Environmental & Natural Resource

Environmental & Natural Resource Economics Professor Fleming Franklin & Marshall College January 5, 2021 Announcements  Read  M. Kotchen (2012), “Public Goods”  E. Ostrom (2009), “Nobel Prize Lecture” (Sections 1 and 4 only!)  Section 1: The EarlierWorldView of Simple Systems  Section 4: Are Rational Individuals Helplessly Trapped in Social Dilemmas?  The Economist (2012), “Elinor Ostrom, Defender of the Commons”  Week 1 Practice Problems posted on Canvas  No office hours tomorrow (Wednesday)… An economics department meeting was scheduled. Course Outline  Economic Theory for Env. & Nat. Resources (Ch. 2)  Externalities  Public goods (not excludable, not rival)  Common-pool resources (not excludable, rival)  Coase theorem  Tools for Env. & Nat. Resources (Ch. 3 and 4)  Natural resource (many chapters: student presentations)  Policy choices This week  Economic Theory for Env. & Nat. Resources (Ch. 2)  Externalities  Public goods (not excludable, not rival)  Common-pool resources (not excludable, rival)  Coase theorem Today  Economic Theory for Env. & Nat. Resources (Ch. 2)  Externalities  Refresher: ECO 100  Externalities  Market Failure  Policy Responses?  Practice Refresher: ECO 100  Marginal cost – “The cost associated with production of one more unit of the good”  Marginal benefit – “The benefit (utility, satisfaction, revenue) associated with production of one more unit of the good” Refresher: ECO 100  Marginal cost – “The cost associated with production of one more unit of the good”  Marginal benefit – “The benefit (utility, satisfaction, revenue) associated with production of one more unit of the good”  …Should you attend school for one more year?  …Should you work for one more hour on a project?  …Should a business produce one more unit, or should Prof. Fleming purchase one more cow? Refresher: ECO 100  Marginal cost – “The cost associated with production of one more unit of the good”  Marginal benefit – “The benefit (utility, satisfaction, revenue) associated with production of one more unit of the good”  …Should you attend school for one more year?  …Should you work for one more hour on a project?  …Should a business produce one more unit, or should Prof. Fleming purchase one more cow?  … Should I add one more slide on this topic? Refresher: ECO 100  Marginal cost – “The cost associated with production of one more unit of the good”  Marginal benefit – “The benefit (utility, satisfaction, revenue) associated with production of one more unit of the good”  Marginal analysis  “The analysis of small (“one-unit”) changes, especially the benefits and costs associated with these small changes”  Marginal analysis is a critical part of economic decision-making Refresher: ECO 100  Marginal benefits are generally decreasing…  Diminishing marginal benefits  When thirsty, compare the satisfaction from your first glass of water to your second glass, third glass, tenth glass, etc.  Marginal costs are generally increasing…  The law of increasing marginal costs  If we’re rational, we’ll generally do things with the lowest cost first Refresher: ECO 100 Optimal allocation  “The optimal allocation occurs when marginal costs equal marginal benefits”  Why is this the optimal allocation? Does this make sense? Refresher: ECO 100 Optimal allocation  “The optimal allocation occurs when marginal costs equal marginal benefits”  Why is this the optimal allocation? Does this make sense?  If the benefit of one more unit is greater than the cost of one more unit (MB > MC)… produce it!  If the cost of one more unit is greater than the benefit of one more unit (MB < MC)… don’t produce it!  Only when MB = MC are we at an equilibrium (assuming decreasing MB and increasing MC). Refresher: Demand & Supply  What does this have to do with demand and supply of economic goods? Remember: Demand curve = Marginal benefit curve!  Draw and label in your notes  Draw the demand curve for electricity from a coal-fired power plant:  x-axis is quantity in kilowatt-hours (kwh)  y-axis is the cost of electricity ($ per kwh) Refresher: Demand & Supply  {Draw and label in your notes!} Refresher: Demand & Supply  Remember: Demand curve = Marginal benefit curve!  More precisely, you can think of the demand curve in two ways: (1) Marginal benefit (MB)  Benefit to the buyer of purchasing one more unit of electricity (2) Marginal willingness-to-pay (MWTP)  How much you are willing to pay for one more unit Refresher: Demand & Supply  Similarly, Supply curve = Marginal cost curve!  Draw and label the supply of electricity from a coal-fired power plant in your notes Refresher: Demand & Supply  Similarly, Supply curve = Marginal cost curve!  You can think of the supply curve in two ways: (1) Marginal cost (MC)  Cost to the power plant of producing one more unit of electricity (2) Marginal willingness-to-accept (MWTA)  How much money will it take to convince the power plant to increase production and sell more unit? Summary Demand curve = Marginal benefit (MB) curve  One way to think of the demand curve is the marginal benefit for a person to consume an additional unit of the good Supply curve = Marginal cost (MC) curve  One way to think of the supply curve is the marginal cost for a company to produce an additional unit of the good Optimal / Efficient allocation is where:  MB = MC, or market demand = market supply… but only if …. Summary Demand curve = Marginal benefit (MB) curve  One way to think of the demand curve is the marginal benefit for a person to consume an additional unit of the good Supply curve = Marginal cost (MC) curve  One way to think of the supply curve is the marginal cost for a company to produce an additional unit of the good Optimal / Efficient allocation is where:  MB = MC, or market demand = market supply …  … only if the prices are right! If market prices reflect true marginal costs and marginal benefits Today  Economic Theory for Env. & Nat. Resources (Ch. 2)  Externalities  Refresher: ECO 100  Externalities  Market Failure  Policy Responses?  Practice Externalities  “An externality is a marginal cost or marginal benefit—caused by producing or consuming a good—which is experienced by someone external to the economic transaction”  Causes a divergence between private marginal costs and “social marginal costs” (SMC), or between private marginal benefits and “social marginal benefits” (SMB) Externalities  Causes a divergence between private costs (or benefits), and social costs (or benefits)  Let’s draw it  Once again, use the example of electricity from a coal-fired power plant (Q = kwh; P = $ / kwh)  Externality: SO2 (sulfur dioxide) and CO2  SO2 causes acid rain, smog, asthma, breathing difficulties to people downwind of the plant who do not purchase electricity from the plant (i.e. people who are external to the economic transaction) Externalities Externalities  When there is an externality, there is over- or under-allocation of quantity by the market, and an over- or under-valuation of price.  In our example, there was an over-allocation of electricity from coal-fired power plants, and it is sold too cheaply Externalities - Ponder  Stop to ponder the power and general applicability of this framework.  How often does it occur that people external to a market transaction experience costs (or benefits) from it … …in relation to environmental and natural resources? …in relation to health and well-being? Not just about social costs…  Externalities are not only about social costs  There can also be social benefits that can be generated by both production of goods and individual purchasing decisions  E.g. Beekeepers, Socially-conscious buying decisions Practice in pairs  Types of externality.  What other examples can you think of? Positive Negative Production “Corporate Social Responsibility” (e.g. …) “The Polluting Company” (e.g. …) Consumption “Socially-Conscious Buying Decisions” (e.g. …) “Garbage” (e.g. …) Practice in pairs  What other examples can you think of? Positive Production Consumption Negative Practice in pairs  Types of externality  What other examples can you think of? Positive Negative Production “Corporate Social Responsibility” (e.g. beekeeper) “The Polluting Company” (e.g. air pollution, CAFO) Consumption “Socially-Conscious Buying Decisions” (e.g. vaccinations, fire-proofing your home) “Garbage” (e.g. loud music, traffic congestion, literal trash) Summary  If the externality is negative…  The market over-allocates → Too much is demanded or supplied;  If the externality is positive…  The market under-allocates → Too little is demanded or supplied  A production externality leads to a divergence between social marginal costs (SMC) and private marginal costs (PMC).  A consumption externality leads to a divergence between social marginal benefits (SMB) and private marginal benefits (PMB). Today  Economic Theory for Env. & Nat. Resources (Ch. 2)  Externalities  Refresher: ECO 100  Externalities  Market Failure  Policy Responses?  Practice Market failure  “A situation in which the allocation of a good or service by the market is not efficient”, i.e. market equilibrium ≠ optimal allocation  There is either over- or under-allocation of quantity, and overor under-valuation of price.  This results in a deadweight loss to society. Deadweight loss  The over- or under-allocation leads to a deadweight loss to society. Deadweight loss  A nice quiz question might be to ask you to draw a certain type of externality (e.g. a negative production externality would be the type in the previous slide), label deadweight loss, and describe what it means. Market failure  Another way to think about market failures: “The prices are wrong”  When prices do not reflect true marginal costs or benefits, economic theory implies there will be a mis-allocation of resources by the market, as Krugman argued in his article.  There are changes in the price and/or quantity of the good that result in a “win-win”—everyone can be made better off.  E.g. People with asthma from SO2 emissions experience more damage per unit (in $/kwh) than the price of electricity.  Thus, win-win trades or negotiation should be possible** **If “transaction costs” are negligible (more on this later) Aside: Causes of market failure  Market failures are not only caused by externalities  Causes of market failure:  Externalities  Public goods, Common-Pool Resources  Monopoly power  Lack of information  Time-inconsistent preferences  If you define optimality based on what people decide to do… And if what we actually do in the moment is different than what we decided to do… then market outcomes will not be optimal  E.g. Gym memberships, Retirement savings, “Tying Ulysses to the Mast” Causes of market failure  Causes of market failure…  Externalities Will be covered in this class  Public goods, Common-Pool Resources  Monopoly power  Lack of information on true costs and benefits  Time-inconsistent preferences Today  Economic Theory for Env. & Nat. Resources (Ch. 2)  Externalities  Refresher: ECO 100  Externalities  Market Failure  Policy Responses?  Practice Policy responses to externalities?  You tell me… Policy responses?  What policy responses are available when there are negative or positive externalities? 1. Command-and-control policies  Bans, limits, quotas, pollution standards (emissions standards, efficiency standards); technology standards or requirements for the production process 2. Market-based policies (put a price on the externality)  Pigouvian tax; subsidy  Tradeable permits, aka “Cap and trade”  In either case, the goal of the market-based policy response is to attach a dollar value to the social cost or benefit Other responses?  What other responses are available when there are negative or positive externalities? 3. Liability laws and private negotiation (Coase Theorem)**  Works when there are a limited number of affected parties (e.g. two); only works when the barriers to negotiation and contract enforcement are negligible (e.g. you want to study, and your roommate wants to listen to music) 4. Responses by intermediate institutions (e.g. cultural / communal sanctions or norms in response to externalities)** **More on these in a couple days Policy Response to Externalities  “Pigouvian tax” is a tax levied on market activities that generate negative externalities  Taxing “bads” instead of “goods”  Examples include all types of pollution taxes, gasoline taxes, and noise taxes  Arthur Cecil Pigou (1877 – 1959) Aside: Policy responses not perfect Government failure (or “non-market failure”)  Two versions:  [weak version] “When the policy-induced equilibrium is not the socially-optimal / efficient equilibrium”  [strong version] “When the policy-induced equilibrium is less optimal / less efficient than the market equilibrium”  The weak version is analogous to the definition of market failure (i.e. a market failure is when the market equilibrium ≠ the socially-optimal / efficient equilibrium).  The strong version directly compares the two. Government failure  Causes / types of government failure  Regulatory capture, Regulatory arbitrage;  Grossly under- or over-estimating the size of the externality;  Lack of information on the part of policymakers;  Crowding out of effective non-policy responses  There can be both market and government failures – the world is not perfect – but you probably didn’t need me to tell you that Today  Economic Theory for Env. & Nat. Resources (Ch. 2)  Externalities  Refresher: ECO 100  Externalities  Market Failure  Policy Responses?  Practice → Practice problems on Canvas!!  Many of the problems come from previous years’ quizzes.