Environmental Economics Course
Market failure and decision making
19/10/2011
Cristina Marta-Pedroso
cristina.pedroso@ipb.pt
cristina.marta@ist.utl.pt
• Externalities
• Public Goods
• Ecosystem services
• Economic Valuation of Ecosystem Services
• Highlighting the inclusion of Economic Valuation in
decision making:
• Governmental intervention (e.g Agri-environmental
policies)
• Castro Verde
• Private sector (TEEB for Business /WBCSD )
• EVI – Cascata da Serra da Estrela
X = Consumer Surplus
Y = Consumer Surplus
• In market equilibrium the marginal benefit is equal to marginal cost.
• This is the general (and necessary) condition for optimization.
• In this case, market equilibrium illustrates the quantity of seedlings that maximize
the sum of consumer and producer surpluses. For example, the net benefit for
consumers (forest owners) and producers (owners of nursery firms).
If the market is perfectly competitive, the market equilibrium is also socially optimal.
Externalities (Negative or Positive)
An external effect, or an externality, is said to occur when the production or
consumption decisions of one agent have an impact on the utility or profit of
another agent in an unintended way, and when no compensation/payment
is made by the generator of the impact to the affected party.
Positive Externality: Bread smell
Analysis of Positive Externalities
Negative Externality: Pollution
Analysis of an negative externality
Public Goods (extreme cases of Positive Externalities)
Characteristics
Public Goods
Private Goods
Goods cannot be confined to Consumers
can
be
excluded
those who have paid for it. In from consuming the product if
[Non]Excludability
this sense, non-payers can take they are not willing to pay for
a
free
ride
and
enjoy
the it.
benefits of consumption.
Consumption
by
one
person One person's consumption of a
does not reduce the availability product reduces the amount
[Non]Rivalry
of a good to others.
available for other people to
consume
Why is there a problem?
When markets are unable to capture some attributes of a given good is there a
market failure, e.g. the private (cost) benefit does not equal the social benefit
(cost).
Inequalities among the private and social cost and benefit are called externalities,
negative positive or externalities.
What is called the free rider problem gives light on why the firms, e.g.
farmers, do not have an incentive, in a competitive market, to provide
public goods too consumers. The absence of a full internalization of
these benefits in the market price of agricultural products is the main
underlying cause for natural resources depletion.
The "free rider" principle says that you cannot charge an individual a
price for the provision of a non-excludable good because somebody
else would gain the benefit from consumption without paying
anything
o consumo de um individuo desse bem
não diminui a possibilidade de consumo
por outro
Rivarly
Purely Private
Mixed Goods
Purely Public
Excludability
uma vez produzido esse bem é
impossível (ou muito difícil) evitar que
outro tenha acesso a ele
The value of a forest is often measured only by the
timber and fuel provided by its trees.
In these countries, however, that is generally less than
one third of the total economic value.
The higher figure includes services such as control of
the climate through absorption (sequestration) of
carbon dioxide, protection of freshwater sources
(watersheds), and recreation.
Because many of these services are not bought and
sold in markets, they are frequently lost or degraded
even though their value to human societies is high.
(Source: MEA)
Millennium Ecosystem Assessment
Environmental Economics Course
Market failure and decision making
20/10/2011
Cristina Marta-Pedroso
cristina.pedroso@ipb.pt
cristina.marta@ist.utl.pt
• Externalities 
• Public Goods 
• Ecosystem services 
• Economic Valuation of Ecosystem Services 
• Wrap up
• Highlighting the inclusion of Economic Valuation in
decision making:
• Governmental intervention (e.g Agri-environmental
policies)
• Castro Verde
• Private sector (TEEB for Business /WBCSD )
• EVI – Cascata da Serra da Estrela
1. Which of the following statements is true regarding externalities?
A. Both negative and positive externalities lead to inefficient outcomes in
markets.
B. Negative externalities lead to inefficiencies in markets, but positive
externalities do not.
C. Negative externalities occur when the good harms those who consume it.
D. Positive externalities occur when the good benefits those who consume it.
2. The two main characteristics of a public good are:
A. production at constant marginal cost and rising demand.
B. non-excludability and production at rising marginal cost.
C. non-rivalry and non-excludability.
D. non-rivalry and large negative externalities.
3. Unlike a private good, a public good:
A. has no opportunity costs.
B. has benefits available to all, including nonpayers.
C. produces no positive or negative externalities.
D. is characterized by rivalry and excludability.
4. Which of the following is an example of a public good?
A. a weather warning system
B. a television set
C. a sofa
D. a bottle of soda
5. The market system does not produce public goods because:
A. there is no need or demand for such goods.
B. private firms cannot stop consumers who are unwilling to pay for such goods
from benefiting from them.
C. public enterprises can produce such goods at lower cost than can private
enterprises.
D. their production seriously distorts the distribution of income.
6. Because of the free-rider problem:
A. the market demand for a public good is overstated.
B. the market demand for a public good is nonexistent or understated.
C. government has increasingly yielded to the private sector in producing public
goods.
D. public goods often create moral hazard and adverse selection problems.
(Under)Provision of Public Goods by farmers
Produção de
Alimento e
fibra
Oportunidades de
Recreio, Lazer e
relaxamento
Manutenção da
identidade e
patrimonio
cultural
Protecção da
biodiversidade
Falha de mercado e a intervenção pública agro-ambiental
Falha de mercado
Os preços de mercado não incorporam as consequências ambientais
das decisões dos agricultores. Estas consequências nã dão assim
origem a custos e ou benefícios privados para o agricultor, pelo que o
óptimo privado não coincide com o óptimo social.
Na ausência de outros incentivos o agricultor actua no sentido de maximizar o
seu rendimento (o rendimento que consegue captar – no mercado).
A grande maioria destes benefícios não são transaccionados no mercado,
portanto não têm preço.
Intervenção pública (e.g agri-enviornmental policy)
As políticas devem fornecer os instrumentos (taxas, subsídios) mais
adequados e ter em conta a disposição a pagar da sociedade por
aqueles benefícios.
A case study regarding the provision of Public Goods by Agricultural
Governmental Intervention
Economic Valuation: contingent valuation
The Cereal pseudo steppes of Castro Verde:
an human dominated ecosystem
Bird’s populations decline and landscape scenery loss
Land
abandonment
Afforestation
Main reasons for land use
change
Marginal economic system (low productivity; low revenue)
A Contingent Valuation Approach
Metodological approach (2)
1) Questionnaire(s) structure
Socio-economic profile of respondents
Individuals’ attitude towards rural landscapes
preservation
WTP elicitation
Non-market good
description and valuation
scenarios
Metodological approach (3)
2. Valuation scenarios
Elicitation scenario
Current EU financial support to keep farmers income would be
suspended and new forms of land use will be adopted
NGO intervention mainly supported by citizens donations
Government intervention supported by an environmental tax
(additional one)
Elicitation procedure
Open-ended questions in a two stage process
Metodological approach (4)
2. Valuation scenarios (cont.)
Budget constraint reminder
Prior to stating their WTP, individuals were asked to have in mind:
 their current net income
 their current expenses
 The existence of other typical rural landscapes in the country
Support materials
A set of pictures and maps have been used to illustrate landscape, its
location and the assemblage of birds depending on it.
Visualization of the landscape pictures and location map
8
Imagine that this financial support is to be suspended and other farming
options, would take place leading to a strong change in landscape
structure.
Regarding this I would like to ask you to consider the following hypothesis:
payment vehicle = tax
A) As part of a national strategy of rural landscapes preservation the
Portuguese government will implement a program of financial incentives to
which the farmers of the municipality of Castro Verde could apply.
The objective of such financial support is to ensure the continuity of
traditional agricultural practices, to achieve the goal of cereal steppe
preservation, at least, in 2/3 of the area of the municipality of Castro Verde
This investment will be partially supported by one TAX to be paid by all
Portuguese. Suppose that tax, additional to your current taxes, will be
managed honestly and will be totally destined to maintain the traditional
agricultural practice that origins the cereal steppe.
What is the maximum that you will be willing to pay annually, as an
environmental tax, to maintain the cereal steppe, at least in 2/3 of the area
of the municipality of Castro Verde.
payment vehicle = donation
B) In order to maintain the current landscape, at least in 1/3 of its
extension, a private and non-profit organization, will acquire that area
Castro Verde being responsible for its management. This intervention will
be essentially supported by citizen donations.
What is the maximum that you will be willing to pay, as a one time
payment, to maintain the Cereal steppe, at least in 1/3 of the area of the
municipality of Castro Verde?
Pictures and information about of Birds species and habitat requirements
9
The landscape introduced to you before is from, an ecological
perspective, an important refugium for a set of birds’ species threatened
at national and international level. Eventual landscape transformations,
arriving from a shift in agricultural practice, will lead to a reduction in
this birds population and to contribute for the risk of their extinction at
global scale.
Facing this information would you like to revise the amount stated
before?
Yes
Rectification of answer 8 A
Rectification of answer 8 B
No, I knew about it
No, I do not consider it important
No, Other
Idade > 30
Regressão
Modo de Entrevista
Rendimento
mi
E (WTP)
95%
Modelo Spike
CI
€
pi
E (WTP)
€
Web
< 500
3.001
48.13
[60.5
- 38.3]
0.49
24.54
Web
500-1100
3.215
59.62
[47.5 - 74.9]
0.49
30.39
Web
1100-1750
3.446
75.11
[94.4 - 59.8]
0.49
38.29
Web
> 1750
3.900
118.27
[148.6 - 94.1]
0.49
60.29
Presencial
< 500
3.430
73.92
[92.9
0.49
37.68
Presencial
500-1100
3.645
91.65
[115.2 - 72.9]
0.49
46.72
Presencial
1100-1750
3.876
115.47
[145.1 - 91.9]
0.49
58.86
4.330
181.82
[228.4 - 144.7]
0.49
92.68
Presencial
> 1750
- 58.8]
Results

Portuguese active population (older than 21 years)
4 802 985

WTP (Combined Spike model); one time payment
30.4 €

Agregated WTP – 18 966, 67 hectares of cereal steppes
146 M€
[121– 160]

Annuity - hectare
446 €
[362 – 491]
t = 40 years
r = 5%
Total Ecosystem Valuation of an hydropower system
watershed in Serra da Estrela, Portugal
Enquadramento
Total Ecosystem Valuation of Cascata da Serra
da Estrela, Portugal
20110826-Ecosystem Valuation Initiative - Total Economic Valuation of Serra de Estrela’s Hydropower System Watershed.pptx
Study Area: located in the highest Mountain in
Continental Portugal
Watershed:
Serra da Estrela Natural Park
7.2 m ha
Objectivos
Estimativa do Valor Económico Total dos Serviços de
Ecossistema providenciados bacia da Cascata da Serra
da Estrela
Análise Custo Benefício de Cenários de Gestão
Alternativos
Stage 1 – Dismantlement as baseline
1
Literature
review
Set System
Boundaries
•Discount rate
variation (2%
and 5%)
2
5
•Time horizon
variation
Ecological
data
collection
Identify Main
Ecosystem
Services
Sensitivity
Analysis
Participatory
Workshop
TEV
Compare with a
dismantlement
scenario
Set time horizon
(concession
period: 20 years)
4
Apply economic
valuation
techniques
3
Biophysical
units
quantification
Private Benefits – Private Costs + Public Benefits – Public Costs
Documento Word –
1. Total Economic Value and Discount rate
2. Valuation Methods
Total Economic Value
Benefits
Power Generation
Emission avoided
Water Supply
Food
Wood
Fire Risk Avoidance
Water Recreation
Recreational Fishing
Biodiversity1*
Biodiversity 2*
Biodiversity 3
Biodiversity 4
Current scenario
Value (€/year)
NPV 20 years (€)
6.047.777
79.137.103
2.745.704
35.928.421
869.146
11.373.054
3.292
43.071
871.532
938
12.271
357.111
4.672.907
4.167
54.527
132.092.886
Sub- Total
493.967
429.413
429.412
954.000
Total 1
Total 2
Total 2
Total 3
1.421.861
1.236.044
5.935.502
12.483.396
133.514.747
5.587.510
551.741
479.637
429.412
954.000
1.588.162
1.380.614
5.935.502
12.483.396
7.175.672
133.328.930
6.968.124
138.028.388
11.523.012
144.576.282
18.070.906
Costs
Dismantlement Costs Lump sum (€)
Total NPV 20 years**
Dismantlement
Value (€/year)
NPV 20 years (€)
0
0
0
0
0
0
3.292
43.071
0
871.532
0
0
357.111
4.672.907
0
0
112.227.500
137.362.087
-101.293.072
1 LIFE; 2 Matrizes CAOF; 3 Gantioler et al, 2010; 4 ITI Serra da Estrela; * €/5 years; **Average Total 1-Total 4
Stage 2 – Agro-forestry Scenarios
1
Biophysical
characterizati
on
4
Hydrological
modelling
FOREST
MANAGEMENT
SCENARIO
3 National2
Authorities
Forest
management
Scenarios
3
Wildfire risk
analysis
Ecological
Modelling
Biodiversity
valorisation
model
59