Economics of Natural Resources Review

ECON 330 Review Sheet
Fall 2008
- Framework: When emitting pollution, the firm/individual doesn’t take into account the
damages that they do to others. We want the amount of pollution to reflect the true cost to
society – without environmental policy, we will have inefficiently low abatement.
Strategy: Maximize Net Benefit of Abatement = Total Benefit -Total Cost:
Max NB(A)=TB(A)-TC(A)
Equivalently: MD(Adding Pollution)=MC(Reducing Pollution)
o Private Mechanisms: Have been shown to break down very easily:
 Coase Theorem
 Lindahl Equilibrium
o Government Policy:
 Command and Control: Quantity Regulation/Technology Regulation
 Market Based: Tax Pollution, Subsidies, Cap and Trade, Indirect Tax
Criterion for Deciding the Right Measure: Cost Effectiveness: minimize the cost of
achieving a standard.
Thinking about the problem in terms of pollution remaining and abatement is the same:
the diagrams above can be considered to be mirror images.
o Point Amax corresponds to 0 pollution;
o Pmax is the same as 0 abatement;
o The distance between 0 and P* = distance A* and Amax;
o Similarly, the distance between P* and Pmax = distance 0 and A*
Market outcome: 0 abatement. Why? The assumptions underlying the Coase Theorem
and Lindahl equilibrium are too strong to be seen in reality (see below). Firms have no
incentive to spend money abating – they set MC=0.
o Consequence: The government needs to regulate pollution
Building the MC/MB curve:
Why are we summing vertically to get MB? Abatement is a public good for consumers–
you can’t exclude someone from benefitting from it, so you add values up holding
abatement fixed.
A=∑i Ai (MC)
Why are we summing horizontally to get MB? Each producer has to abate independently
so abatement is a privately produced good - you want to add up the units that each
producer is able to abate at a given marginal cost to get what the society can do at that
marginal cost.
Reflecting Society (rather than interest groups) when constructing the MB Curve: In
practice: to reflect society you take the weighted sum of MB curves across the population
and use that to determine optimal tax. Problem: people will lobby policymakers to choose
their MB function as the aggregate one and the majority will win. This outcome is not
MB low
MB average
MB high
Potential Market Solutions and Issues:
- Coase: In a market with externalities, private bargaining will result in the economically
efficient outcome under three conditions:
1. Costless bargaining
2. Symmetric information
3. Fully allocated property rights.
o But there are many victims, so transaction costs are high
o Besides, abatement is a public good (nonexclusive), so individuals have an
incentive to understate their willingness to pay for abatement
Lindahl: the MB curve is the vertical sum of individual MB curves. The idea would be
to get each individual to state their value and to tax them accordingly. Problem:
individuals have an incentive to lie in the face of asymmetric information.
Government Solutions:
 Market Based versus Command and Control:
o Rule of Thumb: In general, market based regulations are cost effective and
command and control are not.
o Cost Effective Abatement: equates the costs of abating across firms – you
minimize the cost to society of achieving a given standard.
Quantity vs. Price Rule under Certainty:
Price rule – Diagram on the Left. This results in the efficient solution, each firm abates
until MC(A)=tax, then pay the tax (see below).
Quantity rule – inefficient, the MC of abatement is not equalized across firms to there
could be a net gain to society from reallocating abatement.
Price Rule
Quantity Rule
A1 A2
Price Rule in More Detail: The Abatement and Tax Bill of a Firm faced with a Tax for Polluting
Source: Sheila Olmstead’s lecture notes, Econ 117 – Lecture 19
Quantity Rule in More Detail: Cost Savings that Could be Made
Source: Sheila Olmstead’s lecture notes, Econ 117 – Lecture 19
Cap-And-Trade: Allocate pollution permits across firms and allow them to buy and sell
their allowances until the marginal costs of abatement are equal across firms and are
equal to the equilibrium price of permits.
Note: No matter what the initial allocation of permits, you will attain the efficient
Hot Spots! Problem with Market Based Approaches: Market approaches allow abatement
to vary across firms. If the marginal damage varies across firms (e.g. the damage done by
a unit of sewerage discharge varies according to the size of the population exposed to it)
then you might be worried about creating pollution “hot-spots”.
o One solution: Trading Ratios – since the MD of a ton of pollution varies across
areas, you want the prices of pollution permits to reflect both the quantity of
pollution as well as some notion of “quality”. E.g. 1 pound of pollution in
Maryland is worth 5 pounds of pollution in North Carolina, since it inflicts 5
times the damage in Maryland.
Special Case: Water/Air Pollution – one town’s pollution affects another town’s
o Without regulation: downstream city takes Qupstream as given
MB(Qupstream) = MC(Qupstream)
MB(Qdownstream + Qupstream) = MC(Qdownstream)
o With Regulation: upstream city takes into account the effect on downstream
MB(Qupstream) + MB(Qdownstream + Qupstream) = MC(Qupstream)
MB(Qdownstream + Qupstream) = MC(Qdownstream)
 a system of two equations with two unknowns
Quantity vs. Price Rule under Uncertainty:
In the face of uncertainty, the best you can do is set your target using the expected
position of your curves: E[MD] or E[MC]
Under Cost Uncertainty:
| Slope MC | > | Slope MB |: choose price instrument (tax)
| Slope MC | < | Slope MB |: choose quantity instrument (permits)
When |MC| > |MB|, imposing a quantity instrument is more costly than using a price instrument
- since marginal cost if more responsive to abatement than marginal benefit, moving away from
the efficient quantity increases costs more than it does benefits resulting in a large deadweight
loss to society.
Source: Lecture Note 20 from Econ 117, made by Sheila Olmstead
When |MC| < |MB|, imposing a price instrument is more costly than using a quantity instrument marginal benefit of abatement rises faster than the marginal cost therefore moving away from the
efficient abatement hurts consumers more than it does producers resulting in a large deadweight
loss to society.
Source: Lecture Note 20 from Econ 117, made by Sheila Olmstead
Under Benefit Uncertainty:
Neither taxes nor quantities have an advantage - since the MC curve remains constant, they will
both result in the same amount of abatement and hence the same amount of deadweight loss.
Source: Lecture Note 20 from Econ 117, made by Sheila Olmstead
Stock Pollutants:
 Characteristics: Since they take time to dissipate, they result in a stream of damages over
S(t)=S(t-1)+Q(t)- λS(t)
The stock today (S(t)) is a sum of the stock yesterday (S(t-1)), plus the additional
pollution you emit today (Q(t)) minus the natural amount of depletion that occurs: λS(t)
Considerations: When considering the costs of these pollutants and the benefit of
abatement policy, you need to consider the stream of benefits and costs at different points
in time.
Strategy: To achieve Dynamic Efficiency: Maximize the net benefit of abatement by
equating the marginal benefits of abatement to the marginal costs of abatement at many
different points in time.
Valuing future costs/benefits: In dynamic setting, the efficient policy maximizes the
present value of net benefits to society. This involves converting all the future benefits
and costs of environmental policy into present day prices. Discounting reduces the stream
of costs and benefits into a single present value dollar – a common discount rate to use is
the interest rate, which reflects the value of alternative uses of a dollar of money.
Dynamic Solution: Balance the Marginal Cost of Polluting one more unit with the
Marginal Damage the unit of pollution will do in the long run.
MC(Qt) = MD(Qt)/(r + λ)
Dynamic regulation: usually becomes tighter over time as stock increases.
Thinking about the Costs of Pollution Abatement:
Removing Greenhouse Gases from the Atmosphere: possible technologies with varying costs:
 Transport: Improve Fuel Efficiency, Drive Less
 Lifestyle: Insulate Buildings
 Decarbonize Energy: Natural Gas, Carbon Capture and Storage, Nuclear, Wind, Solar,
 Reforestration
Evaluating the Potential Damages of Climate Change: Translating predictions from Climate
Change Models into Economic Impact
- Production Function Approach: Assumes an underlying production function to determine
the impact of changes in temperature on the yields of specific crops.
- Ricardian Approach: Estimate how changes in the climate will move areas along the
production frontier as well as potentially shift the frontier itself. Examine the impact of
climate, soil type, groundwater and other variables on land values and farm revenues.
Main Difference Between these Approaches: Production Function holds the type of
technology constant.
Modeling relationship between temperature and income:
o There appears to be a “hill shaped” profit response to temperature which varies
by economic sector (fishery, agriculture, energy, water and forestry)
o Sectors in countries/regions currently to the right of the maximum point are likely
to benefit from an increase in yield due to temperature whilst those to the left will
see a decrease in incomes.
Important Lessons:
- Region Specific Model:
o Latin American farmers are sensitive to climate change.
o The impact of climate change varies substantially across the region: initial
geographic position and soil quality is important.
o Uncertainty in the extent of climate change will result in large variations in the
economic predictions.
- Cross Country Model:
o Recent models suggest that developing countries stand to suffer more from
increases in temperatures than developed countries, in absolute as well as relative
o This is mostly a function of where developing countries are situated: often close
to the equator where current temperatures are highest.
Evaluating the Benefits of Abatement/Changing Environmental Quality:
Use value:
o Direct Use Value: How much is it worth? A forest: use market prices to work out
the value of the forest in terms of timber.
o Indirect: Supports a variety of ecosystems which are likely to be interlinked.
 But: this ignores the option value – the value placed on individuals’ future
ability to use the environmental good. (e..g What else is in there? Drugs
not yet invented which reflect the potential value in the future.)
 Also: consider the non-use value – e.g. knowing snow leopards will
continue to exist makes me happy.
o This doesn’t work for assessing the value of environmental quality (e.g. clean air)
since this isn’t traded in a market.
Revealed Preference: “show me the money”(i.e. reveal to me what you think it’s worth)
o Direct prices: Travel cost method: infers individuals marginal willingness to pay
for environmental quality from where they go for recreation. E.g. How much are
you willing to pay to go to the cleaner picnic spot than the dirtier one?
o Implicit Prices: “Hedonic Models” : implicit prices are bundled with other
private goods. E.g. comparing housing prices in areas with high and low air
pollution, comparing wages in jobs with different levels of risk.
 Issue when measuring: they vary in many other ways as well.
Ask People! Stated Preference/Contingent Valuation Method:
o Idea: Ask individuals their marginal willingness to pay to avoid/accept different
environmental scenarios, e.g. how much they’d be willing to pay to accept having
a dirtier environment/to have a cleaner environment.
 Problems:
 The phrasing of the question is important.
 Have a week incentive to tell the truth – not going to be asked to
pay (incentive to misreport) and “just another survey”.