method (HPM) function--defensive/
contingent ranking averting behaviour,
contingent rating cost of illness)
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Lecture Note on: Natural resource and environmental economics

What these mean?

1. Market Price Method
Estimates economic values for ecosystem products or services that are bought and sold in
commercial markets.
2. Productivity Method
Estimates economic values for ecosystem products or services that contribute to the
production of commercially marketed goods

3. Hedonic Pricing Method

Estimates economic values for ecosystem or environmental services that directly affect
market prices of some other good. Most commonly applied to variations in housing
prices that reflect the value of local environmental attributes.

4. Travel Cost Method

Estimates economic values associated with ecosystems or sites that are used for
recreation. Assumes that the value of a site is reflected in how much people are willing to
pay to travel to visit the site.

5. Damage Cost Avoided, Replacement Cost, and Substitute Cost Methods

Estimate economic values based on costs of avoided damages resulting from lost
ecosystem services, costs of replacing ecosystem services, or costs of providing substitute
services.

6. Contingent Valuation Method

Estimates economic values for virtually any ecosystem or environmental service. The
most widely used method for estimating non-use, or “passive use” values. Asks people to
directly state their willingness to pay for specific environmental services, based on a
hypothetical scenario.

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7. Contingent Choice Method

Estimates economic values for virtually any ecosystem or environmental service. Based
on asking people to make tradeoffs among sets of ecosystem or environmental services or
characteristics. Does not directly ask for willingness to pay—this is inferred from
tradeoffs that include cost as an attribute.

8. Benefit Transfer Method

Estimates economic values by transferring existing benefit estimates from studies
already completed for another location or issue

Good Luck!!!!!
Keep the green environment
and let the coming
generation enjoy the benefit
of it!

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