1
Handout environmental economics
Spring 2012
Finn R. Førsund
1. Environmental economics and general economics
Pigou (1920), private and social costs, tax to include sosial costs in private costs
Classical externalities models:
Short- circuit the environment, direct representation of externality-generating activities in
production and/or utility functions.
The materials balance, 1. Law of thermodynamics; mass cannot disappear
Ayeres and Kneese (1969)
Micro-economics, welfare theory as building blocks, applied, external effects, public goods,
efficiency of prices of a competitive market system, first and second welfare theorems
Development of new methods for estimating demand for environmental services
Policy instruments and theory of regulation
Ecological economics: more concerned about sustainability
2. The formal structure of environmental economics
Basic stages:
(1) Extracting/harvesting resources
(2) Transformation of resources into products
Residuals as by-products (Primary/secondary residuals if add-on purification is an
option)
(3) Environmental impacts of absorption of residuals
(4) Evaluation of changes in environmental indicators
Evaluation through utility functions, environment as public good, or damage functions.
Products are also evaluated either through utility functions or benefit functions.
Four types of relations that need specification:
i)
Production of man-made goods
ii)
Generation of pollutants and interference economic activity and the environment
iii)
production of environmental services
2
iv)
Evaluation of man-made and environmental goods
Range of models from very aggregate pedagogical models to detailed micro models for
concrete economic instrument applications,
Different textbook and journal paper traditions, styles, getting familiar with different ways of
representing the four building blocks.
The micro economic building blocks:
Production theory, multiple output production
Public good/bad
Pareto efficiency
Consumer choice, social choice
Demand functions
Cost – benefit analysis
3. Catalogue of environmental economics models
(1) The aggregate pedagogical model
(2) The environment-resource model
(3) The general equilibrium model, Pareto efficiency
(4) The external effect model
(5) The microeconomic policy oriented model
(6) Purification possibilities as cost functions.
Most aggregate pedagogical model of benefit from pollution and costs of pollution:
B = b( z ), b ' > 0, b '' < 0
D = d ( z ), d ' > 0, d '' > 0
(1)
Benefit-function based on aggregating block (i) and (ii),
damage function based on aggregating block (ii) and (iv)
This is the Bachelor course model.
Social choice: how to choose P, no other restrictions explicitly shown
Social choice criterion: Maximisation of net benefits on the aggregate level:
Maxz B  D  b( z )  d ( z )
(2)
3
Necessary first order condition:
b '( z )  d '( z )  0
(3)
The fundamental pedagogical marginal rule:
Optimal pollution where marginal benefit from pollution equals marginal damage of
pollution.
Second order sufficient condition:
b ''( z )  d ''( z )  0
Towards policy instruments:
What is behind benefit of pollution?
What is behind damage of pollution?
Must disaggregate to formulate prescriptions for policy instruments.
(4)
4
5
4. Multiple output production theory
Pollution is generically a problem with joint outputs in economic activities of production and
consumption. The first law of thermodynamics tells us that matter cannot disappear. If we
weigh the inputs into an activity, including non-paid factors like oxygen from the air, and
weigh the products that are the conscious purpose of activities, the difference is the residuals
that may turn out to be polluting the natural environment. Thus, the general feature of
residuals is that they arise from use of inputs in a wide sense. Ayres and Kneese (1969)
coined the phrase materials balance to underline the inevitability of residuals generation
when employing material resources.
Although multiple outputs is the rule rather than exception at the micro level of production,
economists usually specify single output only. This may be interpreted as a reflection of
economics being concerned about principles of resource allocation, revealing economic
mechanisms and devising policy instruments, etc. Operating with a representative firm and an
output aggregate at the micro level will usually suffice. But as pointed out above the latter is
a difficult position to maintain when dealing with pollution. Therefore, some form of multiple
outputs involving «ordinary» or intended outputs, and unintended residuals or pollutants, or
generically «bads», have been used at least indirectly in the old externalities literature, and
explicitly in the more recent environmental economics literature (see Mishan (1971) for a
review of the externalities literature, and Fisher and Peterson (1976), Cropper and Oates
(1992) for reviews of the literature covering the 70-ies and 80-ies decades). However, the
choice in the literature of specifications of relationships between ordinary outputs and bads
vary and is often not based on any explicit consideration of the most suitable model to pick
from the field of multiple output production function theory. Since policy conclusions that
can be drawn on results from environmental economics are basically concerned with choice
among instruments for control of externalities, a firm grasp on the modelling of the multioutput nature is essential.
At the micro level of a firm multiple outputs are the rule rather than the exception. The
preoccupation with single output production in textbooks may be due to the technical
6
complexities involved, or that economic issues often can be dealt with aggregating outputs to
a single output index. When we want to model multiple outputs we should be aware of some
main forms of multiple outputs (see e.g. Frisch (1965), Chapter 1d. for a brief introduction).
Inputs may be employed alternatively to produce different outputs, e.g. a piece of agricultural
land may be used to produce potatoes or wheat, a wood cutting tool may be used to produce
different types of furniture. There is freedom of choice in what outputs to produce. At the
other end of the scale we may have multiple outputs due to jointness in production; sheep
yield mutton as well as wool, cattle yield beef and hide, we get both wheat and straw, and
coal can be converted to coke and gas, to use classical examples from Edgeworth and
Marshall. As an extreme form of jointness we have that outputs are produced in fixed
proportions, as the distillates of crude oil in a refinery. We will regard a firm as the unit, and
not discuss issues concerning internal organisation such as parallel production of
commodities or process chains of intermediate products, etc.