ECON 2J03 – Environmental Economics Cumulative Note

| Professor: Sara Kamali Anaraki | Lectures: A2L video | Ch 1-4 |

ATTENTION: This document is an accumulation for the entirety of the course. Below is a key of what content was
covered

- Week 1: Ch 1-2 What is Environmental Economics & The Economy and the Environment
o Practice Q for ch 1-2 & video solution
- Week 2: Ch 3-4 Benefit/Costs, S&D, Economic Efficiency/Markets/externality/ Public Goods
o Practice Q for ch 3-4 & video solution
o Quiz1: Friday night due (week1-2)
- Week 3:
o Ch 5-6 The Ecoprocnomics of Environmental Quality, Framework of Analysis
o Assignment1: due July 9 11:69pm
- Week 4:
o Ch 7-8 Benefits and Cost Analysis: Benefits & costs
o Midterm: Due June 16 11:59pm
- Week 5:
- Week 6:

Week 1: Chapter 1 – What is Environmental Economics:

Environmental Economics:

- Economics: study how/why ppl make decisions about use of valuable resources (micro/macro)
- Environmental Economics: economic activity impact natural environment (micro)
o Goal: help reduce degradation of environment
o EX. atmosphere, water, land, pollution, waste
- Consider: focus on ways to reduce effect on env.
o Accounting for effect of economic activity on environment
o What inhibits economic systems from using resources efficiently to be sustainable

Evaluating Outcomes and Policies: Two Main Criteria Efficiency and Equity

Efficiency: used in env econ as central criteria for evaluating outcome/policy

- Goal: use policy to max protection env, min cost resources

- Economic Efficiency: occurs when either
o all resources put to highest valued use
o desired outcome reached while only use fewest resources
- Judgment value: has value if someone wants it (EX. walk in forest vs computer)
o EX. resource made into either good A, B, C à Value of use that is highest is chosen

Equity: make policy fair/efficient, how resources divided among people/groups (circumstances)

- Horizontal Equity: treats equals, equally

- Vertical equity: treats unequals, unequally
- Intergenerational Equity: whether future generations have same opportunities as older one
 o Use of resources today impacts future
- EX. Gov divide income equally to each person (total earning/n)

Why People Pollute: Why behave in ways that cause environmental destruction.

- Moral Approach: people are unethical/immoral, incorrect incentive systems

o Challenge: morality subjective (different moral values), hard to motivate change
o Goal: increase environmental morality in society to stop polluting
- Cheapest Disposal: after production and consumption
- Incentive: attracts/repels people to change behavior in some way
o Economic Incentive: related to production and consumption decisions
 Payoffs wrt material wealth (and non-material EX. kids opp, preserve env.)
 Incentive to behave in ways that provide increase wealth
- Profit Motive: (incentive-type), rewarded for profit max
o “Environmental impacts don’t pay”: given no thought
o Includes: corporations, individuals (pouring paint, chargers plugged), gov agencies
(subsidize industries degrade environment, even though they are not profit-motivated)

Externalities and Property Rights: important to understand incentives that exist in env.

- Property rights or lack of ownership: why problems exist

- Lack ownership rights to env resources à few incentives to account for env. Impact

Open Access Resources: Many env resources no clear property rights EX. nobody owns ocean /
atmosphere.

- Open access resources: no 1 clear owner, anyone use without paying

o EX. no permission/pay when car emits pollution
- Private property right: owner has rights to exclude others from using resource
o EX. nobody use car without permission, pay to rent

Common Property:

- Common Property right: power to community to govern resources within borders

o Outside community excluded from resources
- Common Property: a resource shared among group of people
o Open access: if nobody controls (ocean, atmosphere)
o Not open access: set of users well defined and access controlled
 EX. fishing community shared common property but not open access

Externalities: Smog and Motor

- Externality: actions of 1+ ppl affects wellbeing of others, without compensation

o AKA External costs or effects
- EX. Driving car: personal benefits and costs imposed on others (pollution: air, noise, congestion)
o Paid: gas, maintenance, insurance, etc. (not paid: pollution, air, etc.)

Incentives to Address External Costs:

 - Incentives: used to address problem created by externality
- EX. Drivers: forcing drivers to account for external costs when drive? Or companies to adress?
o Target: #vehicles on road, avg km travelled, emissions/km, where people drive
o Number of vehicles:
 levy charge per year for own car + license fee (annual or when renew lic)
 Improving public transit (alternatives/substitutes)
o Average km travelled:
 Higher costs per km
 Direct incentive: tax on number of km driven
 Indirect incentive: tax gasoline > price rise > drive less
o Emissions per km:
 Tax on emissions: EX. Carbon tax in British Columbia
 Buyback program: pay ppl to retire older vehicles
 Advertising & education: inform ppl of affects and well-being
- Waste Disposal: firms have incentive to use services of environment for this purpose
o Challenge: incentives that treat env services as a costly activity (not a free good)
 Firms are profit driven: more use environment = more profit
o Policy Government: reduce firm/business incentive to change behavior
o Laws and regulations: amount a firm can pollute/emit --> reduce emissions per km
 EX. Sulphur content of gasoline regulations
 EX. Oil refiners' tax on basis of Sulphur content of gasoline produced

Greenhouse Gas Emissions / GHG and Climate Change

- GHG Accumulation: concentration of GHG atmosphere rising w rise emissions

- Emissions CO2 and GHG rising: due to growing use of carbon fuels (gas, coal, oil)
o Largest GHG source (1): electricity/heat generation (coal fired power plants)
o Runners up: transport (2), industry (3), Residential (4), other (5).
- Global Climate change: GHG trap heat in atmosphere (costs ~$70-100 B per year)
o Loss crops, health impact, loss species, ecosystems, etc.

Costs of Mitigation

- Burn fewer carbon fuels (gas, coal, oil) to slow global climate change
o Challenge: carbon fuels are low cost and ease of use, alternatives costly/unreliable
o Alternative sources: wind and solar power
o TF: trade off b/w cost associated w changing sources and not changing
- Precautionary Principle: society should weigh trade off b/w costs to switch vs benefit in future
(lower level of climate change and lower risk)

Sustainability:

- Sustainable economy: economy that allows wellbeing rise/constant over time (not fall) while
sustain healthy ecological systems.
o Challenge: using natural resources, cannot sustain economy in future
o Human ingenuity: find ways to overcome resource scarcity (new resources/methods
when run low)
  EX. Green Revolution: rise food production, now world more food/person than
ever (as population rises)

Social Capital

- Social Capital: broad economic capital (1. human, 2. natural, 3. produced)

o Human capital: labour and knowledge
o Natural capital: natural resources
o Produced capital: machines and tools
- Ecological Integrity: overall social capital continual growth (as use resources, new ways
produce/limit pollution) in sustainable economies

Trade-offs and Sustainability:

- Production Possibilities Frontier (PPF): shows trade-off b/w output of g/s and env. Quality
o Depends on: technical and ecological capacities in economy
o Max combo output for given level of env quality at full/efficient utilization.

o
o The Graph ^^^:
 PPF: Concave curve
 Vertical: production of g/s in economy
 Horizontal: environmental quality
 At y = 0; x is maximized (at point Emax)
 Any level x below ebar can result in no g/s (production not sustainable)
 EX. if production at e1. Want increase output to e2, need reduce env quality
from e1 to e2.
 CIC:
 CICb: best point is B (higher value env, lower value g/s)
 CICa:best point is A (balanced value)
o Choice: fossil fuel intensive economy & destruction of ecosystem/economy from CC
- Community Indifference Curve (CIC): combo of output and env quality perceived by society to
provide given level well being
 o Higher IC = Higher social well being
o Goal: mac CIC at point where highest CIC curve is tangent to the PPF
 EX. countries a/b: different CIC1 and CIC2. CIC2 has optimal well being
o Depends on: social values and preferences
 As Y rise > GHG rise > env quality diminishes
 Community preferences (CIC): society decide Q desired and level of env quality

Tradeoffs over time – Future PPF SCenarios:

- Future: many things can change the PPF position, choices influence PPF,
- In LT: society choices impact position of PPF
- Pessimistic Scenario: env degradation, society consume lots fossil fuels, g/s not sustainable
o No matter where society places on PPF, need fewer goods or lower env quality
o high use nat. Resources > PPF shift falls/inward/left > unsustain. Econ > C falls
o EX. keep production at c2, level env quality falls to e3 (see graph)
 E2 is not sustainable anymore
o EX. Want to keep env quality at e2, they need reduce g/s to c3.

o
- Optimistic Scenario:
o Investment/research/efficiency > tech improve > PPF shift out
 When using resources that produce more with higher env quality
o Sustainable economy allows C growth in future while improve env
o EX. Society want stay c2 level production, env quality can increase e2 to e4
o EX. Want increase production level, can achieve at same level of environmental qual e2
Week 1 – Ch2 – The Economy and the Environment:

Natural Capital and Impacts of use:

- Natural Capital: intrinsic value, sustains life/economic activity, well being

o Produce g/s over time (provides inputs into everything consume)
 EX. food, electricity (intangible: well being, quality of life)
o Depletable: if not enough reinvestment sustaining it, will decline g/s
- Natural Capital Components: In Canada
o Natural resource capital: EX. Stocks in renewable/non-renewable resources
 EX. Minerals, Energy, Water, Forests, Fish
o Ecosystems or environmental capital:
 Watersheds give fresh drinking/irrigation water
 Pollution assimilation in air/water/soil
 Water runoff control by wetlands
o Land
- Impacts of Natural Capital Use:
o Draws down stocks available in future: catch too many fish today leave fewer future
o Residuals (waste): created by use EX. Process fish, raise fish create ocean pollution
 Waste will degrade Natural Capital stocks EX. Fish no reproduce in degraded env
o Sustaining stocks important to sustain life and economy

Natural Resource Economics

- Natural Resource Economics: efficiently extract/harvest nat resources over time

o EX. When to cut trees: grow big or cut sooner?
o EX. Q of fish caught without threatening species health?
o EX. Mining company dig ore over LT, produce at maximum ASAP
- Some resources are renewable (timber, fisheries, grow over time, sustainably harvested), and
some are non-renewable (fossil fuels, once used gone forever, not sustainable)

Environmental Economics

- Environmental Economics:
o Examine: waste products/residuals from prod/consume
 o Reduce/Mitigate: flow of residuals, less damage on nat. env & depletion capital

Circular Flow for Environment and Economy:

- Circular flow: flow of natural capital inputs in prod of g/s. “what goes in, comes out”
- Production/Consumption causes residuals (can be recycled EX. Materials in air/water/land)
o Residuals: degrade natural capital and natural environment
o Without means of reinvestment will decline environment
o EX. production side: sulphur, pesticide, waste building material
o EX. consumer: hazardous materials, pesticides, batteries

o
 Natural env provides nat capital stock in production and consumption process
 Producers use natural capital to produce goods (for consumers)
 Both prod/consumption generate residuals, which can be recycled back into
production or discharged into natural environment

Ways to Reducing Flow of Residual Wastes into Environment:

- Reduce amount residuals: reduce input of natural capital in system (4 ways below)
o Reduce Q of g/s produced (not popular)
 Challenge: people reluctant to live with less (or the pop. Must shrink)
 Reluctant: to give up material/income (despite being able to live w less)
 Consider: what are we happy with? What willing to give up?
o Reduce residuals from production (more popular)
 Pollution prevention: improve production, reduce intensity of residuals
 Consume less polluting goods: env. Friendly goods, organic, less harmful
residuals in environment
o Increase recycling:
 Reduce residuals: Need fewer raw natural resources in production
 EX. Recycling aluminum > less bauxite from nature and energy in prod
 Challenge/Limits: not all recyclable, goods degraded, needs input of resources,
costly
o Substitute other inputs for natural capital
  Local foods: less pollution, healthier, taste better (slow food movement)
 Challenge: requires more labour in the field/at home
 Goal: substitute more labour for less usage of natural resources

Types of Pollutants

- Characteristics impact the policies that reduce their harmful effects

- Accumulative vs Non-Accumulative:
o Accumulative: stay in env for long time, new emissions added to stocks of past
 Challenge: hard to address (consider past, present, future emissions)
 EX. plastic, radioactive waste, GHG
o Non accumulative: short-lived, disperse and assimilate quickly in env.
 EX. noise
- Local vs Regional and Global Pollutants:
o Local: affect only small area, pollution produced in specific area, impact local
 Easier identity/deal with: polluter and affected ppl in localized area
 EX. Noise, land degradation, ground level ozone (smog)
o Regional and Global: travel long distance from source, long lived, atmosphere/water
 EX. acid rain, GHG
- Point source vs non-point source:
o Point Source: few identifiable sources, easier to address (can identify/monitor)
 EX. power plant emissions, pollutants from major industrial facility
o Non-point source: no clearly identified source (or numerous cant tell which)
 EX. GHG, stormwater runoff from roadways, nitrogen runoff in waterways
- Continuous vs Episodic Pollutants:
o Continuous: steady production of pollution, easy address (easy measure/monitor,
technology to control)
 EX. car emissions, power plant, wastewater emissions
o Episodic: happen occasionally/rarely, hard to reduce risk episodes of pollution happen
 Hard estimate likelihood of catastrophic event, right supplies/equipment to deal
 EX. oil tanker spills, oil well blow out, pipeline rupture, chemical spill

Week 2 – Chapter 3 – Benefits and Costs, Supply and Demand:

Willingness to Pay (WTP):

- Value of good to a person: what are willing and able to sacrifice/pay for it
- Determinants: individual values and wealth
- WTP: reflects ability to pay, can be inferred from people’s behavior when buying goods
- Direct Survey Method:
 -
o TWTP = $15 for up to point 4 of consumption (4.5+4+3.5+3 = 15)
o Consider: the bar graph approximates the smooth curve (underestimates in bar)
- Diminishing WTP: the WTP declines as number of units consumed rises
- Marginal WTP (MWTP): additional willingness to pay for one more unit of a good
- Total WTP: total amount a person would be willing to pay for a given consumption level
o TWTP = sum MWTP for each item
o

o
 EX. based on graph: q4 WTP for one more unit is 3$
 EX. willing to pay for the 8th unit is $1
 EX. at Q2, willing to pay 3.5$ for the 3rd apple
 Marginal WTP: height of points in line
 Total WTP: sum of Marginal WTP for each item from 0-4
o TWTP = (a+b) = (3*4)+(2*4/2) = $16

Demand Curve & Law of Diminishing Marginal Utility:

- Demand Curve: represents all potential Q available and WTP of consumers for each Q
o Quantity Demanded (Qd): is associated with each price level, decreases as P rises
o General function for linear demand: uniform change in Qd when P changes
 Qd = alpha – Beta*P
 Beta = change Qd / change P (usually: change Qd = 1, marginal)
o Inverse demand curve: P = alpha / beta – (1/beta) *Qd
o Solving the Demand Equation:
 1. Find Qd when P aka WTP = 0 à alpha (intercept)
2. Plug in a point (P, Qd) and alpha (step1) into the equation à solve Beta (slope)
3. Create equation
o Typically: Qd(P)
o Converting P(Qd) à Qd(P)
1. Rearrange equation solve for P
2. P = alpha/Beta – (1/Beta)*Qd (inverse demand curve)
- Law of Diminishing Marginal Utility: more have of something, less TWP for additional unit of it
o D curve downward sloping, points on curve show marginal WTP for product
o Marginal WTP affected by: #same items have, taste/pref., time, situation

Non-Linear Demand Curve

- Many goods have non-linear Demand curve (not constant slope) EX. water usage
- Demand relationship is convex: using the water demand graph
o At low prices and high rates consumption: rise price will reduce Qd
 EX. increase price from 10$ à 20$ > water reduce from 400 to 200 (change 200)
o At high prices and low rates consumption: rise price will reduce Qd by less
 EX. rise price from 20-30$, water use reduces from 200 to 150 (change 50)

Aggregate Demand Curve

- Recall: Measuring individual demand for a g/s: summarize personal consumption attitudes and
capabilities.
o Different for individuals due to taste, WTP, incomes, economic policy, etc.
o Consider: economic policy focuses on groups and totals, aggregate

- Aggregate Demand Curve: horizontal summation of individual demand curves

o Deriving: adding up individual demand curves at each price (sum of Qd at each price)
 o


 Deriving AD:
 Pick a price level point: y= 3
 Sum of the WTP for each person at y=3 (sum) =4+2 = 6
 TF: one point on the Aggregate demand is (6, 3)
 Repeat for all price points to derive the entire line (minimum 2)
 Plot all points on the graph
 Example:
 Complete the inverse aggregate demand: P(Qd):
o Qd = 15 – 3P
o Qd – 15 = 3P
o Qd/3 – 5 = P

Shifts in Demand Curve

- movement along the demand curve (not a shift): caused by change in price
o EX. oil price rise: demand curve stay same in short run, move to Q2 (p2)
 o
- Shifts in Demand Curve:
o Change taste and preferences
o Change in time
o Change in income
- Ability to pay: factor determining demand, marginal WTP, and total WTP for a good

Benefits:

- Benefits: “being better off”, confer benefits on people by give something they value (If WTP)
- Benefit received: amount they are WTP for the good
o WTP = area under Demand curve between two Qs.
- Use ordinary demand curves to determine benefits of making various things available to people
o Change in total benefit (total value) for each person

T
 Consider:
 For D2: At Q1, value = area under demand curve from 0-q1
o At Q2, value = area under demand curve from 0-q2
o Change in value = area b
 For D1: At Q1, value = area under demand curve from 0-q1
o At Q2, value = area under curve from 0-q2
o Change in value = area a + area b
o Who values the good more: those with higher WTP (higher benefit from increase Q)
o Evaluate impact/benefit env. Programs/policies of the gov: based on value ppl place on
- Shortcomings: when measure benefits with the demand curve (based on WTP)
o Demand (benefit): hard measure in environmental questions and g/s
o Demand curve impact by ability to pay and preferences
 EX. lower demand curve (low income) higher demand curve (higher income)
 TF: increase Q can create benefits for higher income not lower
o Why: lower income = high marginal utility, don’t have WTP
  EX. poor has high MU from good than the rich, but cannot be WTP since unable
o Demand affected by how much people know about It (not WTP for good if don’t know it
exists)
 EX. environmental degradation, people don’t know

Opportunity Costs

- To produce goods: need workers (labour), rent buildings, buy raw materials, other inputs
o As Production rises > #inputs required rise > resources bid away from alt. uses > OC rise
- Opportunity cost: maximum value of other outputs could have produced if used alternatively
o Measuring: value of inputs used up in production (need to be valued correctly)
 Shadow prices: measure cost if markets operated perfectly (if distorted market)
 Imputed price: no markets for environmental goods,
 OC in terms of #other could have been made à NOT USEFUL
 OC in terms of value of next best output forgone à HARD

Marginal and Total Costs: cost info summarized in clusters

- Marginal Cost (MC):

o Amount which total cost increases as output increases by 1
o Height of each bar is the marginal cost
- Total Cost (TC): costs of producing the total amount of output
- Example1: Stepped-shape function:
o MC = height of each bar (added cos when Y increases by 1)
o TC for the nth unit (output) = sum of bars up to the nth unit
o What is TC to produce for the 5th unit: 1.67+2+2.33+2.67+3 = 11.67

o
- Example 2: Smooth Linear Function:
o TC of the nth unit = area under the MC curve and up to the nth unit = Area a + Area b
 o
 MC = height of each point
 TC = area under the curve over the units of output range (a+b)
 Area A = 5*1.67 = 8.35
 Area B = (3-1.67)*5/2 = 3.32
 Total Cost = 11.67

Supply Curve

- MC of production: key factor determining supply behaviour of firms in competition

o MC of a firm = supply curve
- Supply Curve: represents #units supplier willing to produce at different P level
o Upward sloping (generally), MC of production rises as more units made
o Firm produce where MC = P (to maximize profits)
o General linear Supply Function: Qs = alpha + Beta*P
 Same steps as deriving supply curve
o Inverse supply curve: MC = P = alpha/beta + (1/beta)*Qs
 Rearrange to P(Qs)
- Example: deriving the supply curve (from the graph)
o Intercept: 1.67 (when output=0)
o Slope: (3-1.67)/5 = 0.266
o TF: P = 1.67 + 0.266*Qs

Aggregate Supply: economist work with aggregate info

- Aggregate Supply Curve: horizontal summation of individual supply curves of firms/individuals

o Derive: adding up the individual supply curves of all firms
- Aggregate MC Curve:
o Derive:
 Calculating inverse supply curve each firm (firms set P=MC, profit max)
 Add up each MC curve
-
 o
o Deriving Aggregate MC Curve:
 Firm1: output at price 2$ can make 2kg
 Any Q lower 2k: price > MC (not profit maximizing, Qd rise)
 Any Q above 2k: price < MC (not profit maximizing, Qd fall)
 Frim2: output at 2$ is 0
 Aggregate Qs at 2$ price level = 2 + 0 = 2
 Aggregate Qs at 4$ price level = 8+2 = 10
 Connect both points to make the aggregate supply line
 Do this for each price point for each firm to capture each point Aggregate curve
o Inverse Equations: MC is vertical axis, rearrange and solve for P
 Firm 1 rearranged: 3P = 4 + Qs à P = 1/3Qs + 4/3
 Firm 2: P = 2 + Qs
 Aggregate: 4P = Qs + 6 à P = 3/2 + 1/4Qs
o Slope = change Qs / Change P

Shifts in Supply Curve:

- Shift Factors:
o Change in cost of input resources: MC changes (positive relationship)
o Change in technology (productivity): as T rise > Supply down (cheaper to produce)
 EX. Tech progress > down shift MC > TC reduced by amount = area A


 Before tech process MC1, TC is area under MC over production range
 After tech progress MC2, TC is area under MC over production range
 Change in TC = area a (Cost savings)
  TF: Technology brings new ways of producing with fewer env. Side effects

Week 2 – Chapter 4 – Economic Efficiency, Markets, Externalities, Public Goods:

Economic Efficiency

- Recall Relationships:
o Output and WTP
o Output and MC
- Economic Efficiency: when marginal benefits from production = MC of production
o D = MC
- Social Efficiency: all market and non-market values and prices in marginal benefits/costs of
production
o When Marginal Benefit (aka. MWTP, Demand) = MC (supply)

Socially Efficient Equilibrium

- Identify socially efficient output level: where MWTP = MC

-

- Solve for Socially Efficient Level of Output:

o Assume MWTP = 100 – 2Qd and MC = 0.5Qs
o Set MWTP = MC and solve for Qe (where: Qd = Qs = Qe = 40)
 100 – 2Qe = .5Qe à 100 = 2.5Qe à 40 = Qe
o Sub Qe into MWTP or MC to get MWTP = $20
 MC = 0.5(40) = 20 = Pe
o TF: Socially efficient level output is 40 units for 20$

Net Social Value

- Net social value (aka social surplus aka net benefits): when output produced at socially efficient
level, NSV max
o NSV = TWTP – TC
 TWTP: area under MWTP (demand) curve from 0-Qe (a+b+c)
 TC: area under MC curve from 0-Qe (area c)
o NSV = (a+b+c) -c = a + b (Difference between the two areas )
o At other Q levels (not socially efficient) TWTP – TC < a+b
 o
 NSV Calculation from graph:
 Area A = 80*40/2 = 1600
 Area b: 20*40/2 = 400
 NSV = 2000

Efficiency and Equity

- Efficiency: market achieves max total benefit (regardless who gets benefit EX. rich richer
o Not all efficient decisions are equitable (small number benefit, majority not)
- Equity: considers distribution of benefits, equitable and fair (hard to determine, shared widely)
- Economic Efficiency: do not need equity in distribution (max pie, not how sliced)
o More benefits > cost à good, regardless of who pays, who receives benefit
- Equity matters if consider/assume Diminishing Marginal utility from income
o EX. 1$ worth less to rich, redistributing money increases utility level of society

Markets and Market Equilibrium

- Markets: countries rely on to allocate scarce resources, buyer/sellers make decision Q produce
o Not completely efficient (beat alternatives for most g/s)
o Preferred to alternatives: allocate to those who value highly, give producer incentive to
make goods people value
 EX. cost minimizing incentive, incentive to cheaper inputs (tech), etc.
- Alternatives to markets: issues how to give right incentives to producers & consumers
o Need-based distribution
o Equal distribution
o First come first serves
o Lottery
o Mad max; might makes right for people
- Market Equilibrium:
o Market Eq point: QS = QD or MWTP = MC
o Markets usually move towards Eq and reach eventually (by adjusting price)
 EX. Items they cant sell: drop prices if they have too many Q
 EX. Items they can sell: raise prices if falling short in Q
o Market work effectively: competition among sellers and buyers
 None large to affect prices/performance (price takers)
  Price adjusts freely

Market and Social Efficiency

- Unregulated markets reach socially efficient equilibrium: when D = MWTP and S = MC

- Two rates of output the same in real world: when market D and S are same as MC and MWTP
o Qm – through market (D = S)
o Qe - through MWTP = MC
-

Market Failures

- Market Failures: cause divergence, affect D/S, prevent socially efficient eq from being reached
o Negative externalities: get too much of something they don’t want
o Positive externalities: get not enough of something they do want
- Environmental values often have: diff market values and social values (market failure)
o Supply side problem “external costs”: drive difference in MC and S (S DNE true MC)
o Demand side problem “external benefits”: drive difference in D and MWPT (DNE)
- Sources of Market failure:
o External Costs or Negative externalities:
 Producers not pay full cost of production
 Production good produces pollution affects others
 Price in market below true price
 Producers produce more than socially optimal Q
o External Benefits or positive externalities
 Producers cant capture full production benefits
 Producers produce less than socially optimal Q

External Costs or Negative Externalities:

- Market economy: account only private costs (in profit-and-loss statements)

o Objective: keep costs low as possible (or profit max)
o Private costs: EX. labour, raw materials, utilities, etc.
- External or social costs: production cost is cost to society, not on firm statements
o External: since firms not accounting for it in decision making (internal to society)
o EX. major external cost: Cost of environmental degradation
- EX. Emissions as a Negative Externality:
 o Pollution emissions: create negative externality or external costs
o External cost: when cost to society and env. From prod/consumption, not paid by prod
o If remove negative externalities (force prod. Pay full cost), pollution still exist (bcs of
benefits of consuming)
- Ex. Water Pollution:
o New paper mill on river giving waste > fishery affected and people living downstream
 Mill does not consider, it over produces and over emits
 Mill should consider private and external costs
o Social Costs accounting = private cost + external (env) costs

o
o Top panel: +Relationship b/w rate of paper production and downstream external costs
 Marginal external costs (MEC) rise as production rises
o Bottom panel: Demand curve for paper and marginal private costs of producing paper
 Pm and Qm occur in competitive market with external costs not internalized
 Marginal Social costs higher: include both MPC and MEC
 Socially efficient level of output is Q* and P*
o External costs make output higher than efficient level & market P lower than efficient P
 Firm uses services of nat environment without paying
 Unpaid input allows easy disposal waste & imposes cost on downstream users
o Private market system: too much prod.at too low a price (compare to soc. Effic rules)

External Costs and Market Outcomes:

- External costs exist when: Marginal Social Cost (MSC) > Marginal Private Cost (MPC)
- MPC not reflect true/full cost of providing the g/s (P in market below correct P, over produce)

Pigouvian Tax aka Pollution Tax: Taxing polluters for damages, firms face full social costs in private costs

- Tax amount = damages the pollution causes

- Socially efficient level pollution: Negative externality no longer exists, but pollution still does
Open Access Resources Cause Market Failure:

- Open access resources: limited/scarce resources uncontrolled access (EX. Ocean, air, land)
- Absence property rights: prevent people overusing/abusing resources (inefficiently used)
- EX. Tragedy of the commons: can cause economy to be unsustainable.

External Benefits or Positive Externalities

- External benefit: action some positive benefit to someone outside/external to decision about
cons/production of good (that causes the externality)
o Use item leads benefit, market WTP understated social willingness to pay
o MB society > MB person producing the good
o Producer makes goods until private MB = private MC (good underprovided in
uncontrolled market)
o EX. lawn mower 50$ external benefit to neighbor.
 Max amount WTP private Is 50$ less than social WTP
 Marginal benefit society > MB personal
- Society better off: compensate ppl who produce goods w external benefits, encourage social
efficient production
o EX. Flower Garden, education, firework show

Public Goods: inherently involve large-scale external benefits

- Pure Public Good:

o Non-excludable: cant prevent people from using g/s for free (firework show, breathe air,
defensive system in country)
 Excludable: can prevent people from using for free
o Non-rival: one person’s use does not diminish another person ability to use good
 Air in city free contaminants, anyone breathe without diminish avail to others
 Rival: one person’s use diminishes ability for others to use (EX. Apple/Fruit)
- Classifications:
o Pure Private Goods: excludable and rival (can prevent people, diminishes)
 EX. consumer goods, food, housing
o Club Goods (public or private): excludable and non-rival (can prevent ppl, no diminish)
 EX. cable TV, Movie theatre, copyrighted media, community services
o Common Pool Resources: non-excludable and rival (all use free, diminishes)
 EX. Fishing Grounds, Ground Water, Free Parking Spaces
o Pure Public Goods: non-excludable and non-rival (all use free, no diminish)
 EX. national Defense, Atmosphere
- Environmental Quality as a Public Good:
o EX. if quality ozone increases, everyone benefits
o Private markets undersupply public goods, relative to efficient levels
o Public goods: non-rival and non-excludable
 Joint consumption, all enjoy whether paid or not
 Free riders: those who pay less than their MWTP for a good
 Challenge: goods suffer since non-excludable, even if they don’t pay
Private Land as a Public Good

- Land Conservation: prevent development of contaminants and preserve land’s natural state
o Benefits: clean air, clean water, greater biodiversity (for all people, whether or not they
contributed to conservation efforts)
o Most people free ride off donations of others & less land conserved than optimal

Market Failure and Public Goods

- Public goods underprovided in free market

o Non-excludable: hard to prevent free riders
o Avoid paying even with positive MWTP (someone else will pay/provide)
o Use taxes address issue (efficient for society, not each individual)

Aggregate Demand for Public Goods

- Demand for public good shows people’s MWTP (difference: how curves aggregated across
consumers)
- Recall: Individual D curve private goods: horizontal summation
o Da priv = Sum (Individual QD at each price)
- Individual D curve public goods: vertical summation
o Da pub = Sum (individual MWTP for a given Q)
o Reason: joint consumption (not exclusive to an individual)

EX. Controlling Water Pollution:

- Situation: 2 houses on small lakeshore. Water contaminated by fertilizer runoff from farms.
Dissolved Oxygen indicated env quality and measured in ppm. Water can be cleaned if each
home buy compound to neutralize fertilizer and improve dissolved oxygen.
o MC treatment is a rising function: MC = 5 + 2Q (where Q – dissolved oxygen target)
o Each home’s MWTP for treatment: MWTPA = 14 – 2QA & MWTPB = 6 – QB
- Find: the socially efficient level of water quality
o MWTPA + MWTPB = MC à 20 – 3Q = 5 + 2Q à Q = 3 ppm
o Graph:
 Total MWTP: at quality 2 MWTP is 10+4=14
 Each household for each env quality level
 
 TWTP AWTP – pick env quantity and add up all MWTP for all individuals
 EX. at env quality 2
o MWTP = 10 for A, 4 for B,
o TMWTP = 10 + 4 = 14
 EX. find socially efficient level of output
o Intersection of AWTP and MC à 3
- Could private firm get contaminant in lake reduced to socially efficient level
o Firm collects amount from households, who have incentive to free-ride/underpay
 Public good free riding off others
 Amount = true WTP
o TF: there would be no Equilibrium price (conventional sense).
 Qe would be substituted into AMWTP to obtain value 11$. (not an eq price)
 “price” of 11 is higher than household B MWTP for any clean water level.
 A want 1.5 units clean water at 11$, not 3 units
o Private market cannot work when a kind of public good is supplied
 Can’t charge uniform price to all that covers MC and = consumer MWTP
o Free-rider Problem: private firms hard time determining true WTP for public goods

Week 3 – Chapter 5 – The Economics of Environmental Quality

Normative and Positive Statements:

- Normative: expresses option, “what should be” (EX. Socially efficient level of emissions)
o EX. how much dioxide in lakes should there be and how can we establish this
o Policy analysis: ID target level achieved, decide how to achieve
 - Positive: study facts and actual events in rea world (EX. Actual target level emissions, how much
need to reduce to reach, how much dioxide is in this city)

General (Simple) Model: The Target Level of Pollution

- Simple model: represent trade-off situation existing in all pollution control activities
- Reducing emissions reduces damages that incurs from environmental pollution
o Takes resources could be used to produce g/s that people want

Pollution Damages & The Damage Function:

- Pollution Damages: negative impacts that users of environment experience as a result of

degradation of the environment
- EX. Paper Mill: pollution enters the river, fishers cannot continue, new drinking water source
- Damage Function: relationship b/w the Q of waste product and the value of its damages
o Types of damage functions:
 Emission Damage function: rel. b/w waste from a particular source and resulting
damages on environment
 Ambient Damage Function: how damages related to concentration of waste
product contained in ambient environment
 Marginal Damage Function: change in damages stemming from one more unit
of emissions or ambient concentration
 Total Damage: total amount of damage at each emission level
- Marginal Damage Function (MD):
o MD: additional damage cuased by additional unit pollution (or higher ambient conc.)
o Positive slope
o Shapes differ:
 Little pollution causes little or no damage
 Safe ‘threshold’ level of emissions without damages may exist
 Higher concentrations, damages increase at an increasing rate
 Highly toxic pollutants (some), any emission may cause
o Possible Shapes:
 Exponentially increasing damage with modest effect at low levels and
intense/widespread environmental impacts at high levels EX. GHG


 Low level immediate deadly effect EX. Toxic substances
 
 Begins higher on vertical axis,
 Variable damage over increasing concentration EX. Air pollutants affecting
sensitive species at low levels/high levels


 Exposure must be above a threshold to incur environmental damage


o Properties of :
 MD function: key ingredient for normative policy analysis
 Design pollution policy: Identify specific sources of emission using relationships
o Assumption Simplifying:
 Linear functions are used
 Single, non-accumualtive pollutant is uniformly distributed
 No threshold: each MD function begins at origin (first emission unit causes env
impact)
o Marginal VS Total Damages:
 Height of MD curve: shows change in damage if small change in emissions Q
 Total Damages for MD1 = area b
 Total Damages for MD2 = Area a + b
 Total Damages: area under MD from 0- given level of emissions
 Example (graph):
  MD1 = 0.4E
 MD2 = 0.6E
 Total damages for MD1 and MD2 = ?


o Factors affecting Marginal Damages:
 Location: higher damage in urban areas (than rural), fewer people less damage
 Knowledge: more know about impacts pollution --> more WTP to avoid it
 Taste and Preference: EX. Child asthma, will more WTP to reduce pollution
 Ability to pay: pollution damages lower in low income areas

Abatement Costs

- Abatement Costs: costs associated of reducing the quantity of pollution being emitted in env.
o Includes:
 Reducing output /switching inputs
 Changing production technology
 Residuals recycling
 Treating wastewater after use
- EX. Paper mill on the river, lots of organic waste: what to do with emissions?
o Cheapest: dump in river
o Alternative (more costly): reduce pollution by adopt new technology

Marginal Abatement Costs

- Marginal Abatement Costs (MAC): added costs of one unit decrease in emission level
o Aka: costs saved if emissions are increased by a unit
o Recall: MC Curve (supply curve) is always upward sloping
o MAC curve is downward sloping
 Q is the reduction of emissions
 As abatement increases: emissions decrease and move from right to left (graph)
 In a sense, MAC is still upward sloping
- MAC Curve:
o Cost of reducing the next unit of emissions
 o Rises exponentially as amount emissions reduced rises
o More pollution reduces, higher cost of next unit (use lowest cost units first)
o Possible Shapes:
 Rise modestly as reduced emissions, rise rapidly as emissions get small (A)
 Rises continuously (B)
 First declines, then rises again (C)

-
- Marginal versus Total Abatement Costs:
o Total abatement costs (TAC) = area under the MAC curve (from right to left)
o Positive intercept MAC: shows tech exists to reduce emissions to zero at a finite cost
 Tech reduces abatement costs > MAC shifts lower/down

 Two sources of pollution

o MAC1 = 60 – 4E
o MAC2 = 75 – 5E
 EX. MAC1 uses cheaper technology to reduce emissions than MAC2
 EX. MAC = 0 , uncontrollable emissions level (for both firms is 15 tons) x-
intercept
 EX. If want to reduce 15 (current) to 10 (desired)
 MAC maximum is 20 and 25 for MAC1 and MAC2, respectively
 TAC when going from 15 to 10 for MAC1 and MAC2
 o Find MAC at E = 0 (no emissions)  MAC1 = 60, MAC2 = 75
o Area under curve from RL under curve
 MAC1 = areab = TAC = 20*5/2 = $50
 MAC2 = area a+b = TAC = 25*5/2 = $62.5
 TF: area A (cost savings) = 62.5-50=12.5
 EX. If want to reduce 15 *current) to 0 (desired)  y-intercept
 MAC: 60 for MAC1 and 75 for MAC2 (finite costs)
o Aggregate Marginal Abatement Cost:
 Steps: horizontal summation of the individual functions (lowest abatement cost)
 Real world: emissions from various sources and groups.


 EX. 2 MAC curves

o pick a level of MAC per month (EX. set at 40$)
o How much each polluter will change/reduce to
 EX. MAC1 at 40  15 to 5 tons & MAC2 = 7
o Aggregate level: add up all the new monthly emissions
 EX. 5+7=12

The Equimarginal Principle: Two different plants producing the same good, a firm minimizes total cost
by equating MC to production of the plants.

- Equimarginal Principal: total prod distributed among sources to equalize their MC

- Aggregate MAC Function (several firms/plants)
o Aggregate level of emissions distributed to equalize MAC
o Reduce the cheapest unit of pollution first, no matter which factory emits it
- To produce 100 units, at the least total cost when <C are equal
o The low-cost plant produces more (62 units). High cost plant produces 38 units (less).
o Total cost = Area a + (d+e)
o If both plants produce 50 units, TC would be higher (a+b+c+d)
 Plant a: MC = 12$
 Plant b: MC =8$
 Total cost at producing 50 units per firm; TC (both firms) = a+b+c+d
 Plant a TC = a + b + c
  Plant b TC = d
o Firm minimizing TC: if re-allocate production from plant A (higher MC)
 Produce more in low-cost plant, produce fewer goods in high cost plants
 Ultimately: plant A produce 38 and plant B 62 (total =100)
 TC = a + (d + e)
 Amount that can be saved = MC1 – MC2 = 12-8 = $4

- Comparing TC before and after minimizing TC:

o TC = a + b + c + d (firms produce same number of outputs)
o TC (after minimizing) = a + d + e
o Generally: e > (b+c), showing the saving
 Difference: b, c, e

The Socially Efficient Level of Emissions:

- Socially efficient level of emissions: where MAC = MD

- At E*:
o Total social costs (damages area a) + total abatement costs (area b) are minimized at
emission level
o Sum (damages costs + abatement costs) > E*
o Can be positive or 0 (if MD and MAC do not intersect at positive level, E* = 0)
 Slopes and shape of MAC and MD curve determine equilibrium
- Why is E* socially efficient:
o Social efficiency: trade off marginal increase in pollution damages against a marginal
increase in pollution abatement costs
o Higher emissions cause greater costs from environmental damages
o Lower emissions cause greater costs from resources devoted to abatement costs
o Socially efficient level of emissions: level where these two types of costs offset each
other (MAC = MD)
- Prove that E* best given current level and curves:
o If emissions were reduced to 0  TD = 0
o TAC = a + b + d = 15*60/2= 450 (larger than 150)
o At any other emission level, the net social cost will be
higher than that at E*

Linear MAC and MD Example: MAC = 60 – 4E & MD = 2E

 - Social Efficiency: MAC = MD
o 60 – 4e = 2e  60 = 6e  E* = 10 tons per month
o The price (sub E* in MAC or MD) = $20
- At 15 units emission: (current)
o Total social costs (damages)TD = a + b + c
o No social abatement costs at this point (high damages to society) TAC = 0
o Emissions that cause high damages can be reduced at low cost, improving social welfare
- At 10 units emission (desired):
o Total social costs (damages): TD = a
o Total social abatement costs: TAC = b
o Net social gain = area c

Computing Net Social Values:

- With no emission control (currently 15 level emissions)

o Total damage: TD = a+b+c = 30*50/2 = 225
o Total abatement cost: TAC = 0
o Net social Cost = TD – TAC = 225 (at 15 tons)
- With emissions at socially efficient level E*
o TD = a = 20*10/2 = 100
o TAC = b = 20*5/2 = 50
o Total social cost = TD + TAC = 150
- Savings from reducing emissions = total social cost without control – total social cost at E*
o Savings = 225 – 150 = $75 by reducing emissions from 15 to 10
o Net social benefit of achieving the socially efficient level of emissions (compared to
none)

Week 3: Chapter 6 – Framework of Analysis:

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