ECN511 – Chapter 1: What is Environmental Economics?
Learning Objectives
●​ Distinguish between efficiency and equity concepts and why they are central to
environmental economics.
●​ Describe the incentives that contribute to pollution arising from people and firms.
●​ Define and distinguish between open access, private, and common property rights
and explain why the assignment of property rights can help reduce pollution.
●​ Explain why people do not take into account the air pollution their vehicle emits when
they drive.
●​ Describe the anthropogenic sources of greenhouse gas emissions and what changes
are needed in the economy to reduce these emissions.​
What is Environmental Economics?
●​ Economics is the study of how people satisfy unlimited wants and needs with limited
resources.
●​ Environmental Economics focuses on how economic activities affect our natural
environment, with a goal of helping society reduce its degradation of the environment.​
Important Questions
●​ Why don’t people take into account the effect of their economic activity on the natural
environment?
●​ What inhibits economic systems from using its resources wisely and efficiently to protect
the sustainability of the planet and people’s livelihoods over time?​
Efficiency vs. Equity
●​ An outcome is economically efficient if all resources are put to their highest valued use,
or alternatively if a desired outcome is reached using the fewest resources
●​ Equity relates to how resources are divided among different people or groups:
○​ Horizontal
○​ Vertical
○​ Intergenerational
Evaluating Outcomes and Policies
●​ Environmental economics uses efficiency as a central criterion for evaluating outcomes
and policies.
●​ An attempt is made to find policies that provide a maximum amount of protection for the
environment at a minimum cost of resources.
●​ Equity is also an important consideration, because it is important for policies to be both
fair and efficient.
Why Do People Pollute? – The Economic Approach
●​ Why do people behave in ways that cause environmental destruction?
○​ Is it because people are unethical or immoral?
○​ Or is it because people have incorrect incentives?
●​ A challenge with a moral approach is that people have different moral values, and it is
hard to motivate people to change behavior based on morality.​
Why People Pollute
●​ People pollute because it is the cheapest way to dispose of the waste products
remaining after the production and consumption of a good.
●​ In many situations, people have an incentive to pollute.
○​ An incentive is something that attracts or repels people and leads them to
modify their behavior.
○​ Economic incentives relate to production and consumption decisions.
Externalities and Property Rights
●​ Many environmental resources do not have clearly defined property rights – no one
“owns” the atmosphere or ocean.
●​ An open access resource does not have one clear owner, and anyone can use it
without paying.
○​ Example: You do not have to ask permission or pay when your car emits pollution
into the atmosphere.
●​ This contrasts with private property ownership – no one can use your car without your
permission and you have to pay to rent a car.​
Common Property
●​ Common property is a resource shared among a group of people.
●​ It can be open access if no one controls the resource – e.g., the ocean or atmosphere.
●​ Some common property resources are not open access if the set of users is
well-defined and access can be controlled.
○​ Example: A group house kitchen is shared common property, but not open
access.
Smog and Motor Vehicles
●​ When you drive your car:
○​ You receive a personal benefit, but
○​ You also impose costs on others due to air pollution, noise pollution, and
congestion.
●​ You do not have to compensate others for these costs.
○​ These costs are called externalities or external costs/effects.
Incentives to Address External Costs
●​ Incentives might be used to address problems created by external costs.
●​ Consider:
○​ What incentives might force drivers to account for external costs?
○​ What incentives might influence companies (e.g., car makers, gasoline
producers) to reduce pollution?​
Greenhouse Gas Emissions
●​ Emissions of CO₂ and other GHGs have been rising due to the increasing use of
carbon fuels (gasoline, coal, oil).
●​ Is GHG good or bad?
○​ Without greenhouse gases, Earth would be about 30°C cooler and human life
would be impossible.
GHG Accumulations
●​ GHGs accumulate in the atmosphere.
●​ As emissions increase, the concentration of GHGs in the atmosphere rises.
Costs of Global Climate Change
●​ GHGs trap heat, causing global warming or climate change.
●​ As the climate changes, living beings must adapt.
●​ Estimated costs: $70–100 billion/year due to: crop losses, health impacts, loss of
species and ecosystems, and other effects
Unequal Costs
●​ Costs of climate change will be unequal:
○​ Some species are more adaptable.
○​ Coastal areas may be harder hit (sea-level rise).
○​ Arctic and Antarctic are warming faster than tropical zones
GHG and Climate
●​ As GHG concentrations rise, the Earth gets warmer.
●​ This leads to changing weather patterns and increased extreme weather events
●​ Lowering emissions today helps reduce future climate change, but the climate will still
change due to past emissions.​
Global Anthropogenic Sources of GHG Emissions
●​ Electricity generation and heat (especially coal-fired power plants) are the largest
sources.
●​ Transportation is another major contributor.​
Costs of Mitigation
●​ To slow climate change, we must burn fewer carbon fuels such as gasoline and coal.
●​ But:
○​ These fuels are cheap and convenient.
○​ Alternatives (e.g., wind, solar) are more expensive and unreliable.
●​ We face a trade-off: the costs of switching energy vs. the costs of not switching.
●​ The precautionary principle suggests weighing:
○​ Costs today to switch to lower-carbon energy, versus
○​ Benefits in the future from reduced global climate change and risk.
What policies would you recommend/support to reduce GHGs?
How much cost should we be willing to bear today to reduce future climate risk?
Sustainability
●​ A sustainable economy is one where people’s well-being rises or remains the same
over time.
●​ Some argue we are using up resources, threatening future sustainability.
●​ Others believe human ingenuity will overcome resource scarcity through innovation.
○​ For example, in the 1960s, there were fears of global food shortages.
○​ The Green Revolution increased production: Today, there is more food per
person than ever, even with rising population.​
Social Capital
●​ Social capital includes: Human capital (labour, knowledge), Natural capital (resources),
and Produced capital (machines, tools)
●​ A sustainable economy grows social capital while maintaining ecological integrity.
●​ As natural resources decline, human capital must increase to compensate and
innovate.​
Case Questions
1. Define externality.
In economics, an externality is an indirect cost or indirect benefit to an uninvolved third party
(not a direct consumer or producer) that arises as an effect of another party's activity
Since it is a third-party effect, sometimes consumers or producers may not notice externalities and even when they do, they may not seek to remedy a negative externality due to the costs
involved.
2. Share an example of a common negative externality.
A very common example of a negative externality is your car burning fuel and causing gas
emissions. Another example is noise pollution caused by construction.
1. What are examples of incentives that might be introduced to force drivers to account
for the external costs created when they drive cars? Use the following formula.
Total quantity of emissions = Number of vehicles × Average kilometres travelled ×
Emissions per kilometre
Incentives are very powerful in influencing consumer and producer activity.
When considering incentives for individuals/households, the government could propose several
incentives, such as:
-​ Imposing a tax if an individual owns multiple cars
-​ Imposing a charge based on kilometers driven (typically reported by car owners when
renewing insurance)
-​ Imposing an additional tax on gas prices
-​ Offering a tax credit or write-off for individuals who own electric cars.
2, What are examples of incentives that might be introduced to influence companies such
as car makers and gasoline producers to address the pollution problems associated with
cars?
When considering incentives for companies the government could propose incentives such as:
-​ Offering a tax subsidy to companies that produces EVs
-​ Imposing a tax on companies that produce gas vehicles
-​ Impose additional subsidies for companies that pursue green practices (such as
powering their building with green energy)
Module 2: Natural Capital, Linkages Between the Economy and the
Environment, and Pollution
Learning Objectives
●​ Describe the three components of natural capital and give specific examples of each
●​ Describe ways to reduce residuals in the economy
●​ Describe the different categories of pollution and contrast the degree of complexity in
reducing emissions
What is Natural Capital?
●​ Canada’s Natural Capital includes:
○​ Natural Resource Capital – such as stocks of renewable and non-renewable
resources: Minerals, Energy, Forests, Fish
○​ Ecosystems or environmental capital:
■​ Watersheds providing fresh drinking and irrigation water
■​ Pollution assimilation in the air, water and soil
■​ Water run-off control by wetlands
■​ Land
●​ Natural Capital sustains life and economic activity
Why is it Called ‘Capital’?
●​ Store of value (huge intrinsic value)
●​ Capable of producing goods and services (becomes an input of production)
●​ Depletable (if there is no reinvestment to sustain the capital stock)
Impacts of Natural Capital Use
1.​ Using Natural Capital draws down the stocks available for the future
○​ Example: Catching too many fish today may leave fewer to catch in the future
2.​ Residuals or waste is created by use of Natural Capital
○​ Example: Processing or raising fish may create ocean pollution
3.​ Waste products may degrade Natural Capital stocks
○​ Example: Fish may not reproduce in a degraded environment
Reducing the Flow of Residual Wastes into
the Environment
●​ The image to the left shows “what goes
in comes out” - the circular flow when
it comes to the Environment and
Economy.
●​ To reduce the amount of residuals,
reduce the input of natural capital into
the system
●​ There are 3 ways to do that:
1.​ Reduce the quantity of goods and services produced
2.​ Reduce the residuals from production
3.​ Increase recycling
1. Reducing Pollution by Reducing Production of Goods and Services
●​ Not popular because it means people must:
○​ Live with less
○​ Accept a smaller population
●​ People often say they can live with less, but are reluctant to give up income or material
possessions.
●​ Reflection questions:
○​ Would you be happy with a lower income?
○​ What possessions would you be happy to give up?
2. Reducing Pollution by Reducing Residuals from Production
●​ More popular approach: pollution prevention
○​ Make production process less polluting (advanced technology)
○​ Shift to consumption of less polluting goods
●​ Allows more overall consumption with less pollution
○​ Examples: Green products – Seventh Generation soap, organic produce
3. Increase Recycling
●​ Popular method: reuse goods that were once waste
●​ Leads to fewer raw natural resources used and lower residuals
●​ Example: Recycling an aluminum can reduces need for bauxite and saves energy in
production
●​ Limits of recycling:
○​ Not all goods can be recycled
○​ Goods degrade during recycling
○​ Recycling still requires energy and resources
It is important to understand different types of pollutants and how their characteristics affect
policy for reducing harm.
Accumulative vs. Non-accumulative
●​ Accumulative pollutants:
○​ Stay in the environment for a long time
○​ New emissions add to existing stocks
○​ Harder to address – must consider past, present, future emissions
●​ Non-accumulative pollutants are short-lived, and disperse and assimilate quickly in
environment
Local vs. Regional and Global Pollutants
●​ Local pollutants:
○​ Affect only one small area
○​ Produced and contained in a specific area
○​ Easier to address – polluter and affected parties are localized
●​ Regional and Global pollutants:
○​ Can travel long distances
○​ Typically longer-lived pollutants
○​ Travel through air or water
Point Source vs. Non-point Source
●​ Point source pollutants:
○​ Come from one or few identifiable sources
○​ Easier to address – can identify and monitor the source
●​ Non-point source pollutants:
○​ Have no clearly identified source
○​ Or sources are so numerous that it’s hard to trace the emitter (often at the
consumer level)
Continuous vs. Episodic Pollutants
●​ Continuous pollutants:
○​ Involve steady production of pollution
○​ Example: Car produces pollution from the moment it is turned on
○​ Easier to address – easier to measure, monitor, and apply control tech
●​ Episodic pollutants:
○​ Occur only occasionally or rarely
○​ Hard to estimate:
■​ Likelihood of catastrophic events
■​ Ensure supplies/equipment are in place for uncommon situations
Emissions Test
Describe whether the following pollutants are:
●​ Accumulative or non-accumulative
●​ Local or regional/global
●​ Point source or non-point source
●​ Continuous or episodic
Examples:
●​ Automobile GHG emissions?
●​ Sulphur dioxide emissions from a power plant?
●​ A loud party next door?
●​ Stormwater sewer overflow after a major rain event?
Canada’s Air Pollution
●​ How do Canada’s air pollution measures compare to:
○​ Other developed countries?
○​ Developing countries?
●​ Is air pollution in Canada getting better or worse over time?
●​ What is happening with GHG emissions in Canada over time? Why?
Case Questions
Classify the following pollutants by category.
Pollutant
Accumulative vs.
Non-accumulative
Local vs.
Point source vs
Regional/Global Non-point
source
Continuous
vs Episodic
Plastics
A
Can be both
N
C
Radioactive
Waste
A
L
P
C
Greenhouse
Gases
A
Can be both
Can be both
C
Noise
A
L
P
Can be both
Ground-level
Ozone
A
G
N
C
Acid Rain
N
G
N
E
Power Plant
Emissions
A
G
P
C
Industrial
Pollutants
A
G
P
C
Stormwater
Runoff from
Roadways
N
G
P
C
Discussion 2.1: How to reduce the human discharge to the environment?
Use the diagram in Chapter 2.
How would you make the first way (reducing production of goods and services) to reduce
residuals possible?
As discussed in the chapter, reducing the production of goods and services is a rather
unpopular approach towards the reduction of residual wastes. It suggests that people should
learn to live with less, and most would be unwilling to do so.
However, a major argument against this line of thinking is the idea of overconsumption.
Overconsumption is the excessive use of resources or the purchase and consumption of goods
and services at a level that surpasses what is needed or sustainable. Due to social media and
consumer culture evolving over recent years, overconsumption has become a very real
problem. Society has reached a point where they consume past the point of necessity. At the
core of this issue is phenomena such as fast fashion, paired with the use of single-use plastics
for packaging. The frequent purchase and disposal of inexpensive clothing is leading to massive
textile waste and exploitation of child labor, while the use of single-use plastics is having a
significant impact on pollution.
In order to address these issues and reduce the residual effects of overconsumption, we should
encourage people to buy higher quality items as opposed to several, low-quality items - or to
even donate to thrift stores when they no longer require items. Additionally, we should
encourage the use of recyclable and biodegradable materials for packaging purposes. Both of
these approaches would reduce the production of goods and services that directly lead to
pollution.
Discussion 2.2: Consumer behavior (Demand)
Write one real life example of any factor that could cause the demand for an environment
related product to change (increase or decrease).
There are several factors that could cause the demand for an environment-related product to
change. However, I would like to focus specifically on advertising and promotion. During the
2018/19 Premier League Season, Manchester United Football Club announced a collaboration
with Parley for the Oceans in creating a football kit from recycled ocean plastic. It was a brilliant
effort aimed at highlighting the environmental issue of marine pollution, and needless to say,
millions of jerseys were sold. Prior to 2018, many people, including myself, were unaware of the
idea that it was even possible to create a football jersey from ocean plastics. However, due to
excellent marketing and collaboration with a prominent football club, there was suddenly a
massive market for similar jerseys. Seeing some of the most famous players in the world
wearing a jersey made from recycled ocean plastic caused demand to increase significantly.
Module 3: Benefits and Costs, Supply and Demand
Learning Objectives
●​ Derive the demand curve for an individual from his willingness to pay and show how to
aggregate to a market demand curve
●​ Derive the supply curve for a firm and show how to aggregate to a market supply curve
●​ Illustrate the impact of technological progress on marginal cost curves​
Demand, Value, and Willingness to Pay (WTP)
Demand Curve
●​ A Demand Curve represents all the different potential quantities of a good available and
the WTP of consumers for each quantity (price y-axis, quantity x-axis)
●​ A single Quantity Demanded (Qd) is associated with each price level​
Law of Diminishing Marginal Utility
●​ A Demand Curve is downward sloping due to the Law of Diminishing Marginal Utility
●​ This law suggests the more you have of something, the less you are willing to pay for
an additional unit of the good (you get the highest satisfaction from the first unit)
●​ Across groups of people (aggregate demand), WTP falls because different people hold
different values for a good​
Marginal Willingness to Pay
●​ MWTP = your willingness to pay for the next item (one more)
●​ The points on a demand curve show MWTP for a product
●​ Your MWTP is affected by:
○​ How many of the same items you already have
○​ Tastes and preferences
○​ Time and situation​
Total Willingness to Pay
●​ TWTP = the total amount you are willing to pay for a set of items
●​ It is calculated by summing the MWTP for each item (cumulative)
●​ TWTP represents the total value of a set of goods
●​ It can be calculated by finding the area under the demand curve
The Price of 1, 6, and 12 Cans of Sprite
●​ Example of diminishing WTP and
how we can sum MWTP to find
TWTP
○​ 1 Can of Sprite costs $1.00
○​ 6 cans cost $3.00
○​ 12 cans cost $3.99
●​ What is the MWTP for each can,
TWTP, AWTP?
INSERT TABLE
Average Willingness to Pay (AWTP) is the TWTP / # of the variable.
We can aggregate the demand curves of individuals to find the “aggregate demand curve” for
a group of people or society​
Questions on Demand
●​ Why does Willingness to Pay (WTP) diminish as you get more and more items?
●​ What is an example of diminishing WTP for goods you buy?
●​ What is the relationship between WTP and the total value of a good?
●​ How is it found using a demand curve?
●​ Does a low price mean a good has little value?
Shifts in Demand Curves
●​ A change in price yields movement along a demand curve, not a shift of the curve
●​ If the price of oil rises, the demand for oil will stay the same (in the short run)
●​ A demand curve shifts due to changes in tastes and preferences, population, time,
expectations (expecting prices to rise), income, and in prices of related goods
(substitute vs complementary).
●​ Ability to Pay is an important factor in determining Demand, and therefore MWTP and
TWTP for a good
Qd = f(P) - quantity demanded is a function of demand,,,
Price elasticity of demand (PED) = % change in Qd / % change in P
Inelastic demand occurs where the % change in price > % change in Qd
Elastic demand occurs where the % change in Qd > % change in P
Supply and Marginal Cost (MC)
Supply Curve
●​ A Supply Curve represents the number of units a supplier is willing to produce at
different price levels
●​ Marginal cost is the cost of producing one additional unit of a good
●​ Supply curves are generally upward sloping, because the Marginal Cost (MC) of
production rises as more units are produced
●​ Costs rise because of Opportunity Costs – resources used in production must be bid
away from alternative uses
Opportunity Costs and Marginal Cost
●​ To produce goods, firms must invest in land, labor, and capital: hire workers, rent
buildings, and buy raw materials and other inputs
●​ As production increases, the number of workers, raw materials, etc. also increases
●​ As technology becomes better, production may become more efficient = lower cost
●​ Increasing MC is explained by the Law of Diminishing Marginal Returns (Product)
●​ If P>MC, Q increases, if P<MC, Q decreases, if P=MC, Q* (profit-maximizing)
●​ Note that firms cannot change the market price, they only have control over their costs​
MC and TC
Aggregate Supply Curves
●​ Aggregate supply curves are a horizontal summation of the individual supply curves of
different individuals or firms
Shifts in a Supply Curve
●​ A Supply Curve will shift due to:
○​ Changes in the costs of the resources used to produce a good
■​ Land - Rent, Labour - Wages, Capital - Interest rates
●​
●​
●​
●​
○​ Changes in technology (productivity)
When technology improves:
○​ The supply curve shifts down
○​ It becomes cheaper to produce each unit of the good
Government regulations
Expectations in price
Natural and market shocks (both positive and negative)
An increase in supply (positive supply shock) shifts the curve to the right, while a decrease
(negative supply shock) shifts the curve to the left
MB = MWTP = Price
TB for Consumers vs TC for Producers
PES = Price Elasticity of Supply = %Change in Qs / %Change in P
-​ Describes how suppliers react to price change
-​ Inelastic Supply: Change in P > Change in Qs, PES<1 (steeper)
-​ Elastic Supply: Change in P < Change in Qs, PES>1 (flatter)
-​ PES = 1 is Unitary Elastic Supply
-​ PES = 0 is Perfectly Inelastic Supply (straight line)
-​ PES = very high number is Perfectly Elastic Supply
Questions on Supply
●​ Why does Marginal Cost rise as you produce more and more items?
●​ What is the relationship between MC and the total cost of producing a good?
●​ How is it found using a supply curve?
●​ How do technological improvements change MC and the supply curve?​
Chapter 4: Economic Efficiency and Markets
Learning Objectives
●​ Define social efficiency and graphically illustrate when it is achieved.
●​ Explain why a competitive market may fail to reach a socially efficient equilibrium.
●​ List and explain the causes of market failure.
●​ Contrast the equilibrium outcomes in markets where externalities are accounted for
versus when they are not.
●​ Explain the distinguishing characteristics of public goods and why they give rise to free
riding.​
Economic Efficiency
●​ Economic efficiency in production is achieved when the marginal benefits from
production equal the marginal costs.
●​ This is achieved when:
Marginal Willingness To Pay (Demand) = Marginal Cost (Supply)
Efficiency and Equity
●​ Efficiency does not distinguish between people – a market that achieves the maximum
total benefit is considered efficient no matter who receives the benefits (one person
can achieve all the benefits)
●​ Equity considers distribution of benefits – to be equitable, the distribution must be fair.
●​ An efficient outcome may not be considered equitable if a small number of people
benefit and many do not.​
Example
To solve for a socially efficient equilibrium:
Note: MWTP = P = MB
Let: MWTP = 100 − 2Qᴰ and MC = 0.5Qˢ
Equilibrium values are found by setting MWTP = MC:
100 – 2Qᴱ = 0.5Qᴱ, therefore Qᴱ = 40
Where Qᴰ = Qˢ = Qᴱ
Market Equilibrium
●​ The price level where Quantity Supplied (Qˢ) =
Quantity Demanded (Qᴰ) is the only point of
market equilibrium.
Net Social Value
●​ Net social value/net benefits/social surplus = area a + b
●​ Area a is consumer surplus, Area b is Producer surplus (Profit = TR-TC)
●​ Area a+b+c = Total Benefit (TB)
●​ Area b+c = TC for Consumers = TR for Producers
●​ Area c = TC for Producers
●​ Let’s find the net social value for the previous example.
●​ Area a = (80*40 / 2) = 1600, Area b = (40*20 / 2) = 400. NSV = 2000
Suppose the MWTP for a certain good is represented by the equation MWTP = 490 - 0.25Q and
the marginal cost equation is MC = 40 + 2Q. Assuming these curves capture all market and
non-market values, solve for the socially efficient level of output and the net social benefits.
490 - 0.25Q = 40 + 2Q, 450 = 2.25Q
Q* = 450/2.25 = 200, P* = 490 - (0.25*200) = $440
Consumer surplus = (490-440 * 200) / 2 = 5000
Producer surplus= (440-40 * 200) / 2 = 40,000
NSB = 45,000
Market failures prevent a socially efficient equilibrium from being reached.
Note that as production increases, so do the costs of production…​
Main Types of Market Failures
Negative Externalities
●​ Producers do not pay full costs of production (e.g.,
pollution).
●​ Market price is below the true price.
●​ Producers produce more than the socially optimal amount.
Positive Externalities
●​ Producers can’t capture full benefits of production.
●​ Producers produce less than the socially optimal amount.​
Emissions as a Negative Externality
●​ Pollution emissions create a negative externality.
●​ There are costs to society/environment from production/use
not paid by producers/consumers.
●​ Even with full-cost pricing, pollution would still exist due
to consumption benefits.​
When MSC > MPC
●​ Marginal Social Costs (MSC) > Marginal Private Costs
(MPC) = Negative Externality
●​ MPC does not reflect full cost.
●​ Without external costs added:
○​ Market price is below correct price ($4.50 vs. $5.50)
○​ Overproduction occurs (3.5 vs. 2.5)
Air pollution is a common negative externality that has a negative impact on human health,
and causes damages through the degradation of materials (degradation of visual environment,
can cause acid rain, impact the food chain.
​
Water Pollution Example
●​ New paper mill discharges waste into a river.
●​ Downstream fishery suffers.
●​ Mill ignores external impact → overproduction and excess emissions.
●​ Solution (Policy Preview):
○​ Impose a tax on the polluter equal to damage caused.
○​ Now the paper mill considers full social costs in its private costs
○​ Negative externality is internalized.
○​ Pollution remains, but at socially efficient level.
Open Access Resources
●​ Open access resources are scarce with uncontrolled access:
○​ e.g., oceans, air, public lands.
●​ Absence of property rights → overuse and abuse.​
Positive Externalities
●​ Action benefits others but is not considered in decision-making.
●​ MB to society > MB to individual.
●​ Producers produce where private MB = private MC → underproduction in a free
market.​
Examples of positive externalities include Flower gardens, Firework shows, Education,
Vaccinations​
More on Positive Externalities
●​ Society benefits by compensating producers of positive externalities.
●​ Encourages production at socially efficient level.
●​ Public Goods are related to positive externalities.​
A pure Public Good is:
●​ Non-rival – One’s use doesn’t reduce another’s (breathing air, listening to music).
●​ Non-excludable – Cannot prevent free usage (watching fireworks, breathing air)
Free Riders
●​ Free riders pay less than their Marginal Willingness to Pay (MWTP).
●​ Many public goods suffer from free riding due to non-excludability.
●​ People benefit without paying.​
Application Example:
●​ Assume there is a small lake near two homes.
●​ Water quality is degraded by fertilizer runoff → algae blooms → low dissolved oxygen →
dead fish + poor swimming conditions.
●​ Dissolved oxygen (ppm) is an environmental quality indicator.
●​ Households can buy treatment compounds to address this issue.
●​ Marginal Cost of Treatment: MC = 5 + 2Q
●​ Household MWTP functions:
○​ MWTPₐ = 14 – 2Qₐ
○​ MWTPᵦ = 6 – Qᵦ
●​ MC = 5 + 2Q
●​ SOLVE???​
Market Failure and Public Goods
●​ Public goods are underprovided in a free market.
●​ Non-excludable → encourages free riders.
●​ People avoid paying despite positive MWTP, hoping others will pay.
●​ Taxes can help address the issue:
○​ Efficient for society, not necessarily for individuals.
Module 5: The Economics of Environmental Quality
Learning Objectives
●​ Distinguish between positive and normative economics.
●​ Define the marginal damage function and distinguish between four different shapes
and what each means.
●​ Distinguish between marginal and total damages and illustrate graphically.
●​ Interpret the meaning of the marginal abatement cost and illustrate graphically the
distinction between marginal and total costs of abatement.
●​ Show graphically how to aggregate marginal abatement cost curves.
●​ Explain the equimarginal principle and how it applies to marginal abatement costs.
●​ Illustrate graphically the determination of a socially efficient level of pollution and how
this equilibrium minimizes net social costs compared to no emission control.​
Normative and Positive Statements
●​ A normative statement is one that expresses an opinion, what “ought to be”
●​ A positive statement is a study of facts, the actual events in the real world.
●​ The socially efficient level of emissions is a normative concept.
●​ The actual target level of emissions and how much emissions need to be reduced to
reach that target are positive concepts.​
Pollution Damages
●​ People have a WTP (Willingness to Pay) to avoid damages caused by pollution.
●​ We examine the Marginal Damages – additional damage caused by additional units of
pollution (or higher ambient concentrations).​
Pollution and Damages
●​ In general, the greater the pollution, the greater the damages it produces.
●​ A damage function shows the relationship between the quantity of a waste product and
the value of its damages.​
What Matters for Damages?
●​ Location Matters: Damages may be higher in urban areas than rural areas.
●​ Knowledge Matters: The more you know about the impacts of pollution, the more you
are WTP to avoid it.
●​ Ability to Pay Matters: Pollution damages may be lower in low income areas.
●​ Tastes and Preferences Matter: If my child has asthma, I may be WTP more to reduce
pollution.​
Types of Damage Functions
●​ Emission damage functions: relationship between waste from a source and resulting
damages.
●​ Ambient damage functions: damages related to concentration of waste in the
environment.
●​ Marginal damage functions: change in damages from a unit change in
emissions/concentration.
●​ Total damages: total amount of damage at each possible emission level.​
Marginal Damage
●​ Marginal Damages – additional damage caused by additional units of pollution.
●​ MD tends to rise exponentially:
○​ Low pollution → little/no damage.
○​ A threshold level of emission may exist with no damage.
○​ High concentrations → rapidly increasing damage.
○​ For toxic pollutants, any emissions may cause large damages.​
Measuring values is challenging, but some damages can be estimated via defensive
expenditures. For example: Heavier insulation to protect against noise.
Representative Marginal Damage Functions
Group Work: Marginal and Total Damages
●​ Area b = Total Damages for MD1. Area a + b = Total Damages for MD2.
●​ Consider: Which curve represents an urban vs rural area? Could differences relate to
time of year?​
Marginal Abatement Cost (MAC) Curve
●​ Cost of abating next unit of emissions.
●​ Rises exponentially as the amount of emissions to be abated increases
●​ The more pollution you abate, the higher the cost of abating the next unit of emissions
because you have already abated the lowest cost unit.
Marginal vs Total Abatement Costs
●​ Area under MAC curve = Total Abatement Cost.
●​ Technological improvement → MAC curve shifts downward (e.g., MAC₁ vs MAC₂).or
curve becomes flatter
●​ Key: Read graph from right to left when calculating Total Abatement Costs (TAC).​
How to Aggregate MAC Curves
●​ Choose an abatement cost (e.g., $40/month).
●​ Polluter 1 abates 5 tonnes/month; Polluter 2 abates 7 tonnes/month.
●​ Total abatement = 12 tonnes/month.
●​ Repeat for other cost levels and graph the aggregate curve.​
Aggregate Abatement Cost Functions
●​ Aggregate MAC curves by horizontal summation to achieve lowest possible total
abatement costs.​
Equimarginal Principle
●​ Distribute production so marginal costs are equalized among all sources.
●​ An aggregate MAC function always represents the minimum MAC achievable.
●​ Abate the cheapest unit of pollution first, regardless of the source.​
The Socially Efficient Level of Emissions
●​ Found where MAC = MD.
●​ This equilibrium minimizes total social costs.​
Example
Given: MAC = 60 – 4E, MD = 2E
Set MAC = MD:
●​ 60 – 4E = 2E → E* = 10; At E = 10: MAC = MD = $20
●​ Total Social Costs (TSC) = Total Damage (TD) + Total Abatement Cost (TAC)
○​ TD = (10 × 20)/2 = $100
○​ TAC = (20 × 5)/2 = $50
○​ TSC = $150
At this level, TSC is minimized.
The Proof
●​ Suppose emissions = 0. What are TD, TAC, and TSC? Compare to $150 from the
efficient case.​
Proving Social Efficiency Minimizes Social Cost
●​ TSC (Total Social Costs) = Damage costs (area a) + Abatement costs (area b).
●​ At efficient emissions (10 units): TSC is minimum.
●​ Emissions above/below this level → higher TSC.
●​ At 15 units: no abatement costs, but high damages (a + b + c).
●​ Abating high-damage emissions at low cost improves welfare.​
Questions
●​ Why is it not in society’s interest to completely eliminate pollution?
●​ Some companies argue that pollution control costs jobs – how would you counter this?
Practice
Suppose MD = 0.5E and MAC = 200 - 2E
a.​ What would be the socially efficient level of pollution (E*)?
b.​ What would be the total social costs at the socially efficient level of pollution?
c.​ What would be the uncontrolled level of emission (Emax)?
d.​ What would be the maximum possible damage at the uncontrolled level of emission?
e.​ How much damage (in monetary value) could be reduced if the emission reached at the
socially efficient level?
MAC = MD
200 - 2E = 0.5E
2.5E = 200
E* = 80 (a)
At E = 80, MAC = MD = 40
TD* = (80 × 40)/2 = $1600
To find TAC*, we need to know Emax (MAC = 0)
2E = 200, Emax = 100 (c)
Emission reduction = Emax - E* = 100 - 80 = 20
TAC* = (40 × 20)/2 = $400
TSC* = $2000 (b)
MDmax = 0.5 * 100 = 50
TDmax = (50 * 100)/2
TDmax = $2500 (d)
Reduced damage = 2500 - 1600 = 900 (e)
Chapter 6 – Benefit-Cost Analysis (General Framework)
Learning Objectives
●​ Define the basic framework for the benefit-cost analysis and how it could be used to
assess government projects and regulatory actions.
●​ Show graphically that a project which maximizes net social benefits will be equivalent
to the socially efficient equilibrium.
●​ Explain the role of discounting in benefit-cost analysis and why the social and private
discount rates will typically differ.
●​ Explain how equity and the distribution of income enter into benefit-cost analysis.
●​ Describe how expected values can reflect uncertainty and how they can be used in
benefit-cost analysis.
●​ Define cost effectiveness and when it is used instead of benefit-cost analysis.​
Benefit-Cost Analysis (BCA)
●​ BCA involves measuring, adding up, and comparing all the benefits and all the costs
of a public program.
●​ BCA can be used to analytically quantify potential effectiveness of a decision by
estimating a net positive or negative result.
●​ BCA helps society make informed decisions and use scarce resources efficiently.
●​ BCA is done from the standpoint of society rather than a single profit-making firm.
●​ It incorporates social valuation of all inputs/outputs whether or not transacted in private
markets.​
Basic Framework for BCA
1.​ Specify the project or program, including its scale and perspective.
2.​ Describe quantitatively the inputs/outputs (in quantities).
3.​ Estimate the social costs and benefits (usually in dollars).
4.​ Compare these benefits and costs to find net benefit.​
Socially Efficient Scale
●​ Occurs where MAC = MD (Marginal Abatement Cost = Marginal Damage).
●​ This is where net benefits are maximized.
Benefits vs. Costs
●​ Benefits: Reduction in Total Damages
●​ Costs: Total Abatement Costs
●​ Net Benefits: Benefits – Costs
●​ Net Social Benefits are maximized when MAC = MD
See the graph to the right.
MAC = 60 - 4E, MD = 2E
TB = TD reduction = TDmax - TD*
TDmax = ABC = 30*15 / 2 = 225
TD* = AED = 20*10 / 2 = 100
TB = TDmax - TD* = DEBC = 225 - 100 = 125
TC = TAC = DEC = 20*5 / 2 = 50
NB = TB - TC = 125 - 50 = 75
Discounting and Multiple Projects
●​ For projects lasting more than a year, future costs and benefits must be discounted
before computing net benefits.
●​ When choosing between multiple projects with the same goal, choose the one with the
largest net benefits, within budget.​
Discounting in Benefit-Cost Analysis
●​ Discounting is a way of aggregating a series of future net benefits into an estimate of
present value for use in BCA calculations.
●​ Projecting return on investment and interest rates allows economists to determine net
benefits over time.
●​ Key formulas:
○​ Future Value = Present Value / Discount Factor
○​ Present Value = Future Value × Discount Factor
○​ Discount Factor = 1 / (1 + r)^t
■​ r = discount rate (interest rate)
■​ t = time in years
Choosing a Discount Rate
●​ Reflects society’s rate of time preference
●​ Low discount rate: Future costs/benefits valued similarly to present
●​ High discount rate: Future costs/benefits valued much less than present
●​ The higher the discount rate, the lower the present value of future costs.​
Sensitivity Analysis
●​ Tests how robust results are to key assumptions:
1.​ Interest rate (e.g., 5%)
2.​ Project duration (e.g., 5 years after construction)
●​ Used to evaluate if changes in assumptions affect project rankings.​
Public vs Private Discount Rates
●​ Private Discount Rates (PDR): Based on private capital markets, commonly used.
●​ Social Discount Rates (SDR): Based on the government
○​ Considers lower borrowing costs, as it comes from a government perspective
○​ Reflects externalities (e.g., pollution)
○​ Include Social Rate of Time Preference (SRTP) and Social Opportunity Cost
(SOC)​
Social Discount Rate
●​ Nominal Interest Rate = Real Interest Rate + Rate of Inflation
●​ SRTP: After-tax real return on a government bond (e.g., 3% nominal – 2% inflation = 1%
SRTP)
●​ SOC: Estimated using pre-tax return on business investment.​
Distributional Issue
●​ Program impacts vary by individual. A program may be:
○​ Horizontally equitable: Equal benefit to people with same income.
○​ Not horizontally equitable if benefit distribution differs unjustifiably.​
Distributing Net Benefits
●​ Economic efficiency and equitable distribution of costs and benefits must be taken
into account when a government introduces programs and policies.
●​ 3 Types of distributional impacts:
○​ Proportional: A program takes equal % of income from all individuals to achieve
net benefit.
○​ Regressive: A program provides wealthier individuals proportionally higher net
benefits over lower income individuals based on proportion of income used..
○​ Progressive: A program that provides a higher proportion of net benefits to lower
income individuals than it does to high-income.
Future Uncertainty
●​ Hard to predict future events (e.g., earthquakes, environmental disasters).
●​ Use probabilities from historical data or expert judgment to assess risks.
Expected Value vs Scenario Analysis
●​ Expected Value (EV): Used if probabilities are known and reliable.
●​ Not useful if probability data is lacking.​
Scenario Analysis
●​ Useful when probabilities are uncertain or unreliable.
●​ Example:
○​ Program A: Conventional Power Plant
○​ Program B: Nuclear Power Plant
●​ Evaluate based on slow, moderate, or fast future technological advancements.​
Cost-Effectiveness Analysis (CEA)
●​ Focuses only on costs, not benefits.
●​ Identifies which policy achieves greatest benefit for the lowest cost.
●​ Used when:
○​ Measuring benefits is too difficult
○​ Reliable cost data is available but benefit data is limited.