1. Environmental Economics
Lecture 1
Prof. Dr. Carsten Vogt
University of applied sciences Bochum
Summer term 2013

2. Core problem of economics: Evaluation criterion:
How to use scarce resources?
Evaluation criterion:
Efficiency
Means: scarce resources are used best if they are used efficiently
Minimum principle
Maximum principle

3. Is efficiency a senseful criterion? Yes, because:
Loosely speaking: efficient use means there is no waste of resources
Ethically: step from inefficient to an efficient allocation is a pareto-improvement
Hard to justify why we should not realize such improvements

4. Ways of achieving efficiency?
What are institutions suited to guarantee efficiency?
Historically, two approaches:
Central planning
markets

5. Market economies
Supply and demand model

6. Question 1: Equilibrium

7. Self regulation: The price mechanism („invisible hand“)
Market tends towards equilibrium, because:
Excess supply: prices decline
Leading to reactions by market participants that drives the market towards equilibrium (as p decreases, quantity supplied increases while the quantity demanded increases)
Excess demand: just vice versa

8. Important:
No need for governmental intervention
No regulation needed to achieve equilibrium
Market clearance guaranteed by the price mechanism
 theoretical basis for laisser-faire conception of economic policy

9. Question 2: Welfare What about welfare in equilibrium?
First: measures for human welfare:
Consumers‘ surplus
Producers‘ surplus

10. Welfare
Welfare in market equilibrium:
Achieves a maximum !

11. Welfare social welfare reaches a maximum in market equilibrium
Trick of the market: All individuals only pursue their self interest
Producers: maximizing profits
Consumers: Maximizing utility
Nevertheless, optimal allocation for society as a whole is achieved!

12. Welfare Harmony between Individual rationality Collective rationality
What turns out to be good for individuals also turns out to be good for society!
Strong justification for market economies

13.  link to environmental economics?
Very simple: If all goods (services, natural resources …) were allocated efficiently via markets there was no „environmental problem“ (from an economic point of view).
 Can we expect real world markets to work efficiently in the management of environmental goods?

14. Why markets are efficient
Main reason:
Equilibrium price reflects
The marginal value (benefit) of providing a good for consumers
The marginal costs of provision for producers
Hence: In equilibrium, marginal benefits equal marginal costs
The good ina a perfectly working market is provided as long as marginal benefits exceed marginal costs or both are equal

15. External effects
Thus: Markets work efficiently if prices truly reflect costs and benefits
Not always given.
EXTERNAL EFFECTS AND EXTERNAL COSTS
If external effects are present, the first law of welfare economics does NOT hold.

16. External effects: Definition and examples
External effect is given, if economic activity of one economic agent has a DIRECT impact on another economic agent
Examples:
External effects between consumers (consumer externality)
Someone smokes at the neighbour restaurant table
External effects between producers (porducer externality)
Waste of one plant (e.g. steel plant) leads to lower profits in another plant (e.g. a fishery)

17. Kinds of external effects
Further distinction: negative or positive
Negative external effects: someone is doing harm to someone else (the steels plant lowers the profits of the fishery)
Positive external effects: someone is doing good to someone else (beekeeper doing good to an orchard)

18. External effects: Characteristics
Main characteristic:
Has to be a DIRECT impact
i.e. an impact NOT reflected in market prices
Example: South Corea increases its steel production
 world market price declines
 external effect?
(No! Just the working of the price mechanism)

19. External effects: Characteristics
Steel plant produces more steel and more waste water
Yield in the fishery is directly affected (decreases)
This decrease is not reflected in the market price for steel
Thus: An external effect is only given, if market prices do NOT react to a change in activity

20. External effects in detail
If external effects come into play, efficiency is destroyed
 comes to a divergenc of individual and collective rationality
First: what is individually rational for the steel producer?
Simplifying assumption: steel market is competitive

21. External effects in detail
Steel plant produces until marginal costs equal the market price:
Graphically:

22. External effects in detail
For the single enterprise, this is efficient
Production is worthwhile as long marginal revenue is higher or equal to marginal costs!
Steel plant takes into account
All costs ist has to bear (to pay for)
E.g. costs for labour force, costs for machines (capital), costs for rental of buildings …

23. External effects in detail
Steel plant does not take into account
All costs imposed on others it does not have to pay for
E.g. foregone revenue of the fishery due to water pollution
What is the effect of these external costs?

24. External effects in detail
If external costs are present, the total cost of production are higher than those costs, the steel plant has to bear
i.e. there is an extra cost
The true cost function froma collective point of view (taking ALL welfare effects into account) is simply higher then the private cost function of the steel plant

25. External effects in detail
Graphically:
Social costs of production are higher than the private costs

26. External effects in detail
Main effect: Market outcome is no longer efficient!
Efficient: Provision until social marginal costs equal market price
Equilibrium: Provision until private marginal costs equal market price
Since

27. External effects in detail
Also holds at the market level:

28. External effects in detail: Market failure
Hence:
Quantity supplied in equilibrium is too high
Welfare loss associated to this (triangle between social, private cost function and inverse demand function)
Note: Generally efficiency requires still positive amounts of the good!
Not efficient to reduce production down to zero
Or: Generally, it exists an optimal degree of pollution and/or environmental degradation (sometimes odd for other disciplines like, e.g. natural sciences)

29. External effects in detail: Market failure
Due to welfare loss:
Market outcome does not lead to a maximum of social welfare
Individual and collective rationality are at odds
Functioning of the „invisible hand“ (price mechanism) is distorted
Market price does not reflect all costs of production