Handout for “Natural Resource and Environmental Economics”

Jimma University College of agriculture

and veterinary medicine

Department of agricultural economics

and extension

Natural Resource and Environmental

Economics

Jimma Ethiopia

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 Handout for “Natural Resource and Environmental Economics”

UNIT ONE
INTRODUCTION

Basic Concepts

What is economics? is the social science that analyzes the production, distribution, and
consumption of goods and services. It also deals with how scarce resources are allocated among
competing uses.

Scarcity

Something is said to be scarce if the following is true: If it were offered to people at no cost,
more would be wanted than is available. Scarcity exists in all countries with out regarding to
their level of economic development. Scarcity necessitated choice in resource allocation. (What,
how and for whom to produce) What is the tradeoff of that choice? Opportunity cost.

What is opportunity cost? When something scarce is allocated to one particular use, the
opportunity cost of that choice is the value of the best alternative given up. Opportunity cost can
be easy or very difficult to measure. It is a key concept in economics. It has been described as
expressing "the basic relationship between scarcity and choice. The notion of opportunity cost
plays a crucial part in ensuring that scarce resources are used efficiently. Thus, opportunity costs
are not restricted to monetary or financial costs: the real cost of output forgone, lost time,
pleasure or any other benefit that provides utility should also be considered opportunity costs.
The concepts of scarcity and opportunity cost can be illustrated in a production possibilities
frontier (PPF).The following PPF represents all the possible combinations of food and clothing
that can be produced in a given time period when available resources are fully and efficiently
employed.

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1.1. Natural Resource vs. Environmental Economics

What is economic rationality? A choice from among competing options is said to be

economically rational when it yields anticipated net benefits that exceed the opportunity cost.
What is natural resource economics? is the study of how to best govern scarce natural
resources, especially, those such as air ground water, marine fishery that are common rather than
private properties. The sort of questions and problems to be studied in the area of natural
resources economics are:
✓ Production, markets, management, uses, and abuses of natural resources such as
fisheries, forests, and non renewable resources extraction
What is environmental economics? is the study of the impact of the goods and services
produced by economy, particularly market systems of allocation, on environmental quality and
ecological integrity. The sorts of questions and to be studied under environmental economics are:
✓ Economics of pollution, causes, targets and instruments for their control, and
environmental valuation.
1.2. The Three Themes

❖ Efficiency –is in terms of the missed opportunity. If it is possible to avoid wastage and make
some society beneficiary, that resource allocation is said to be inefficient. Example, energy

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inefficiency and technical inefficiency. It is possible to avoid through employing different

techniques in which resource could be saved with out hurting the final output. But economics
focus on allocative efficiency. Example it is possible to generate electricity from fossil coal
in a technically efficient way, but it produces pollution waste which costs society health care.
If that cost, not paid by the electricity supplier, exceed it’s saving from producing electricity
from coal, then it is economically inefficient. This is due to choice in resource allocation; it is
possible to produce electricity from less polluting resource. The concern of economics here is
to choose the allocation of less polluting resource so that the society as whole will be better
off.

❖ Optimality –is related to efficiency but it is distinct from it. To understand this concept lets
have the following in our mind;
1. Some society is there
2. Some overall objective that this society has, in terms of which we can measure the extent
to which some resource use decision is desirable from that society’s point of view.
So, resource use decision is socially optimal if it maximizes that objective given any relevant
constraints that may be operating. A resource allocation cannot be optimal except it is efficient.
So efficiency is the necessary condition for optimality but not sufficient.
❖ Sustainability – is taking care of intergenerational equity. Is the optimal allocation of the
resource means sustainable? If it is not, the sustainability should be the constraint for
optimality.

2. The Emergence of Natural Resource and Environmental Economics

2.1. Classical economists, (Smith, Malthus, Ricardo and Mill)

While the emergence of Natural resource and environmental Economics as a discipline is a

recent idea, concern with the substance of natural resource and environmental issue is past
history (antecedent). The label Classical identifies a number of economists writing in the 18th and
19th century at the time when industrial revolution was taking place at least in (Europe and North
America) and agricultural productivity was growing rapidly. It was the time at which the

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political- economic debate concerned with the appropriate institutional arrangements for the
development of growth and trade.

Adam Smith (1723-1790) was the first writer for the importance of markets in allocating
resources. In his book “the nature and causes of the wealth of nation” (1776) contains the
famous statement of the role of the ‘invisible hand’. This belief in the efficacy of the market
mechanism is a fundamental organizing principle of the policy prescriptions of modern
economics, including resource and environmental economics.
The central interest of classical economists was the question of what determines the standards of
living and economic growth. Natural resources were seen as important determinants of the
wealth of nation. Land (sometimes used to refer to natural resources in general) was viewed as
limited in its availability. They also included that land is a necessary input in production and that
it exhibit a diminishing return.

Thomas Malthus (1766- 1834) in his essay on the principle of population (1798), raised the
question of the continuity of long run economic growth as “neo-Malthusian”. For Malthus, the
fixed land quantity and continual positive population growth and diminishing returns in
agriculture lead to output per capita to fall over time. According to Malthus, the long run
tendency for the living standards of the mass of people to drove down to a subsistence level,
steady state or subsistent level of living standards.

David Ricardo (1772-1823) in his principles of political economy and taxation (1817)
extended the concept of steady state. He replaced the assumption of a fixed stock of land by land
was available in parcels of different quality. Agricultural production can be expanded by
increasing the exploitation of a given parcel of land more intensively or by increasing the
extensive margin (bringing the uncultivated land under cultivation). However, in either case,
returns to the land input were taken to be diminishing.

In the writing of John Stuart Mill (1806-1873), in particular (1857) one finds a full statement
of classical Economics at its conclusion. His work utilizes the idea of diminishing return, but
recognizes the knowledge of technical progress in agriculture and in production more generally.
He placed less emphasis on diminishing returns, and writing in Britain when output per person is
increasing but not falling, as fossil fuels were increasingly exploited and as innovation rapidly

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increased agricultural productivity. In addition, Mill also adopted the broader view of the roles
played by natural resource than his predecessors. In addition to agricultural and extractive use of
land, mill saw it as a source of amenity value (such as intrinsic beauty of country side) that
would become of relative importance as material conditions improved.

2.2. Neoclassical Economics: marginal theory and Value

A series of major works published in 1870s began the replacement of classical economics by
what subsequent became known as neoclassical economics. One outcome of this is the way in
which value has been explained. Classical economics saw value as a rising from the labor power
embodied (directly and indirectly) in output. Neoclassical economists explained value as being
determined by exchange, so reflecting preferences and costs of production. Previous notions of
absolute scarcity and value was replaced by relative scarcity and relative value (price)
respectively and determined by the forces of demand and supply. Diminishing returns have been
given a formal basis in terms of diminishing marginal productivity in the context of a distinct
production function. The concept of general equilibrium and partial equilibrium supply and
demand based analysis of price determination was developed. However, this direction of
mainstream of economics has little direct impact on the emergence of natural resource and
environmental economics.

But Keynesian macroeconomics as opposed to neoclassical microeconomics was of indirect

importance stimulating interest in the growth theory in the middle of the 20th century and the
development of neoclassical theory of economic growth. What makes this growth model
different is the absence of land or any natural resource from the production function used in such
models. The introduction of natural resource in to neoclassical models of economic growth
occurred in the 1970s, when some neoclassical economists 1st systematically investigated the
efficient and optimal depletion of resources. This body of work and the development that have
followed from it, is natural resource economics – the efficient and optimal exploitation of natural
resource.

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3. Fundamental Issues in the Economics Approach to Resource and

Environmental Issues

Property right, Efficiency and Government Intervention

The central question in resource and environmental economics concerns with allocative
efficiency. The role of market and price is central to the analysis of this problem (question). A
central idea in the modern economics is market bring an allocative efficiency if the necessary
conditions fulfilled. Well defined and enforceable private property rights are one of the necessary
conditions. Because property rights do not exist, or are not clearly defined for many
environmental resources, markets fail to allocate that resource efficiently. In such circumstances
price signals fail to reflect the true social cost and benefits, and a prima facie case exists for
government policy intervention for efficiency gains. Deciding where a case for intervention
exists, and what form it should take, is a central in all resource and environmental economics.

3.1. The Time Dimension Economic Decision

Here we need to see the nature of resources; Flow resources and stock resources. Flow
resources-current uses have no implication on future availability. E.g., solar energy, tide wind,
sea (river). Stock resources are plant and animal and mineral deposits of which current use
affects future availability. Stock resources can also be categorized into renewable and non
renewable.

Renewable-plant and animal (biotic)-has capacity to grow over time. Non renewable-exhaustible
(depletable) resources – no positive constant rate of use to sustain it indefinitely. Example,
abiotic stocks of minerals. The term exhaustible can also be applied for renewable resources if
they are used beyond the regenerating capacity. From economic perspectives, stock resources are
assets yielding the flow of environmental services over time. In efficiency and optimality of their
use we need to consider the inter-temporal or dynamic dimension as well as, intra-temporal or
static dimension. The rate of return for these environmental services should also be considered
over time.

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3.2. Substitutability and Irreversibility

Substitutability and irreversibility are very important and related issues in thinking about policy
in relation to the natural environment. If the depletion of a resource stock is not reversible, and
there is no close substitute, for the services that it provides, then the rate at which that resource is
depleted has a major implication on its sustainability. On the other hand, if the resource is
irreversible but has a close substitute for its service, the sustainability of that resource needs less
concern.

Two main dimensions for sustainability issue are:

1) To what extent one natural resource can be replaced by other. E.g. can solar energy substitute
fossil fuel at large scale?
2) The degree to which an environmental resource can be replaced by other inputs, especially
human- made capital resulting from saving and investment. E.g.to what extent can an artificially
produced oxygen replace natural oxygen?
• Human capital is reproducible but depletable resources are not reproducible but might
gat depleted through time.

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UNIT TWO
CONCEPT OF SUSTAINABILITY

What is sustainability?

In economics literatures it has been difficult to come up with the all-embracing definition of
sustainability. But it can be illuminated by the concept of development-sustainable development.
According to the World Commission on Environment 1987: Sustainable development is defined
as, “development that meets the need of the present without compromising the ability of future
generations to meet their need.

➢ Two main concepts we should concern ourselves for the term sustainability are
1. Intergenerational equity: - Which entails the reservation of the different environmental
resources for the coming generation.
2. Non declining per capita income over time for the current generation.

The Origins of the Sustainability Problem

Population is dramatically increasing in the past century and to double in the future. The material
demands being made by the average individual have been increasing rapidly. Since the 1950s
and 1960s, economic growth has been generally seen as the solution for the problem of poverty.
Without economic growth poverty alleviation involves redistribution from better-off to the poor
w/c encounters the resistance from better-off. On the other hand, relative to better off the poor is
very large to redistribute and to achieve the set objective.

However the world resource base is limited, and contains the complex and interrelated set of
ecosystems that are currently exhibiting fragility. It is increasingly questioned whether the global
economic system can continue to grow without undermining the natural system. This issue we
call the sustainability problem-how to alleviate poverty without affecting the natural
environment.

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1.1. Economy-Environment Interdependence

All economic activity takes place within the environment and there is two way relations between
the environment and the economy. The services that environment provides
a) Environment serve as a resource base- all resource and energy come from the environment
to the economy (production and consumption-these resources are may be renewable or non-
renewable. For renewable resources, it is possible to use the resource indefinitely if growth
rate>=harvest rate. This level of harvest is called sustainable yield. In the case of non-
renewable stock resources, e.g. fossil fuels are irreversible and their use emits pollution to the
environment.
b) As waste sink- in production and consumption, give rise to waste products or residues in to
the environment w/c creates a pollution problem. There are two views about pollution:
Economists:-pollution is the resident of material in natural environment. Ecologists: -
pollution as the flow which affects the natural environment. In the case of economists’-
residues flow in to the environment add to stock with subtraction of natural decay. The flow
model treats the environment as having an ‘assimilative capacity’. There is no pollution if the
residual flow rate is less than or equal to assimilative capacity. If it exceeds assimilative
capacity, it may become zero.
c) Amenity service- flow directly from the environment to individuals. The biosphere provide
human with recreational facilities and other sources of pleasure and stimulation without
requiring production activity. E.g. ocean swimming, sunshine bathing, etc. it will also not
directly concern consumptive material flow.
d) Life supporting function- the ozone layer of the atmosphere absorbs the Ultra-violet UV-B
which is dangerous for human life and other biotic if reached the surface of the earth. So it
filters this ultra violet to the tolerable and useful level.

Today the stratospheric ozone layer is depleting due to chloro-floro-carbons (CFCs) which exists
by virtue of human economic activity. They have been used since 1940s but their ozone
depleting properties were understood in 1980s. The interdependencies b/n economic activity and
the environment are pervasive and complex. The four classes of environmental service each
interact to one another. E.g. consider a river which serves as resource base in the local economy
in that commercial fishery operates in it. It can serve as waste sink in which urban sewage is

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discharged in to it. It serves as a source of amenity value in being used for recreational purpose
like swimming and boating. It contributes to life support function so far it supports the marine
ecosystem.

1.2. Substituting for Environmental Services

There is a possibility of substituting from manmade capital to resource base, amenity service,
waste sink and the environment shows possibility of substituting for natural capital
(environmental services).But to what extent? Consider the recycling –interception of the waste
stream prior to its reaching the natural environment and the return of some part of it to
production.
• This has two ways advantages-
1st it substitutes the resource to be extracted from the environment;
2nd it decrease the burden of waste sink value of the environment.
E.g1. If we use a waste reducing technology, for the sewage to be discharged to the river estuary,
it is possible to substitute the waste sink service of the river.
E.g2. For amenity service, swimming, it is possible to use manufactured pool instead of ocean or
lake.

It appears that in the life support function, many scientists regard substitution possibilities as
most limited. To solve this, artificial environment capable of sustaining human life out of
biosphere has already been created. But it is for few people and for limited periods. So the
quantity of human life to sustain out of the natural life supporting functions would appear quite
small. This is not to mean that these services are absolutely irreplaceable, but that they are
irreplaceable on the scale that the natural capital operates. The possibility of substitutability of
service for natural capital is that, capital is accumulated when out put from current production is
not used for current consumption. Current production is not only of material structures,
reproducible capital doesn’t only comprise equipment, machines, buildings, roads but also
human capital is increased when current production is used to add to the stock of knowledge and
is what forms the basis for the technical change (technological progress)

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However, while the accumulation of human capital is very important, in regard to environmental
problems, in order for technical change to impact on economic activity, it generally requires
embodiment in new equipment. Knowledge that could reduce the demands made up on
environmental functions doesn’t actually do so until it is incorporated in to equipment that
substitutes for environmental functions. Capital for the environmental service substitution is not
the only form of substitution that is relevant to economy environment interconnections.

1.3. The Deriver of Environmental Impact

This can be looked through the extraction from or insertion in to the environment. In either case
the impact is determined by the size of population and the per capita impact. The latter depends
on how much each individual consumes and the technology.
➢ Mathematically, the impact can be written as ;
I = P*A*T, where I is impact, measured in mass or volume
P is population size
A is per capita affluence
T is technology as the amount of the resource used or waste generated per unit
production
The following figure shows the IPAT identity.

GDP resourceuse $ tonnes

popultion * *  tonnes  n * *
population GDP n $

By canceling population by population and n by n and $ by $ the right hand side equation equals
the left hand side equation (tones = tones). So the IPAT identity decomposes the impact in to
three multiplicative components; population, affluence (wealth) and technology.

Consider the following example;

❖ Let’s see the impact of carbon dioxide on the environment, if in1999 the population of
the world was 5.8627bil. the per capita GDP was $6948 and technology (resource
extraction per $) is 0.0005862 then what is the Impact (I) on the environment?
Solution;
I = P*A*T = 5.8627*6948*0.0005862 = 23.8819bil.of tones.

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1.4. Three Characteristics in Human History

1. The hunter-gatherer phase: where the main source of energy was fire for individuals for their
muscle strengthening. At that level the per capita energy use was, 1HEE (approximately,
10megajoules). Where HEE is human energy equivalent, which is what is required by an
adult leading a moderately active life in favorable climatic condition.
2. The agricultural phase: lasted about 12,000years and end before 200 years ago. The average
human being was deploying 3-4 HEE. Agriculture involves producing food by
domesticating many plant and animal species and managing the environment so as to
favor the domestic and hurt the wild species. In addition to 1HEE from the fire, which
completely come from the biomass human uses animals, for transport purpose and get 2-
3HEE energy. Comparing the situation energy consumption at the end of agriculture,
population increased by the factor of 200 and the energy consumption by a factor of 400.
3. The industrial phase of human history began 200 years ago, around 1800. Here the
systematic and pervasive use of the fossil fuel started. In the instance the use of coal
mainly for manufacturing and then transport was becoming common. In the 20th century
it was also important to produce electricity. In the modern economy all economic activity
uses extra somatic energy (the energy from other animals but out of the muscle of
human being) and most of is used from fossil fuel combustion. In 1900 the average
human use about 14 extra somatic HEE. By the end of the 20th century, the average
human used 19 extra somatic HEE. By 1997 the per capita somatic energy use in USA
was 93 extra somatic HEE.

Comparing the situation at the end of 20th and 18th cen., the population was increased by factor
of approximately 6. In 200 years, total global extra somatic energy use has increased by a factor
of 35. This implies that the impact of economic activity on the environment was increased by a
factor of 35.

1.5. Population Growth and Sustainability

There are indications that civilizations have collapsed because resource degradation led to
desertification and climate change. Since the work of Frank Notestein in 1945, demographers

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have recognized empirical inverse relation regularity in the data on the relationship between the
stages of economic development and population growth rates. According to (Todaro, 1989),
there are four common stages through which population dynamics progress.

Stages of Demographic Transition – Conceptual

Example
Birth and
Death Rates Birth
Rates

III IV

Death
Rates

Stage 1: High
I birth rates and death
II rates in pre-industrial subsistence economies.
Net population growth rate fluctuates around near-zero. Reasons:
Level of Econ Develop.
✓ Little access to birth control
✓ High child mortality rate due to poor healthcare, famine, unsanitary water, disease
✓ Desire for large families b/c children are workers on the farm today, and your social
security tomorrow…
✓ Religious beliefs and social status regarding large families
Stage 2: High birth rates and falling death rates in newly industrializing economies. Net
population growth rate is high. Reasons:
✓ Improvements in medical care ➔ less child mortality
✓ Improvements in sanitation, and in transportation and distribution of water, food,
medicines, etc.
✓ Quality and quantity of food rises
✓ Social and religious norms slow to change. May still need children as social security.
Birthrates remain high.
Stage 3: Falling birth rates and continuing declines in death rates in more industrialized
economies. Net population growth rate is slowing. Reasons:

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➢ Women’s empowerment: Improved access to contraception, education, and work

opportunities for women ➔ women have rising opportunity cost and more choice
regarding children
➢ Industrialized agriculture ➔ don’t need children for workforce
➢ Social safety net ➔ don’t need children for care in old age
➢ Technologically advanced jobs ➔ successful childrearing and education is expensive
Stage 4: Low birth and death rates, fluctuating from generation to generation due to culture,
economics, and diseases. Characterizes advanced, high income, industrialized countries with
considerable empowerment of women.

The major impact on natural environment is born by population, technology and affluence. The
solution for sustainability of the natural environment was through controlling population size.
How? The powerful means to control population size is through transferring the subsistence
agriculture in to modern Agriculture. Increasing family income, by creating free market for
labor through defining property right more clearly, giving the society greater control over the use
of local resources, and creating financial incentives to manage, and market resources in
sustainable way.

Ethics, Economics and the Environment

Ethics and Environment

1. Naturalist moral philosophy- there are two views here; humanist and naturalist moral
philosophies. According to humanist- right and duties are exclusively given to human being
either as individual or community. Other things have no right and responsibility in
themselves. Naturalist ethic denies the exclusivity of right to human being. Values not
derive exclusively from human being. A thing is right when it tends to preserve the integrity
stability and beauty of the biotic community, it is wrong when it is otherwise. Sometimes it is
called as ‘deep ecologists’.

2. Libertarian moral philosophies- are humanist moral philosophies, deals with free action.
Accordingly distributions are just if they are entirely the consequence of free choice and not

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otherwise. Property rights should be set free. Libertarians do not accept the concepts of justice on
consequence. They limited government action to maintaining the institutions required to support
free contract and exchange. But they didn’t give any idea on the following questions
1. What should the government do about unjust holding?
2. How are open access resources to be dealt with?
3. How do external effect and public good relate to the concept of just acquisition?

3. Utilitarianism- is the ethical basis for modern normative economics. Utility is the term
introduced by early utilitarian writers for the individual’s pleasure or happiness. The term
welfare is used to refer to social good. Social welfare is some aggregation of individual utilities.
For utilitarian the actions w/c increase welfare are right and other wise wrong. Utilitarianism is a
consequentiality moral philosophy. It is only the consequence that determines the moral worth of
an action. For utilitarian the ends (needs) might justify the means (wealth). Though moral
consideration is given to human being, non-human things are also have utility. Humans use some
plant and animal values so care should be given at least for future availability of these renewable
resources. Some values may not have market so the concern of natural resource and
environmental economics is inducing market systems to take proper account in both direct and
indirect use of these resources.

Preference satisfaction utilitarianism- given we decided that what right and wrong is decided
by the consequences for human individual, how can we decide which consequence is good? i.e.
utility enhancing and what is bad -utility diminishing.
✓ How could we decide that is what good is for people?
According to utilitarian the affected people will decide. If individual A prefers I from II, then I
confers more utility on A than II.

1.1. Inter-temporal vs. Intra-temporal Distribution

Distribution within the same time/same generation is intra-temporal distribution. If we consider

different generations (more than one generation) while allocating/distributing resources for the

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consumers, this distribution is known as inter-temporal distribution. We need to discount to find

the present value of future utility.
Discounting
Why discount for future utility? Because, consumers prefer current consumption than future so
the utility discount should be positive. Example; assume that there is 100 unit of certain
commodity for consumption in different times. Then estimate the level of consumption for the
generations 1, 2, 3, 4, 5, 10…50 for discount rate 0.1, 0.25, 0.5 and 1.0

The table shows how the present value for the generation decreases from generation to
generation. What is enjoyed by the 1st generation when the discount rate is 0.1 is 90.91 and it is
0.85 for the 50th. This discount rate will also be used for consumption. How to find the right
consumption path so as to maximize welfare is to use the Discount rate. Cost-benefit analysis

Generation Discount rate

0.1 0.25 0.5 1.0

1 90.91 80.00 66.67 50.00

2 82.65 64.00 44.44 25.00

3 75.13 51.20 29.63 12.5

4 68.30 40.96 19.75 6.25

5 62.09 32.77 13.17 3.13

10 38.55 10.73 1.73 0.10

50 0.85 0.001 2*10-7 1*10-13

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Economists and Ecologists on sustainability

In the previous section, we dealt with the assumption of one commodity & same utility function
approach. Here we deal with sustainability by taking one non-renewable resource.

3.1. Economists on sustainability

Nobel Laureate economist Robert Solow has criticized environmentalists and summed up the
intergenerational justice as; ‘what is expected from current generation is preserving the
productive capacity of the resource for future generation not the resource itself’.

Here we have to understand two main concepts:

1. Part of what is produced is consumed
2. Part of what is produced is to be saved and reinvested for further production.
Here there is a possibility to substitute man made capital for natural capital. Consider if the
production function Qt=Q( Rt, Kt) where:
Rt is the level of non-renewable natural resource input and
Kt is the level of capital input.
Qt is the level of output produced from the combination.
If the equation is given as Qt = αKt +βRt, and if it is possible to produce any level of output using
K, then the resource is non-essential. I.e. if Rt=0, Qt= αKt. That is if capital is perfect substitute
for that non-renewable resource. So, constant consumption does not require special attention to
the rate of that resource use. If the resource is essential and input to production and if there is no
substitution possibility, then the inter-temporal problem reduces to making last as long as
possible by consuming at each point in time as little as possible consistent with survival.

α
Consider the following equation, Q= Kt Rtβ, where α + β=1, this is called Cobb-Douglas
production function under constant rate of return. For this problem if α > β it is possible to have
constant consumption over time by using more of capital and less of the resource. But it is
impossible to produce without the resource because if Rt is set at 0, Qt will be 0.

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Most economists follow Solow in taking the view that, in fact, substitution possibility are such
that sustainability as constant consumption forever (or at least for a very long time is possible) is
feasible.

The Hartwick Rule-John Hartwick (1977-1978): He came with the concept that, constant
consumption would be the out come of saving/investment rule, known as the ‘Hartwick rule’ if
the depletion of resource satisfied the inter temporal efficiency. At every point in time the total
rent arising in the resource extraction industry in the perfect competitive economy be saved and
invested to produce reproducible capital. The rule for the sustainability in consumption is that K
(capital accumulation) must be equal to the total rent arising in the resource extraction industries.
The total rent is the difference between the price of that resource and its extraction cost. It is the
scarcity value of the resource. Here we have two types of sustainability: weak and strong
sustainability.

3.1.1. Weak sustainability

What is weak sustainability? A central element of weak sustainability theory is the assumption
that human-made capital can effectively Substitute natural capital and the services provided
by ecological systems. Here it uses the equation
Qt= Kt α Rtβ, where α> β.
Natural capital: - is any naturally provided stock, such as aquifer and water systems, fertile
land, crude oil and gas, fisheries, forests and other stocks of biomass, genetic materials and
earth’s atmosphere itself.
Human made capital: - is the sum of physical (equipment building…etc), human capital (stocks
of learned skills,) and intellectual capitals (like the store of knowledge in books and state of
technology). An implication of weak sustainability is that it allows for the mitigation of lost
natural capital with manmade capital. Ex: Constructed wetlands for natural wetlands

3.1.2. Strong Sustainability

Running down the natural environment and replacing it with technological substitutes is not
widely seen as being consistent with sustainable development. Strong sustainability rejects the

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notion that constructed (or human made) capital can effectively substitute for lost natural capital.
Arguments for strong sustainability:
• Uncertainty- the ecosystem service is complex and unpredictable.
• Irreversibility: destruction of certain forms of natural capital, such as biodiversity, is
irreversible.

3.2. Ecologists on sustainability

According to ecologists there are two main points:

1. A sustainable state is one in which resource is managed so as to maintain a sustainable

yield of resource service.
2. Sustainable state is one which satisfies minimum conditions for ecosystem resilience
(dynamism) through time.
Sustainable yield
The concept of sustainable yield is for the renewable resources where the resource regenerates
through natural reproduction. Here if the harvest is below growth potential, the resource is
underutilized and if the harvest is more than growth rate then the resource is over exploited.

What is the sustainable harvest (yield)?

Sustainable yield is the level of harvest where growth rate equals harvest rate. For resource
managers who come from ecologist back ground, the correct rate of harvest is the sustainable
yield.

H*=G(S*)

H2

H1

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Points H1 is sustainable yield for the stock size S1 & H2 is more than sustainable yield and
decrease stock size. The sustainable yield is at the point where the change in the total yield is
equal to 0 or growth rate equals harvest rate, H*=G(S*) sustainable yield, S* is stock size, and H*
is called harvest at maximum sustainable yield. In this situation it is possible to use the resource
indefinitely without affecting its stock size.
• What is ecologically sustainable is may not be economically efficient.

Resilience
Ecologists-sustainability is assessed in terms of the extent to which the prevailing structure and
properties of the ecosystem can be maintained. Accordingly sustainability is a r/ship b/n human
economic system and the larger dynamic, but normally slower-changing ecological systems in
which,
1. Human life can continue indefinitely
2. Human individual can flourish
3. Human cultures can develop; but in which effects of human activities remain with in
bounds, so as not to destroy the diversity, complexity and function of the ecological life support
system.

3.3. The Institutional Conception

It is the view found in the writings of political scientists and sociologists. Sustainability defined
here as involved consensus-building and institutional development. Sustainability is a problem
with political, social and cultural dimensions. A good example for this school of thought is A
Graaf et al writing in (1996), in this paper sustainable development defined as;
1. Development of a socio-environmental system with a high potential for continuity
because it is kept within economic, social, cultural, ecological and physical constraints.
2. Development in which the people involved have reached consensus. Graaf et al, begin
that one can’t separate environmental objective from other social and political objectives;
example poverty elimination.

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They looked in to insufficiency of conventional approach for sustainable development. Classified

these conventional approaches as;
1. Recognizing, human being as element of ecosystem, determining the carrying
capacity of the ecosystem and legislating human activity to prevent exceeding that
carrying capacity. (Ecologists).
2. Conceptualizing, environmental decline as external costs, evaluating these costs in
monetary terms, and using a price mechanism to internalize these costs. (Economists).
Both are not sufficient for sustainability; because;
➢ The problem on the first approach is that it needs persuading citizens to respect carrying
capacity and carrying capacity is unknown. The second approach is also not sufficient
because; it over estimates the possibilities of pricing under difficult social circumstance
and some values are unpriceable example, cultural development, nature conservation and
landscape planning.
So, because of inability to know consequence human behavior it is useless to look in to
necessary or sufficient condition for sustainability. Their sustainability criterion is consensus-
building through negotiation on what should and shouldn’t be done. Their view was very broad
referring to the institutional process of social choice that involves people as widely as possible.

3.4. Sustainability and Policy

It is still researchable on the structure and management of these negotiations. Involves a process
of trade-offs b/n all costs and benefits from the avoidance of environmental disturbances. The
issue of sustainability we have been discussing so far comprises a number of natural and social
sciences. Those sciences should be regarded as complementary than competitive. These synthetic
approach yields some policy in which we deal the particular observations on policy can
conveniently classified as incentive, information and irreversibility. As it is about NRE
economics we deal with some economic models.

Economic models and policy directions

We will use economic model to illustrate the policy for sustainability; that is the rent arising
from resource extraction should be saved and invested. If constant consumption is feasible,

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condition1 and if resource extraction program is efficient, condition 2, then the constant
consumption is possible indefinitely. But consumption must decline since it needs to invest more
to substitute the depleted resource.

How Hart wick rule can be implemented?

The solution relies with market economy with socially optimal discount rate for the capital
accumulation, this fail many times in many market economies. Other mechanism- governments
tax the resource rents and invest in human made capital.
• But still taxing resource rent is difficult, because it is not easy to identify.
What is the solution?

Incentive
Is about identifying the intervention mechanism in to the market, so that, it works properly, and
policy to improve its performance to bring efficient out come. Efficient out come is a situation
where it is not possible to make one better-off unless through making other worse-off there is no
wastage. But is that distribution fair? E.g. it may be efficient when individual A gets 99% of and
individual B gets 1% of some resource. It is not fair. In environmental services we often get
market failure. There should be corrective policy measures which enable to bring fairness and
maintaining the incentives to work in appropriate direction.

E.g. in the absence of policy intervention, financial incentives work in opposite direction. To
bring these all many economists raise about property right on environmental resources.
According to many economists, the solution is private property right and ongoing policy
intervention on the proper working of the market.

Information
Strong and clear information for both producers and consumers about the environmental service
is very important to make effective policy. The powerful vehicle to disseminate is avoiding
ignorance (education policy) Education –research-has two advantages
1st the product of research is public good-it can be used by all generations once documented.

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2nd there is a possibility to search for new technology for environmental protection through
research.
Irreversibility

Reversibility implies that nothing could be irretrievably lost. But many environmental services
cannot be reversed. Irreversibility + imperfect knowledge = optimal decision making can change
significantly. So it needs keeping options open and behaving in a relatively cautious manner.
This has important implication for policy appraisal which we look in other chapters.

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UNIT THREE
WELFARE ECONOMICS AND THE ENVIRONMENT

Welfare economics is the branch of economics theory that has investigated the nature of the
policy recommendations economists are entitled to make. It is the base for environmental
economics.

3.1. Economic efficiency

• An allocation of resource is efficient if it is not possible to make one better-off by

reallocating the resource without making at least one other worse-off. And not
otherwise.
A gain of at least one without making the other worse off is called Pareto improvement.
Resulting allocation is Pareto optimal or Pareto efficiency. Efficiency in allocation requires three
conditions to be full filled-
➢ efficiency in consumption,
➢ efficiency in production and
➢ Efficiency in product-mix.

Efficiency in Consumption
Consumption is efficient when MRUSA = MRUSB

Efficiency in production

Efficiency in production where the economy has two inputs L&K and produce two commodities
X & Y is achieved if the marginal rate of technical substitution for the two commodities is equal,
MRTSX =MRTSY.

Product mix efficiency

The final condition necessary for economic efficiency is product-mix efficiency. For product-
mix efficiency to be attained the rate at which marginal rate of transformation and the rate at

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which marginal rate of utility substitution in consuming one of the goods should be the same.
That is,
MRTL=MRTK = MRUSA = MRUSB.

In other words the slope of the indifference curve and that of production possibility frontier
should be equal.

Xm
Fig 3.3. Product mix efficiency
Here we have one indifference curve for both consumers; and the same production possibility
frontier for producers (for the economy as a whole). Reason, the slope of indifference curves
same at efficient consumption and same for production.

3.2. Allocation in a Market Economy

Conditions for markets to be efficient:

Markets exist for all goods and services
❖ All markets are perfectly competitive
❖ All transactors have perfect information
❖ Private property rights are fully assigned
❖ No externalities exist
❖ All goods and services are private goods there are no public goods

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❖ All utility and production functions are “well-behaved”

All market agents are maximizers:
➢ Consumers utility maximizer
➢ Producers profit maximizers or cost minimizers.
Consumer maximize utility where budget line tangent to indifference curve. The slope of budget
line equals the slope of indifference curve. Slope of budget line is price ratio PX/PY. Hence
utility is maximum at MRUSA =MRUSB =PX/PY. Budget is the total many income that consumer
has to consume the two goods. Budget line is the locus of points which show the combination of
two goods the consumer can consume by totally investing his income.

In the following graph U*U* represents indifference curve and Ymax Xmax represents the budget
line at Xmax the consumer can buy only commodity x and at Ymax the consumer can buy only
good Y spending his entire budget. From the combination of the two goods the consumer
maximizes his utility at point B.

Y
Now consider firms minimizing cost of production by using two inputs capital and labor. In the
figure the straight lines represent isocost line. That is the expenditure of the firm to produce good
X which is represented by isoquant line. In the same figure the isocost lines to the right shows
that the expenditure on input to produce that level of out put is greater than that is found to the
left.

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X*

K3

K2
X*

K1

Cost minimizing firmLproduces

1
at point
L2 L3
b. where budget line is tangent to isoquant line X*X*.
Consider point ‘c’ and ‘a’ the producer is producing the same quantity at higher cost. Because
K1L1<K2L2<K3L3. At point ‘b’ the slope of isoquant line and that of isocost line are the same. I.e.
MRTS = Pl/Pk

Partial Equilibrium Analysis of Market Economy

L

Partial equilibrium in a competitive market is the point at which the demand and supply curves
for the good are the same And it is also at the point where marginal cost and marginal revenue
are equal and marginal benefit equal price in case of competitive market. So at equilibrium,
P=MC = MB. In a competitive market, sellers supply along their marginal cost curves
• Profit = total revenue – total cost. Marginal cost (MC) = increase in total cost caused by a
small increase in output.
Marginal product of labor = additional output added by an additional unit of labor.
Marginal revenue (MR) = increase or decrease in total revenue caused by a small increase in
output. In a competitive market, MR is equal to market price P.
• The following figure shows you market equilibrium

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Fig 3.8. Equilibrium price is P5 and equilibrium quantity is Q. If it is not achieved, there is
market surplus and shortage.

1.1. Consumer and producer surplus

Consumer Surplus: consumer surplus measures the gains from voluntary trade that flow to
consumers. It is measured by the difference between the demand curve and price, up to quantity
purchased.
Producer Surplus: Like profit (except leaving out fixed cost), producer surplus measures the
gains from voluntary trade that flow to producers (firms). It is measured by the difference
between price and the supply curve, up to the quantity sold.

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Market Failures, Public Policy and the Environment

1.1. Market Failure

Market fails when one of the assumptions not fulfilled. Cases;

1. Monopolies, cartels, and market power ➔ firms are able to withhold quantity from the
market to raise price, which results in inefficiency.
2. Lack of market for environmental services
3. Externalities (positive or negative)
4. Collectively Consumed Goods (public goods)
5. Imperfect information on quality, safety, etc.

Existence of market for environmental services

For many environmental services there is no market. Example; for the amenity value of the
environment it is difficult to find the market equilibrium and so that enforce efficiency. So
market fails to determine the price of such services.
• But we will see in chapter 4 how to value it through different techniques

Public Goods
Public goods have two key features:
1. Non-rival - one person enjoying the good does not keep others from enjoying it.
2. Non-excludable -people cannot be kept from enjoying the good. This leads to free-rider
problem. Because the goods are non-rival, efficiency requires that the sum of each individual's
marginal benefit equal marginal cost.

Externalities

Production or consumption decisions of one agent affect the utility or production possibilities of
another agent in an unintended way; (no compensation is made by the producer of the external
effect to the affected party).
Positive and negative externalities

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1. Positive externality

An unpaid-for benefit to other members of society generated as a side effect or consequence of

an economic exchange, such as between a buyer and a seller. Illustrative example: Open space,
view shed, wildlife habitat, watershed benefits of pastureland. Suppose that pastureland is bought
and sold in otherwise well-functioning competitive markets for land. What happens if market
demand only reflects the benefits to the private landowner?

Unpaid for benefits are wonderful things. That isn’t problem?

The problem is that the market will not allocate enough resources to produce the socially optimal
quantity of the thing (pastureland) if only the farmer’s benefits are reflected in willingness-to-
pay. One common government intervention is to provide subsidies to those who provide society
with positive externalities. Ex. Subsidized vaccinations, it may also be given by unselfish health
organizations. What matters here is the way in which property right is allocated.

The five categories of property right and the four ownership regimes are;
2. Access: Non- extractive right to enjoy benefits of property. access rights, such as permission
to bike on roads.
3. Withdrawal: Right to extract or remove some or the entire product of the property.
Authorized users have access and withdrawal rights, such as those with valid fishing licenses.
4. Management: Right to regulate use (access, withdrawal) and improvements. Claimants such
as farmers who participate in the management of government-owned irrigation systems hold
these rights.
5. Exclusion: Right to exclude others from access, withdrawal, and management. E.g.
proprietors who collectively govern common-property.
6. Alienation: Right to sell (“alienate”) property to someone else. Owners of cars have the right
to sell their cars to someone else.
Ownership Regimes:
• Private property
• Common property
• Government (state) property
• Open access (no property—res nullis)

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2. Negative externality
An uncompensated cost borne by members of society (or the aspects of the natural world they
care about) that comes about as a byproduct of economic exchange,
Assertion: When production of a good or service generates significant negative externalities,
profit-maximizing firms in a competitive market will supply too much of that good or service.
Consumers will pay a subsidized price and so will consume too much.

1.2. Theory of Efficiency-Enhancing Policy Interventions

Pigouvian tax: Tax per unit of output (e.g., electricity) equal to marginal external cost, with tax
revenues being used to compensate those harmed and/or fix environmental harms. There are
some criterions for this to work efficiently;
➢ Ability to accurately measure marginal external cost
➢ Ability of the political system to produce an efficient environmental policy
➢ Ability to monitor emissions, charge appropriate tax, and enforce this system

Examples:
1. Given: Demand: P = 1500 – 0.1Q
Private-cost supply: P = 100 + 0.1Q
Marginal external cost: $200
Social-cost supply: P = 300 + 0.1Q
Required: Solve for total external cost and for the true or net gains.

Solution: Since marginal external cost is a constant $200, (that is the difference b/n the
private supply and social supply curves)
= 300+0.1Q – (100+0.1Q) = 200 (marginal external cost)
=> Total external cost = MEC*Q
To calculate for Q, equate demand equation and the private supply cost equations.
=> 1500 – 0.1Q = 100 – 0.1Q => Q = 7000
=> TEC = MEC*Q = 200*7000 = $1,400,000

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Total gross gains from trade = CS+PS

To solve for CS and PS,

P
1500
S
cs
800
ps
D
100 Q
7000
Then you can find the areas using the rule followed for calculating area of right angled triangle
i.e. 1/2b*h, where b is base and h is height. Therefore:
CS = ½*700*7000 = 2,450,000
PS = ½*700*7000 = 2,450,000
Total gross gain is therefore, CS + PS = $4,900,000 and from above we have TEC of $1,400,000.
Thus, net gains from trade will be the difference between total gains and total external costs.
NG = TGG – TEC = $4,900,000 - $1,400,000 = $3,500,000

2. For the above example, solve for equilibrium P, Q, and total gains from trade assuming a
Pigouvian tax. Here since there is an assumption of Pigouvian tax, we will use the social
supply cost equation to solve for equilibrium P and Q. Thus, equilibrium Q can be solved by
equating demand and social-cost supply equation.
1500 – 0.1Q = 300 + 0.1Q ➔ Q = 6000
By substituting Q in the social-cost supply equation, we will get equilibrium P to be $900.
CS = $(1500-900)*6,000/2 = $1,800,000
PS = $(900-300)*6000/2 = $1,800,000
Total gains from trade = $3,600,000, which is $100,000 larger than in the free market without the
Pigouvian tax.

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Activity
1. Given:
Demand: P = 1200 – 0.1Q
Private-cost supply: P = 100 + 0.1Q
Social-cost supply: P = 400 + 0.1Q
Solve for equilibrium P, Q, and total gains from trade assuming a Pigouvian tax. By how
much does the Pigouvian tax enhance efficiency (net gains from trade)?

1.3. Imperfect Information

Imperfect information will lead People to make wrong decision. E.g. if individual A is smoker
and individual B is not and B doesn’t find that smoke Unpleasant, and is unaware of the danger
of passive smoking. Then, individual B hurt because of lack of information. How it is relevant to
Natural & Env’tal resource? If people have no information about the danger of pollution and the
effect of resource degradation, then it will end up with crisis. So the solution is information must
be provided by the government or by private individuals. The government may provide services
that are not provided by the market because of imperfect information (e.g. insurance).

1.4. Government Failure

Government failure refers to situations where allocative efficiency may have been reduced
following government intervention in markets designed to correct market failure.
When does government step in?
o To correct shortages or surpluses
o To provide when the market does not or can not provide some goods or services.
o To regulate and correct where there is perceived inequality or inefficiency
o To protect individuals and groups in society and provide a safety net for those unable
to help themselves
o To reduce poverty
o To influence property rights

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How does government intervene?

Taxation – to redistribute and provide incentive or disincentive effects

Subsidies – to encourage production/consumption
Regulation – guides, codes of practice, legislation, independent regulators
Identifying property rights – ownership of property, e.g. intellectual property, granting of
patents, etc.
Direct provision of goods and services – health, education, etc.

How does Government Failure manifest itself?

• Distortion of markets – e.g. rent control, minimum wage, agricultural subsidies, taxes
on fuel
• Welfare impact – erosion of consumer surplus and producer surplus – e.g. tariff support
for manufactured goods and food
• Disincentive Effects – High taxes hampering business expansion or enterprise, Welfare
benefits reducing, the incentive to find work
• Short termism – solving the ‘hot topics’ of the day rather than the long term important
issues – e.g. ID cards versus pension crisis?
• Electoral Pressure-Desire to get elected and pass ‘popular’ policies to capture votes.
E.g. spending on public services at the risk of higher inflation and future interest rates?
• Imperfect information: Lack of knowledge of, Prices, Value, Costs, Benefits, Long
term effects, Behavioural changes, External costs and benefits, Value of producer and
consumer surplus. All mean less than efficient allocation may result from government
intervention

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UNIT FOUR

ENVIRONMENTAL VALUATION

Introduction

Human activity strongly relies on the natural environment. Environmental resources are put to
different and sometimes competing uses by people. Many environmental resources are not traded
in markets and so do not have an obvious price. Though environmental effects do not have a
price that does not mean they do not have value. The economic concept of value has been
broadly defined as any net change in the welfare of society.
a fair or proper equivalent in money- represents the sum of money that would have an
equivalent effect on the welfare or utilities of individuals

Valuation is the heart of environmental economics and is emerging as a very active and rapidly
expanding field. The basic strategy for environmental valuation is the co-modification of the
services that the natural environment provides. It serves to assess individual and group priorities
and tradeoffs in the case of unpriced scarce commodities. In its simplest form economic
valuation is the process of identifying the relevant changes in consumer demand and producer
supply arising from a (project-induced) change in environmental quality, or the change in the
provision of an environmental resource. In brief Environmental Valuation is concerned with the
analysis of methods for obtaining empirical estimates of environmental values, such as the
benefits of improved river water quality, or the cost of losing an area of wilderness to
development.

Definition: Environmental valuation is the process of placing monetary value on the

environmental impact. It can also be defined as pricing of environmental impacts such as
environmental degradation.
➢ Market failure is the main cause for the occurrence of environmental impact. Especially
for non-marketable resources i.e. public goods.

➢ Market failure means that market fail to allocate resources efficiently. It occurs when
market do not allocate the scarce resources to generate the greatest social welfare.

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The Need to Value the Environment

There are two reasons why we need to value the environment;

1. Environment providing value to human being (it is base for life)

2. Many environmental goods and services have no market prices

Measuring damage is simple than measuring benefits, because benefits are not typically market
transaction. We can measure damages directly, by looking at damages and the value of what is
lost, or we can infer damages indirectly from the behavior of individuals.

Types of Environmental Value

There are two major types of environmental values. Use value and Non-use value
Total Environmental value = use value + non use Value
1. Use value
The benefits people get from direct use of a good.
• For most consumer goods, this is what we care about.

• For environmental goods, this can include:

– The value of recreation at a site

– The value of open land near a home

– The value from better health

Types of use value

There are three types of use value

1. Direct use value (DUV) - the value which we get directly from consuming some
environmental resource. The Direct use value is derived from goods, which can be
extracted, consumed or directly enjoyed. It is also therefore known as extractive or
consumptive use value. E.g. using tree for fuel.

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2. Indirect use value (IUV) - Indirect use value is referred to as non-extractive use value,
derived from the services that an environmental resource provides. A wetland, for example,
acts as a water filter, often improving water quality for downstream users. This service is
valued by downstream users, but does not require any good to be extracted or consumed.
Arise from resources indirectly. E.g. the existence of forest enables the existence of wild
animals. The use from that wide animal is indirect benefit arises from forest.
3. Option value – the amount a person would be willing to pay to preserve the option of being
able to experience a particular environmental amenity in the future. Option value is the
value derived from maintaining the option to use a good or service at some point in the
future, it is sometimes treated as a special case of use value

2. Non-use value

Non-use values are defined as those benefits or welfare gains/losses to individuals that arise from
environmental changes independently of any direct or indirect use of the environment. For
environmental goods, not all value is use value. Non use values are of different forms:
1. Existence value – a willingness to pay simply to help preserve the existence of some
environmental amenity. Example; Protection of endangered species
2. Bequest value – a willingness to pay to leave behind environmental quality for future
generations.
3. Stewardship value (SV) – a value placed on preserving the environment not for human use,
but rather to maintain the health of the environment for all living organisms.

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The Role and Limit of Valuation in Achieving Efficiency

Many environmental resources and services do not have well defined property rights. For
example clean air, such resources are used but without traded through market and will not have
market prices. Externality is a special case for this. That externality may exist from production
and consumption for which the surrounding society is not to be compensated for it. Emission of
SO2 from coal burning may be an example. But the resource has value despite the lack of price.
It has either negative or positive value since it brings a positive or negative change on the well
being of the society. In order to make allocatively efficient decision, such values need to be
estimated through different environmental valuation techniques. But these valuations by
themselves are assumption-the objection here is that, that assumption may lead to wrong
decision.

Valuation Techniques

Since there is no market for many environmental goods and services, there are some methods
used to value the environmental goods and services. Economists typically use one of two
approaches to measure the benefits of environmental quality:

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1. Revealed Preference Approach – infer the value of environmental goods from other market
transactions.
➢ Note that revealed preference approaches get at use values, but not non-use values.
Example: it is possible to use revealed preference approach for consumptive use values of
farming, forestry, fishing, grazing, hunting, mining, that contribute to resource depletion.
2. Stated preference techniques – ask individuals hypothetical questions about their
willingness to pay.

Willingness to Pay (WTP)- is the maximum amount of money an individual would give up in
exchange for all the benefits associated with an environmental resource.
• It is the value placed on an environmental good in terms of money.

• We can think of WTP as the area under an individual’s demand curve.

• That is, an individual can be said to be willing to pay an amount equal to the total
benefits received from the environmental good.

Willingness to Accept (WTA) - is the opposite of WTP. It holds in the case in which the
individual is the owner of the resource. WTA is the minimum total amount of money an
individual would accept to forego all the benefits associated with an environmental resource.
Example: if there is pasture land used by some farmers for grazing and that area is potential for
underground water extraction, then WTA what the farmer claim to leave the land. Since, WTP is
bounded by an individual’s budget constraint we can assume: WTP<WTA

Many indirect techniques are used to value. Many recreational amenities are not purchased in
markets so their value must be inferred from associated expenditures. Indirect measuring of the
cost is necessitated. Different methods:

1. Aversion Costs

Note that, in reaction to environmental harms, people may undergo expenses to remedy the
problem. Examples:

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• Filters for drinking water (refining)

• Air conditioners so that windows can remain closed

• Medication to mask symptoms of health effects

• By studying how much people spend on averting expenditures, we can estimate

the benefits they would receive if the harm were removed.

2. Travel Cost Method

The travel cost method looks at how far visitors travel to come to a site. By placing a value on
the cost of travel, we can infer the value of the site. The travel cost includes both direct costs
(e.g. airfare) and indirect costs (e.g. the opportunity cost of travel time). We can infer the value
of a change in quality by looking at demand during different days (e.g. in different types of
weather). It needs survey on the following questions:
– How many days did you use the site?

– Where are you from?

– How much did it cost to get there?

– What is the total length of your stay?

For example, assume there is one lake in a region, Lake Tana

➢ It attracts 40,000visitors/month. Each visitor spends 5 hours boating and 2 hours
traveling. The opportunity cost of time is $8/hr for every individual. Gas and car use cost
$6/travel hour per visitor. Entry cost is $2/visit. Thus, the total travel cost is:

= 40,000 * [8 * 7 + 6 * 2 + 2]
= 40,000 * 70
= $2,800,000
➢ Then $2.8 million per month is an estimate of a lower bound on WTP for recreational
benefits from the lake.

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➢ It is a lower bound, because anyone that finds it optimal to spend time at the lake must
receive at least enough benefit to cover the travel cost of getting to the lake, but might
receive considerably more.

The travel cost method may be used in assessing the lost recreational value resulting from
closure of the lake, if, say, an oil spill or excessive pollution from agricultural runoff causes the
lake to close due to public health concerns. If there are other substitute lakes, travel cost methods
become more complex. If there are three lakes, A, B, and C, closure of A will cause some people
to use B and C. However, B and C will be more crowded and the benefits of using them will
decline. Thus, we need to understand patterns of use of A, B, and C to assess their benefits and
the impact of congestion on benefits.

3. Hedonic Pricing

It is based on consumer theory, which postulates that every good provides a bundle of
characteristics or attributes. Market goods are often regarded as intermediate inputs into
production of more basic attributes that the individuals really demand. For example, the demand
for housing can be considered a derived demand. A house yields shelter but through its location
it also yields access to different quantities and qualities (example: schools, activities etc.) and
different quantities and qualities of environmental goods (open space, access to clean air,
woodland etc.). Thus HPM relies on the proposition that an individual’s utility for a good or
service is based on the attributes, which it possesses. If the hedonic analysis is conducted on
housing data, it is referred to as the property value approach. When applied to wage data – to
measure the value of changes in morbidity/mortality risks – it is often referred to as the wage
differential or wage-risk approach.

The hedonic property value approach measures the welfare effects of changes in environmental
goods or services by estimating the influence of environmental attributes on the value (or price)
of properties. In order to obtain a measure of how a specific environmental attribute of interest
affects the welfare of individuals, the technique attempts to: (1) identify how much of a property
price differential is due to a particular environmental difference between properties and (2) infer

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how much people are willing-to-pay for an improvement in the environmental quality and to
estimate the social value of improvements.

In attempting to isolate the effects of specific environmental attributes on the price of houses we
have to “explain” the price of a house as a function of its key characteristics. If we take house
price to be a function of all the physical features of the house (e.g. number of rooms, central
heating, garage space etc.), neighborhood characteristics, and environmental attributes, then the
following relationship can be identified. Price of home = f(lot size, number of rooms, location,
environmental quality…..)

Ph = f(x1, x2, x3,….E)

Where E measures environmental quality and x1, x2, x3… are the characteristics mentioned
above. The hedonic technique has several advantages. Firstly, hedonic analysis uses market, i.e.
observed, data on property sales or wage rates. The method is versatile and can be adapted to
consider several possible interactions between market goods and environmental quality.
Moreover, estimated values obtained from one study can be used in other policy areas if the
environments have similar demand and supply characteristics. On the negative side, the results of
hedonic studies are sensitive to the econometric assumptions adopted. Furthermore, the
assumptions necessary to interpret the results as measures of WTP are restrictive and, in many
real world settings, unrealistic. From a practical perspective, full hedonic pricing studies require
a considerable amount of data, which may be difficult and expensive to collect, such studies tend
not to be done quickly.

Contingent Valuation Method (CVM)

[Interviewing Technique]

It is a direct method of valuation. Currently, there is no other way to elicit non market values
besides asking people directly. This method uses interview techniques to ask individuals to place
values on environmental goods and services. The most common approach in the CVM is to ask
individuals the maximum amount of money they are willing to pay (WTP) to use or preserve a

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good or service. Alternatively the respondents could be asked the maximum amount of money
they are willing to accept in compensation (WTA) to forgo the given environmental good or
service. The basic notion underpinning CV is that a realistic, yet hypothetical market, for buying
or selling uses and/or preservation of an environmental good/service can be described in detail to
an individual.

Individuals are then asked to participate in this hypothetical market, by responding to a series of
questions. The features of the hypothetical market include:
• A detailed description of the good/service being valued. The situation before and after
any proposed change in environmental quality and subsequent provision of the
good/service should be clearly stated. In addition, it is vital that the respondents perceive
the correct good/service.
• A detailed description of the “payment vehicle”, i.e. the means by which the respondent
would pay for the change in provision of the good/service. The payment vehicle should
be appropriate to the good/service and the hypothetical market. Moreover, it should be
realistic and emotionally neutral.
• The procedure to elicit the respondent’s valuation. The actual valuation can be obtained
in a number of ways, for example, asking the respondent to name an amount, having
them choose from a number of options. The respondent could also be asked whether they
would pay a specific amount. In the case of the latter, follow-up questions with higher
and lower amounts are often used. Statistical analysis of the responses is then undertaken
to estimate the average WTP in this hypothetical market.

In principle, it can be used to value any change in environmental quality. Furthermore, CV can
be used to accurately elicit values about very specific changes in the provision of goods/services,
since it does not rely on observed data. But it requires that the hypothetical market and elicitation
questions be appropriately worded. Another advantage, with CV is that, in contrast to the other
valuation techniques described above, which only provide a partial estimate of the value of a
good/service, CV can provide a measure of the TEV of a change in environmental quality.

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However a CV method has been the subject of much criticism, mainly relating to their reliance
on hypothetical markets. In short, some economists argue that asking individuals hypothetical
questions only provides you with hypothetical answers, which cannot be meaningfully used to
value environmental quality changes.

In addition to the above conceptual concerns over the validity of CV based benefits estimates,
survey-based research is expensive and time-consuming, valid benefit estimates require properly
designed sampling and enumeration procedures.

Six stages in CVM

1. Set-up a hypothetical ‘market’
➢ Create a reason for payment eg. Conserving forest
➢ How are funds to be raised
2. Obtain bids
➢ Bidding game: higher and higher amounts suggested
➢ Close-ended referendum: yes/no reply to a single payment
▪ Single bounded and Double bounded
➢ Payment card: a range of values on a card
Open-ended question: no value suggested
3. Estimate mean WTP or WTA
➢ Mean/median of the bids are calculated
➢ Protest bids: e.g., refuse to attach any value, non-response
➢ Outliers:
4. Estimate bid curves
➢ How are the bids related to the individual characteristics of respondents?
WTPi or WTAi = f(Ii , Ei , Ai , Qi , O) Ii = income; Ei = education; Ai = age; Qi = size
of forest; O = other relevant factors
5. Aggregate data
➢ The bid value from the sample has to be scaled-up to the relevant population. If the
bids are related to different periods of time → discounting

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6. Evaluate the CVM exercise

➢ Proportions of protest bids
➢ Understanding of hypothetical ‘market’ by respondents
➢ Comparing with results from other studies

Main problems in interviewing include:

➢ Strategic Bias-(Not telling the truth)-Individuals may report benefits higher or lower
than their true benefits.
➢ Framing Bias: People's answers may vary according to the context in which a question
is put.
• For example, answers to a WTP question may differ depending on whether
the starting point of the initial value is $0 or $100.

• For example… start: $0 or start: $100 response: $10 response: $110

➢ Not well- formed Preferences: People may not have well-formed preferences (e.g. WTP
and WTA) for unfamiliar goods.
➢ Information Bias: Failure to comprehend or to interpret questions correctly.

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UNIT FIVE

ECONOMICS OF POLLUTION CONTROL

Introduction

The economics of pollution control deals with; how severe should environmental standards be
for: air quality, surface water quality, drinking water quality and any other pollutant. In this unit
we back to the flow of wastes in to the system focusing on:

1. What is the appropriate level of waste flows?

2. How to allocate the flows?

Pollution Taxonomy

Pollution is the introduction of contaminants into a natural environment that causes instability,
disorder, harm or discomfort to the ecosystem i.e. physical systems or living organisms. Pollution
can take the form of chemical substances or energy, such as noise, heat, or light. Pollutants, the
elements of pollution, can be foreign substances or energies, or naturally occurring; when
naturally occurring, they are considered contaminants when they exceed natural levels. Pollution
is often classed as point source or nonpoint source pollution. The damage caused by waste
disposal depends crucially upon the environment's ability to absorb the waste. The absorptive
capacity refers to the environment's ability to absorb waste products.

Examples of absorptive capacity:

➢ Carbon dioxide is absorbed by plant life
➢ Organic pollution in waterways can be transformed into less-harmful inorganic matter by
bacteria in the waterways.

Absorption capacity
of the environment

Emission Pollution
Load Pollution Damage
Accumula
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If emissions exceed the absorptive capacity of the system, they will accumulate in the
environnent and cause damage.

1. Classification of Pollutants by Absorptive Capacity

A pollutant is a waste material that pollutes air, water or soil. Three factors determine the
severity of a pollutant: its chemical nature, the concentration and the persistence. Depending on
the capacity of the environment to absorb waste pollutants can be classified in to two as:
a. Stock pollutant is a pollutant for which the environment has little or no absorptive
capacity. E.g.
• Non biodegradable bottles
• Heavy metals (e.g., lead)
• Some synthetic chemicals (dioxins and PCB’s)
b. Fund pollutant is a pollutant for which the environment has some absorptive capacity.
Examples:
• Carbon dioxide
• Waste paper products
There are two types of fund pollutants.
a. Uniformly mixed fund pollutant: - is one whose damage depends upon the total amount of
the pollutant entering the system.

b. Non-uniformly mixed fund pollutant: - is one whose damage is relatively sensitive to

where emissions are injected into the system.

2. Classification of Pollutants by Horizontal Zone of Influence

Depending on the horizontal zone of influence pollutants can be classified as:

a. Local pollutant: The damage caused by a local pollutant is experienced near the source
of the emissions. E.g.
• Non biodegradable plastics
b. Regional pollutant: The damage caused by a regional pollutant is experienced at greater
distances from the source.

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• Sulfur dioxides from coal emissions are believed to be a reason in the acid rain
problem.
• Carbon dioxide
Note: It is possible for a pollutant to be both. E.g. CO2

3. Classification of Pollutants by Vertical zone of influence

A. Surface pollutant: is one whose damage is determined mainly by the concentration of the
pollutant near the earth's surface.
Examples:
➢ Water pollutants, plastics etc.
B. Global pollutant: refers to a pollutant whose damage is determined by its concentration
in the upper atmosphere.
Examples:
➢ Carbon dioxide is often cited as a contributor to the greenhouse effect.
➢ ii. Chlorofluorocarbon emissions are linked to ozone depletion.

The Efficient Allocation of Pollution

Like other resource allocation, efficient allocation is one that can maximize the present value of
the net benefit. Different approaches needed to be considered in dealing with fund versus stock
pollutants.
a. Stock Pollutants
Stock pollutants cannot be treated in a static framework; because the decision made today affects
future generation’s welfare. Why, because stock pollutants are non biodegradable. Stock
pollutants have many of the same problems as nonrenewable resources with rising extraction
costs. What is done today has a permanent effect on all future generations.
I. Emitting pollutant ↔ extracting resources
II. MC of emission on society increases as stock of pollutant increases ↔ MC of
extraction increases as stock of resource decreases.
In fact the efficient solution is the same
I. The quantity of X produced over time should decline as the marginal cost of damage
increases. This will lead to a reduction in the amount of pollution.
II. The price of X should increase over time to reflect the increased social cost of pollution.
Resources committed to pollution control should increase over time. Eventually, a

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steady state will be reached where additions to the stock of pollutants would cease,
with emissions controlled instead.
Technological change can modify the efficient allocation by:
➢ Developing ways of recycling the pollutant
E.g. Recycling of water to reuse it.
➢ Developing ways of making the pollutant less harmful.

b. Fund Pollutants

Fund pollutants are to stock pollutants what renewable resources are to nonrenewable resources.
If emissions of fund pollutants exceed the absorptive capacity of the system, then the pollutant
will accumulate.
✓ This is similar to the regenerative capacity in renewable resources.

If the emissions are less than the absorptive capacity, no problem exists.
✓ However, as in renewable resources, one has to be concerned with what processes are
allowed to contribute to using up the renewable resource: "absorptive capacity."

MC Marginal Marginal
cost of damage
pollution cost

Quantity
of
Pollution
Q*
Emitted

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Suppose a product is going to be produced (i.e. fix the output level), generating Q 0 units of
pollution without abatement.

What is the efficient amount of pollution emission versus pollution control? There are two
marginal cost curves, both of which are increasing.
i. The marginal cost of pollution damage is increasing.
• Small amounts of pollution have only minor effects.

ii. The marginal cost of pollution control is increasing.

▪ It is harder to control all emissions than the first portion of emissions.

Activity
Is zero the efficient level of fund pollution? How?

Not necessarily. In the following diagram, the optimal level is Q*. Even if damage costs are high
enough, however, it can be efficient. We would generally expect the optimal level of pollution to
vary by region and types of pollution.

The Market Allocation of Pollution

Market does not naturally lead to the optimal allocation of pollution emission due to:
- The common property aspects of air and water
- Pollution is an externality.
The argument for government intervention in this case is particularly strong. Efficient policies of
achieving Q*:
1. Impose a legal limit (quota system)
2. Taxing pollutants
The amount of information needed in order to determine the efficient level of pollution is
enormous and existing estimates are uncertain. Instead that we focus on how to achieve a
predetermined level of pollution reduction in the most cost-effective manner.

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General Points

The cost of pollution control for the same pollutant can be expected to vary by industry and
within industries, depending upon:
• The size of the operation

• The age of the plant … etc.

The best source of information on the costs of pollution control will likely lie with the plant

managers. It is not realistic to expect industries to express accurate information on pollution

control costs. They will tend to overestimate the costs.

Pollution Control Policy Measures

I: Emission Standard

An emissions standard is a legal limit on the amount of a pollutant that an individual source is
allowed to emit. This is referred to in the literature as the "command and control approach." A
uniform standard is not cost-effective in this case. It is unlikely that the government would be
able to determine the cost-effective allocation.
➢ It does not have the necessary information to do so.

II: Emission Charge

An emissions charge is a fee, collected by the government, levied on each unit of pollution
emitted.
• How would the firm choose to control its pollution level faced with an emissions charge of
T?
✓ The firm should move to where the MC of control equals the emissions fee.

✓ Firms pay T which is equal to their marginal cost of control. It is possible for the two
firms to pay the fee amounted to the level of control q1 =10 & q2 =5 respectively.

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MC
30

MC1
20

10
T

0 5 10 15

The firm determine the pollution level at MC 1 equals T

194

It is better than emission standards in a number of ways:

• The firms now control in the least cost manner relative to each other, without the
government knowing the costs of pollution control for each firm.

• An iterative method can be used to achieve the efficient allocation by comparing the
pollution abatement goal with actual impacts.

• Firms have an incentive to adopt new technologies in pollution control, while standards
create incentives for firms to hide new control technologies.

The problem with emissions charges is that finding the efficient level can be costly and time
consuming.

III: Transferable Emission Permits

Under a transferable emissions permit system, all sources are required to have emissions permits
matching their actual emissions, with each permit
o Specifying how much the firm is allowed to emit and
o Being freely transferable.

Under this system the control authority issues exactly the number of permits needed to produce
the desired emissions level. Severe monetary permit are imposed upon sources polluting in
excess of the amount allowed by its permits. Notice that trading yields the most cost-effective

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allocation of clean-up among the two firms. Initial allocation of permits does not affect
efficiency: it only has distributional consequences.

Question: What are the distinctions among standards, permits, and charge systems?
✓ Standards are not only information intensive or likely no cost effective, but they also are
less likely to encourage innovation in pollution control.
✓ Permit systems adjust automatically, while the charge system must iterate to a solution
Problems for charges versus permits:
✓ Charges do not react to changes in the number of sources.
o Adding sources will not change the permit result, just the value of the permits
being traded.
o Adding sources will increase pollution in the absence of changes in the charge
system.
o Charges will not react to inflation unless they are modified. Permits will
automatically adjust.
o Permits will not enable technological change in pollution control to alter the
overall level of pollution, but a charge system will.

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UNIT SIX

THE THEORY OF RESOURCE EXTRACTION

Allocation of Non-Renewable Resources

Renewable Versus Non-renewable Resources

Renewable resources are replaceable naturally or by human activity. Examples of renewable

resources include trees and other plants, animal populations, groundwater, etc. Non-renewable
resources are those that are not replaceable, or replaced so slowly by natural or artificial
processes that for all practical purposes, once used they would not be available again within any
reasonable time frame. Examples are oil and mineral deposits…etc.

Economists define resource as renewable and non renewable not only based on fixed stock but
also has limited supply relative to the demand for them. E.g. a tree which takes 1000 yrs for
maturity may be considered as non renewable resource but is renewable by definition. Some
resource economists consider coal as renewable because of ample stock but is non renewable by
definition, because, it is possible to use the available coal for 3000 yrs. So, according to
economists there is no immediate coal scarcity only because of its fixed stock. I.e. there is no
scarcity rent associated with its extraction.

What is scarcity rent?

The Hotelling Model of Resource Depletion

Hotelling (1931) showed that the price for a nonrenewable resource will rise at the real interest
rate in efficient market equilibrium. The central question in non-renewable resource economics
is: given consumer demand and the initial stock of the resource, how much should be harvested
in each period, so as to maximize profits? Assume the extraction cost and the price P of the
resource in the market. Risk free interest rate on the investment in the economy is r% per year.
Then the owner of the resource can either extract today or hold it to extract in the future.

There are two factors influencing extraction decision here; any resource extracted today not
available in the future, and any resource left untouched may fetch higher price in the future.

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There are two comparable advantages for the owner; rate of interest and the increase in price in
the future. If rate of interest is greater than the increase in price per unit, it extracts today and
invests the money if otherwise it holds the resource to extract in the future and get higher return.

NRR extraction in perfectly competitive market

In a competitive market where there are a large number of sellers, and each seller can sell any
quantity at the going market price. The price rises exactly at the interest rate. If price raise
slower, resource owners will sell much and the price will fall. If it is to raise more than r%,
resource owners choose selling in the future there by decrease market supply and rise in price.
So, price of NRR increase continuously until the resource exhausts. Because the quantity
extracted is continuously falling.

As price increases the demand for resource is slowly choked off. I.e. price is so high that demand
is totally eliminated. Basically, this is when the resource stock is exhausted. Understanding this,
resource owners would sell their positive available resource before the choke price is reached.
There is over supply and there is lower price in the market.
✓ This would extend the time of the resource until the resource is entirely depleted.

NRR extraction in monopolistic market

Monopolists have the advantage of lower price elasticity of demand and can extend the time of
the resource having identical cost, initial stock and consumer demand with the competitive
resource owners. Because of lower price elasticity, monopolist can charge higher price than
perfect competitive. The result is that the extraction path tends to get stretched out over time than
the competitive one. That is monopoly slows depletion rate. This result has led to the saying, “a
monopolist is a conservationist’s best friend”.

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Allocation of Renewable Resources

Economics of Fishery

Fishery can be defined as the interaction of fish populations and human harvest activity. The
economically valuable portion of a fish population is a renewable but potentially exhaustible
natural resource.

Terms to be known in fishery

Bio-economics combines the biological mechanics of a fish population with the economic
activity of harvesting fish.
Biological mechanics: the dynamics of fish populations. Consider some habitat for fish which
has carrying capacity (K) for fish. Under biological condition the fish grows until the carrying
capacity exhausts. When it is maximum death rate =birth rate. This is biological maximum for
the available fish population. If conditions do not change, the population will remain at this
maximum, making it equilibrium.

Rate of Population growth rate curve:

Growth Describes population growth
for different populations of
fish
145

100

60

56

10

Number of
0 2 12 50 126 224 Adult Fish

Bio-Economics
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Begin with an unexploited fishery in biological equilibrium (where X = k): Suppose that the
harvest rate H exceeds even the highest possible population growth rate for the fishery. Then
population X eventually falls to zero. Fishers are “mining” the fishery. When the harvest of
fishery is sustainable?

The highest rate of harvest H that can be sustained by the fishery occurs where the growth rate of
the fishery stock is at its maximum (145 in the figure above).
✓ This point is called maximum sustainable yield (MSY).

Example of Mining the Fishery

The level of harvest at H is
maximum sustainable yield of
Rate fish harvest per year?

Fishery
Stock X
0 K

If we start with the stock at X = k (the unexploited biological equilibrium), and set harvest equal
to MSY, then what happens? Hmsy > F(X), which causes X to decline. This process continues
until X = Xmsy, at which point the harvest rate H equals the stock growth rate F(X) and no
further reduction in biomass occurs. This is equilibrium. Suppose that the fishery had been over-
harvested in the past and the stock is at X < Xmsy. If we start at a relatively low stock and set
harvest equal to MSY, then what happens? The population will be extinguished.

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Biological Mechanics
Rate

Hmsy

Fishery
stock X
0 Xmsy K

Steady-State Equilibrium Harvest

Rate
Steady-state equilibrium
harvest occurs where harvest rate
H = biomass growth rate F(X).

F(X*) = H

F(X)

0
X* Fishery stock X

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Due to low fishery stocks

(Xlow), it takes a higher With high fishery stocks
level of effort (E2) to (Xhigh), it takes a lower
generate the same harvest level of effort (E1) to
rate. generate the same harvest
rate.

H = G(E1,X)

0 Xlow X high Fishery

Stock X

Since effort costs money in a fishery (fuel, labor (opportunity) costs), the low biomass
equilibrium is bio economically inefficient for the fishing industry as a whole. It generates the
same harvest rate (i.e., tons per day) as the high biomass equilibrium, but involves higher effort
costs.

Derivation of the open-access equilibrium

Efficiency of the Open Access Equilibrium:

Under open access, equilibrium can only occur when profit is zero (no incentive to enter or exit).
Economic efficiency occurs at the profit-maximizing level of effort where MR = MC. Yet under
open access, the equilibrium level of effort is selected where profit equals zero and MC > MR.
Thus the open-access equilibrium always features an inefficiently large amount of effort being
deployed in the fishery. Group optimum harvest (“socially optimal” harvest) takes into account

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the stock effect, and occurs where industry-wide profits are maximized, which occurs where
marginal revenue equals marginal cost.

Steady-State Equilibrium Effort

$ Open access means that equilibrium effort (Ehigh) is

found where fishing industry profit = 0, which
occurs where total revenue equals total cost.

TC = cE

TR = pH(E)

Extinction
0 Ehigh Effort E

Why is extinction more likely to occur under open access than under group-optimum harvest?
Biologically, a key characteristic of fisheries susceptible to extinction is that there is a threshold
population > 0 that must exist in order to sustain the species. If the population falls below this
threshold, the population declines to extinction. Threshold effects are more likely to occur in fish
species with few births per fertile female. Economically, extinction can occur under open access
when the price of the fish rises sufficiently that the zero-profit level of effort only occurs at the
origin.

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Forest Economics

Optimal Timber Harvest Interval

Imagine that you are a profit-maximizing timberland owner. What are the economic tradeoffs
involved with either harvesting or allowing your trees to grow for another year? Some
simplifying assumptions: Objective: maximize the net present value of the land for production of
timber
– Assume uniform-aged stand
– Assume harvest and replanting occur in the same time period
Imagine again that you are a profit-maximizing timberland owner. What are the costs involved
with operating commercial timberland?
Two important types of landowner cost:
– Stand management costs (planting, silviculture, harvesting, etc.)
– Opportunity cost of allowing the stand to grow another year—i.e., earnings that could
have been obtained if the trees were cut, the profit were invested, and that investment
generating income.
The landowner receives the residual income or profit from the land, called the land rent.

Timber production production curve

Stand
Volume V(t)
Vmax

Inflection point where

growth rate begins to
slow

tx t (Vmax) Age of stand t

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Timber Production Terminology

Current annual increment (CAI): Incremental growth (marginal product) as a function of time.
CAI = V’(t).
Mean annual increment (MAI): Mean increase (average product) in timber volume. MAI =
V(t)/t.
Culmination of MAI (CMAI): When MAI reaches its maximum. CMAI occurs where CAI =
MAI.

The drop in MAI after CMAI is reached signals a relative decline in the stand’s growth rate
compared to previous years’ growth rates. CMAI is sometimes considered a harvest rate broadly
consistent with forest sustainability. While the ecological sufficiency of CMAI-based harvest
intervals is debatable (CMAI does not represent a tree’s biological maturity, nor do CMAI-based
harvest intervals necessarily produce the late successional forest habitats needed by many
sensitive species), it stands in contrast with standard timber industry rotations of 40 to 50 years.
The harvest interval that generates maximum sustainable yield occurs at CMAI.

The optimal time to harvest from a profit maximization perspective would be the age that
maximizes the present value of net benefits from the wood. Recall the costs associated with one
harvest interval:
✓ Planting costs ($D)
✓ Silvicultural and harvesting costs ($c per unit of volume V).
Since harvesting costs are in the future, we need to take their present value. Harvesting costs are
discounted and are proportional to the amount of timber harvested. The net benefit of a unit of
wood harvested at any age is the price of the wood minus the marginal cost of that unit. A tax
levied on each cubic foot of wood harvested would simply raise the marginal cost of harvesting
by the amount of the tax. High discount rates and high replanting costs could make replanting
prohibitively expensive.

Recall the “S”-shaped growth curve for trees. At first they grow quickly, and then slow down.
For the profit-maximizing timberland owner, the issue is how fast the trees grow in volume
(“V”) relative to how fast their bank balance grows (interest rate “r”). All else equal, if a

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timberland owner can make a high rate of return by investing in a stock market, how does that
affect the harvest interval?
Factors Supporting Longer Intervals

Occasional thinning can increase the growth of residual trees, even in relatively old stands,
thereby delaying CMAI, enhancing the stands’ overall productivity, and increasing revenues.
Thinning can also provide a significant source of revenue prior to final harvest. By delaying
CMAI and generating revenue prior to final harvest, thinning can increase the economically
optimal timber harvest cycle, depending on the cost of thinning.

Property Rights and Forestry Management

The state has traditionally played a central role in forest management in post-colonial India.
Large tracts of forests were nationalized with a view to promote soil and water conservation and
maximize revenue from the sale of forest products. However, the record of state stewardship of
forests has not been encouraging, both in terms of increasing productivity of forests and
sustaining supply of forest products to rural communities. In recent years declining productivity
of forest lands and rising costs of forest protection efforts have been a cause of concern at the
level of policy making. If property rights are not very secure (e.g., indigenous people, dictatorial
central governments, unlawful tenants, etc), then sustainability will not be achieved.
Security of tenure of natural resources is an important issue if local communities are to use
sustainably natural resources in their localities. Tenure is a set of rights that a person or some
private entity holds to land or trees (Bruce, 1989). It includes questions of both ownership and
access to resources. Tenure determines whether local people are willing to participate in the
management and protection of forests (Bromley, 1991/92).

Failure to recognize indigenous systems of forest management and indigenous rights to resources
has led to:

• Loss of incentives by the local communities to protect trees;

• Discouragement of local people to engage in tree planting and reforestation projects; and
• Excessive reliance by the state on punitive measures to enforce the law.

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Certified Sustainable Forestry

Concerns about the environmental and social impacts of commercially-driven timber harvest,
and about the sharp conflicts between timber companies and environmentalists, led to the
creation of the Forest Stewardship Council (FSC) and the idea of certified sustainable forestry.
The FSC promotes responsible forest management globally by certifying forest products that
meet the most rigorous standards in the world. The organization brings industry,
environmentalists, and community groups together to promote practical solutions that meet its
diverse stakeholders’ needs.

The organization was founded in 1993 by environmental groups, the timber industry, foresters,
indigenous peoples and community groups from 25 countries. The FSC in the United States is
backed by 14 major environmental organizations (the Nature Conservancy, World Wildlife
Fund, Sierra Club and others) and by major businesses (Home Depot, Lowes, Anderson
Windows).

FSC standards encourage environmentally appropriate, socially beneficial and economically

viable management of the world’s forests. FSC’s Principles and Criteria are the basis for
defining responsible forestry and for evaluating and accrediting certifiers. Consumers
purchasing products bearing the FSC label can be assured that their wood product comes from a
forest that has been managed to FSC standards.

In order to be FSC certified, a company must:

• Meet all applicable laws
• Have legally established rights to harvest
• Respect indigenous rights
• Maintain community well-being
• Conserve economic resources
• Protect biological diversity
• Have a written management plan
• Engage in regular monitoring
• Maintain high conservation value forests

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 Handout for “Natural Resource and Environmental Economics”

• Manage plantations to alleviate pressures on natural forests

The Forest Stewardship Council provides an independent guarantee of integrity. The FSC
provides a credible and consistent approach to certifying forest products. This certification
system ensures an independent evaluation of a forest company's practices, according to rigorous,
publicly available forest management standards. The Forest Stewardship Council is the only
system that verifies claims from the forest all the way to the final product, a process known as
"chain of custody (protection)” monitoring.

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