Lecture 2: Key Concepts in
Environmental Economics
• Demand (benefits) and supply (costs)
• Economic efficiency and markets
• Economics and environmental quality
• Assignment #1
10/3/01
IST Lecture 2 : F. Menz
Overview
Economically efficient management of ecosystems
(maximization of social welfare – not minimal energy
use or environmental impact – as the basis for
making resource allocation choices)
Difficulties include valuing complex, adaptive natural
systems; pervasive externalities (negative and
positive); and uncertainty.
Intergenerational and intragenerational equity issues
must also be considered.
For example, how are alternative uses of land used
to produce olives valued? Tropical forest ecosystems?
Mangrove swamp ecosystems?
10/3/01
IST Lecture 2 : F. Menz
Demand and benefits
Demand, benefits, and willingness to
pay
Total WTP and marginal WTP
Consumer surplus: a measure of net
economic welfare for consumers
Individual and aggregate (market)
demand
Measuring economic benefits
10/3/01
IST Lecture 2 : F. Menz
Benefits of an economic activity
Consumer surplus equals total benefits (the area under the
demand curve from the origin to the last unit purchased) less
the total amount paid (the area of the rectangle) at each price.
CS is a measure of net economic welfare for consumers,
derived from individual or aggregate demand curves for a
commodity. If price is $5, consumer surplus is maximized at a
quantity of 20, and is ($130 – 100) = $30.
Price
Consumer surplus at p = $5
$8
$5
$2.50
MB = Demand
0
10/3/01
20
35
50
IST Lecture 2 : F. Menz
Quantity/time period
Costs and supply
Supply and willingness to incur costs
Total vs. marginal costs
Producer surplus, a measure of net
economic welfare for producers
Individual and aggregate (market)
supply
Measuring economic costs
10/3/01
IST Lecture 2 : F. Menz
Net benefits of an economic activity
Net economic benefit (welfare) is the excess of benefits over
costs at a given level of output, equal to the portion of the area
under the demand curve that lies above the supply curve.
At a price of $5, total net benefits to consumers and producers are
maximized at q = 20. Note that total net benefits are maximized
where marginal benefits and marginal costs are equal.
MC = S
Price $8
$5
Net
Benefit
MB = D
$1
20
10/3/01
IST Lecture 2 : F. Menz
Quantity/time period
Static and dynamic efficiency
static efficiency – a resource allocation is
efficient if the net benefit from the use of
resources is maximized by that allocation.
dynamic efficiency – a resource allocation
across n periods is efficient if it maximizes the
present value of net benefits resulting from
the use of resources of the n periods.
10/3/01
IST Lecture 2 : F. Menz
Equimarginal principle
Total costs will be minimized when
total output is allocated among
producing units in amounts such that
marginal costs are equalized among the
production sources.
This principle applies for producing any
type of good or service, including
pollution abatement.
10/3/01
IST Lecture 2 : F. Menz
Economic efficiency and
markets
Social efficiency vs. private effficiency
Markets and social efficiency
External costs
External benefits and public goods
External costs and benefits as the basis
for corrective public policies
10/3/01
IST Lecture 2 : F. Menz
Social vs. private efficiency
Economic efficiency: total net benefits
are maximized (MB=MC).
Private markets may not automatically
yield socially efficient outcomes.
With external costs, private output will
exceed socially efficient output.
With external benefits, private output
will be less than socially efficient
output.
10/3/01
IST Lecture 2 : F. Menz
Points worth noting
Open-access resources (common
property) as a source of external costs
Air, water, and other environmental
resources as open-access resources
External benefits result from private
pollution control activities.
Public goods as examples of large-scale
external benefits (EQ improvements?)
10/3/01
IST Lecture 2 : F. Menz
Economics of pollution control (or
environmental quality)
The efficient level of an activity that generates
external costs is where MSC=MSB.
The efficient level of pollution abatement is where
marginal benefits of abatement equal marginal costs
of abatement.
The economically efficient level of pollution is where
marginal damages of pollution equal the marginal
abatement costs.
Reducing pollution damages, achieving higher
environmental quality levels, and reducing output of
polluting activities are equivalent ways of analyzing
the problem of pollution.
10/3/01
IST Lecture 2 : F. Menz
Economic efficiency in pollution control
Net economic benefits (welfare) from pollution control are
maximized when marginal benefits of more abatement are equal to
the marginal costs of more abatement. Note that the optimal level
of abatement depends on the positions of the MB and MC curves,
which depend on the type of pollutant, control options, etc.
MB, MC
($)
a
MC of abatement
b
Net
Benefits of
Abatement
d
0
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MB of abatement
(reduced damages)
q
IST Lecture 2 : F. Menz
Quantity of pollution
abatement
The efficient level of emissions
The efficient level of emissions is the amount where the sum of
damages plus abatement costs (total pollution costs) is minimized.
This is the amount where MD = MC. The efficient level of emissions
depends on the positions of the marginal damage (MD) and
marginal abatement cost (MC) curves, which depend on the type of
pollutant, control options, etc.
MD, MC
($)
Marginal damages (MD)
d
a
b
c
Total
pollution
costs
Marginal abatement
costs (MC)
0
v
x
q
z
w
Total emissions/time period
10/3/01
IST Lecture 2 : F. Menz
Efficient emissions (continued)
The efficient level will change with changes
in marginal damages and abatement costs.
Enforcement costs will increase abatement
costs and the efficient level of emissions.
The MC curve reflects minimum abatement
costs, which requires marginal abatement
costs among sources to be equalized.
Static efficiency, dynamic effficiency, and
sustainable development
10/3/01
IST Lecture 2 : F. Menz