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FACULTY OF SCIENCE TECHNOLOGY AND
ENVIRONMENTAL STUDIES
DEPARTMENT OF ENVIRONMENTAL STUDIES
OEV 210 ENVIRONMENTAL ECONOMICS
Extended Course Outline
BY
NGARUKO D.D.P (PhD)
Centre for Economics and Community Economic Development
The Open University of Tanzania
2009
i
TABLE OF CONTENTS
TABLE OF CONTENTS ............................................................................................................ i
ABSTRACT ............................................................................................................................ vii
COURSE DESCRIPTION ...................................................................................................... viii
LECTURE ONE ........................................................................................................................ 1
INTRODUCTION TO ENVIRONMENTAL ECONOMICS...................................................... 1
1.1. What is Environmental Economics?.............................................................................. 1
1.2 Why do we use economics in environmental policy? ........................................................ 1
1.3 Why Study Environmental Economics? ......................................................................... 2
1.4 Key questions for environmental economics .................................................................. 2
1.5 Introduction to the theory of economics ............................................................................ 3
1.5.1 Definition of Economics ............................................................................................ 3
1.5.2 Microeconomics and Macroeconomics ...................................................................... 3
1.5.3 The Problem of Scarcity and Choice .......................................................................... 4
1.5.4 Choice and Opportunity Cost ..................................................................................... 5
1.5.5 Functions of Economic Systems................................................................................. 5
LECTURE TWO........................................................................................................................ 8
THE THEORY OF DEMAND................................................................................................... 8
2.1 Introduction ...................................................................................................................... 8
2.2 Demand Theory................................................................................................................ 8
2.2.1 Determinants of Quantity Demanded ......................................................................... 8
2.2.2 Demand Function....................................................................................................... 9
2.2.3 Demand Schedule ...................................................................................................... 9
2.2.4 Demand Curve......................................................................................................... 10
2.2.5 Market Demand ....................................................................................................... 10
2.3 Factors leading to the violation of the law of demand ..................................................... 12
2.4 Change in Quantity Demanded and Change in Demand ................................................. 12
2.5 Types of Demand ........................................................................................................... 13
LECTURE THREE .................................................................................................................. 15
THE THEORY OF SUPPLY AND EQUILIBRIUM PRICE.................................................... 15
3.1 Introduction .................................................................................................................... 15
3.2 Determinants of Quantity Supplied ................................................................................. 15
3.3 Supply Function ............................................................................................................. 16
3.4 Market Supply ................................................................................................................ 16
3.4.1 Supply Schedule ...................................................................................................... 17
3.4.2 Supply Curve ........................................................................................................... 17
3.4.3 Changes in Quantity Supplied and Change in Supply ............................................... 18
3.5 Price Determination and Market Equilibrium................................................................. 18
3.6 Changes in equilibrium price .......................................................................................... 19
LECTURE FOUR .................................................................................................................... 21
ELASTICITY OF DEMAND AND SUPPLY .......................................................................... 21
4.1 Introductions .................................................................................................................. 21
4.2 Elasticity of Demand ...................................................................................................... 21
4.2.1 Price Elasticity of Demand (η)................................................................................. 21
4.2.2 How to Interpret Price Elasticity of Demand ............................................................ 22
ii
4.2.3 Determinants of Price Elasticity of Demand............................................................. 23
4.2.4 Income Elasticity of Demand (ηY ) ......................................................................... 24
2.2.5 Interpretation of Income Elasticity of Demand ......................................................... 24
4.2.6 Importance of Income elasticity of Demand ............................................................. 25
4.2.7 Cross Elasticity of Demand (ηC) ............................................................................. 25
4.2.8 Interpretation of Cross Elasticity of Demand............................................................ 26
4.3 Elasticity of Supply (ε) ................................................................................................... 26
4.3.1 Interpretation of Price Elasticity of Supply............................................................... 26
4.3.2 Determinants of Price Elasticity of Supply............................................................... 27
4.3.3 Point Elasticity and Arc Elasticity............................................................................ 28
LECTURE FIVE...................................................................................................................... 30
FUNDAMENTAL ECONOMIC CONCEPTS FOR ENVIRONMENTAL POLICY ANALYSIS
................................................................................................................................................. 30
5.1 Introduction ................................................................................................................. 30
5.2 Marginal analysis ........................................................................................................... 30
5.3 Sunk costs ..................................................................................................................... 31
5.4 Opportunity costs ........................................................................................................... 31
5.5 Scarcity: The Key Problem in Economics ....................................................................... 31
5.6 Positive Economics Vs Normative Economics................................................................ 31
5.7 Models of Scarcity: The Key Problem in Economics ................................................... 32
5.7.1 Malthus Model: because land is fixed, scarcity is inevitable..................................... 32
5.7.2 IPAT : Devised by biologist Paul Ehrlich in 1971 .................................................... 32
5.7.3 Doomsday Models: computer models that predicted severe shortages of resources .. 32
5.7.4 Lomborg Model: pessimistic predictions get more attention than reality .................. 33
LECTURE SIX ........................................................................................................................ 34
MARKET STRUCTURES....................................................................................................... 34
6.1 Introduction .................................................................................................................... 34
6.2 Perfect competition......................................................................................................... 34
6.2.1 Advantages of Perfect Competition.......................................................................... 35
6.2.2 Disadvantages of Perfect Competition...................................................................... 35
6.3 Monopoly....................................................................................................................... 35
6.3.1 Factors leading to Monopoly.................................................................................... 36
6.3.2 Examples of Monopolies in Tanzania (as of 2004) ................................................... 36
6.3.3 Advantages of Monopoly ......................................................................................... 37
6.3.4 Disadvantages of Monopoly..................................................................................... 37
6.3.5 Measures to Control Monopoly................................................................................ 37
6.4 Price Discrimination under Monopoly ............................................................................ 38
6.4.1 Advantages of Price Discrimination ......................................................................... 38
6.5 Monopolistic competition ............................................................................................... 39
6.5.1 Advantages of Monopolistic Competition ................................................................ 39
6.5.2 Disadvantages of Monopolistic Competition ............................................................ 39
6.6 Oligopoly ....................................................................................................................... 39
6.6.1 Examples of Oligopolies in Tanzania:...................................................................... 40
LECTURE SEVEN .................................................................................................................. 41
MARKET FAILURES FOR ENVIRONMENTAL RESOURCES ........................................... 41
7.1 Introduction .................................................................................................................... 41
7.2 The Invisible Hand ...................................................................................................... 41
7.3 Categories (Causes) of market failures............................................................................ 42
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7.3.1 Common property resources are one category of market failure. .............................. 42
7.3.2 Externalities are another class of market failure ....................................................... 44
7.3.3 Public Commodities................................................................................................. 46
7.3.4 Excess Market power (monopoly and oligopoly)..................................................... 47
7.3.5 Lack of markets ....................................................................................................... 48
7.3.6 Distortions in capital markets................................................................................... 49
7.3.7 Imperfect Information ............................................................................................ 49
LECTURE EIGHT................................................................................................................... 51
VALUING ENVIRONMENTAL BENEFITS.......................................................................... 51
8.1 Introduction .................................................................................................................... 51
8.2 Concepts of the value of a life......................................................................................... 51
8.3 Revealed Preference Approaches (RPA) ..................................................................... 52
8.3.1 Aversion Costs....................................................................................................... 53
8.3.2 Travel Cost Method .............................................................................................. 53
8.3.3 Hedonic Pricing Techniques .................................................................................... 54
8.4 Stated Preference Approaches (SPA): Contingent Valuation........................................... 54
LECTURE NINE ..................................................................................................................... 56
COST-BENEFIT ANALYSIS OF ENVIRONMENTAL POLICY........................................... 56
9.1 Introduction to Cost-Benefit Analysis (CBA)............................................................... 56
9.2
Steps to cost-benefit analysis .................................................................................... 56
9.3 Dealing with Uncertainty................................................................................................ 56
9.4 Discounting methods ...................................................................................................... 59
9.4.1 Discount rate, r ........................................................................................................ 59
9.4.2 Social discount rate.................................................................................................. 60
9.5 Concepts of Cost.......................................................................................................... 61
9.5.1 Important concerns on how costs will be conceptualized.......................................... 61
9.5.2 Broad categories of costs ......................................................................................... 61
9.5.3 Estimating Costs ...................................................................................................... 62
9.5.4 How Accurate are Cost Estimates?........................................................................... 63
LECTURE TEN....................................................................................................................... 65
NATIONAL INCOME............................................................................................................. 65
10.1 Introduction .................................................................................................................. 65
10.2 National Income Accounting ........................................................................................ 65
10.3 Uses of National Income accounts ................................................................................ 65
10.4 Measurement of national Product.................................................................................. 66
10.5 Expenditure Approach to GNP ..................................................................................... 67
10.6 Income Approach to GNP............................................................................................. 68
10.7 Other Social Accounts .................................................................................................. 69
10.8 GNP, Expenditure and National Income ....................................................................... 69
LECTURE ELEVEN ............................................................................................................... 73
ECONOMIC GROWTH AND THE ENVIRONMENT ........................................................... 73
11.1 Introduction ............................................................................................................... 73
11.2 The fundamental issues of environment in GDP............................................................ 73
11.3 How Does the Environment Affect the Economy ....................................................... 74
11.4 Income and the Environment: Case study of the environment in East Asia.................... 75
11.4.1 History of Japan’s environmental policy ................................................................ 75
11.4.2 History of environmental policy in South Korea..................................................... 76
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11.4.3 History of environmental policy in China............................................................... 76
11.4.4 Convergence of environmental policy .................................................................... 76
11.4.5 Differences ............................................................................................................ 76
11.5 The Environmental Kuznets Curve (EKC) .................................................................... 77
11.5.1 Theoretical requirements for EKC.......................................................................... 78
11.5.2 Implications of the EKC......................................................................................... 79
LECTURE TWELVE .............................................................................................................. 80
THE ENVIRONMENT IN DEVELOPING COUNTRIES ....................................................... 80
12.1 Introduction .................................................................................................................. 80
12.2 Causes of environmental problems in developing countries .......................................... 81
12.3 Access to clean water in LDCs...................................................................................... 81
12.4 Air pollution in LDCs ................................................................................................... 82
12.5 Timber and deforestation in LDCs ................................................................................ 82
12.5.1 Reasons why deforestation is a problem................................................................. 83
12.6 Resource management .................................................................................................. 84
12.7 Agriculture in LDCs ..................................................................................................... 84
12.7.1 Costs of increased agricultural productivity............................................................ 85
12.7.2 Can biotechnology be a solution?........................................................................... 85
LECTURE THIRTEEN ........................................................................................................... 87
SUSTAINABLE DEVELOPMENT ......................................................................................... 87
13.1 Introduction .................................................................................................................. 87
13.2 Definition of environmentally sustainable development .............................................. 87
13.3 Neoclassical vs. ecological economics .......................................................................... 88
13.4 How to Incorporate the Environment in Economic Analysis ...................................... 89
13.5 How should Green GDP be measured? ......................................................................... 90
13.5.1 Principles to measuring green GDP........................................................................ 90
13.6 Will Sustainable Development Occur in Market Economies?..................................... 91
13.7 Audits for resource-rich countries ................................................................................. 93
LECTURE FOURTEEN .......................................................................................................... 94
INTERNATIONAL TRADE, TRADE AGGREEMENTS AND THE ENVIRONMENT ........ 94
14.1 Introduction .................................................................................................................. 94
14.2 Critical Reasons for International Trade........................................................................ 94
14.3 Theories explaining basis for international trade ........................................................... 96
14.3.1 Mercantilism......................................................................................................... 96
14.3.2 Absolute Advantage Principle ................................................................................ 96
14.3.3 The Law of Comparative Advantage...................................................................... 97
14.4 Criticisms of the Law of Comparative Advantage ......................................................... 98
14.5 Pollution Haven Hypothesis.......................................................................................... 99
14.6 International Agreements: GATT.................................................................................102
14.7 Climate Change and International Agreements ............................................................103
14.8 Lessons for design of global agreement .......................................................................104
14.9 The Montreal Protocol .................................................................................................104
LECTURE FIFTEEN ..............................................................................................................106
EXHAUSTIBLE RESOURCES..............................................................................................106
15.1 Introduction .................................................................................................................106
15.2 Quantification of exhaustible reserve resources............................................................106
15.3 Principles for understanding exhaustible resource problems.........................................107
v
15.3.1 Arbitrage Principle................................................................................................107
15.3.2 Exhaustion principle .............................................................................................107
15.4 Government taxation on exhaustible resources.............................................................109
15.5 Exploration and extraction rights .................................................................................110
15.6 Prices of exhaustible resources over time.....................................................................110
15.7 Optimal Extraction of an Exhaustible Resource .........................................................111
15.8 The Costs of Extraction ...............................................................................................111
15.9 Marginal user cost (MUC) ...........................................................................................112
15.10 Changes in the marginal extraction cost .....................................................................113
vi
ABSTRACT
This study material covers syllabus for the course OEV 210, Environmental Economics, for the
second year students pursuing BSc. in Environmental Sciences programme offered at the Open
University of Tanzania. The study material is written to introduce students to the basic elements
of environmental economics. The course is all about the contribution of that economics can make
to our understanding of environmental problems in the 21st century. Students should note that
almost all standard textbooks of environmental economics are tailored towards economics
students studying environmental economics course. The books assume that students reading must
have had prior knowledge of economics. This study material is intended for students who do not
posses prior knowledge of economics although it could also be useful to undergraduate
economics students taking environmental economics course as an optional course. As such there
is very little theorization and formal conceptualization of economic concepts, and where
necessary, the concepts are presented in a style easy to grasp by the students.
This study material is divided into fifteen lectures. Lecture one covers the introduction to
environmental economics. Chapter two to chapter four covers theories of demand, supply and
elasticity which in many cases are referred to as price theory. Lecture five introduces some
fundamental concepts of economics relevant for environmental policy analysis. The theory of
market structures and market failures in relation to utilization of environmental resources are
covered in lectures six and seven respectively. The concepts of valuation of environmental
aspects and cost benefit analysis of environmental policy are presented in respectively, chapters
eight and nine. Chapter ten covers the concepts of national income from the environmental
economics point of view. Economic growth and its relationship with the environment are
explained in chapter eleven whereas in chapter twelve the environment is viewed from the
developing countries point of view. International trade and trade agreements with impact on the
global environment are covered in chapter fourteen and the lastly, chapter fifteen covers all about
theories governing exhaustible/depletable resources from the economics perspective. Where
possible review questions and activities are posed at the end of each lecture or in between
lectures. Again, the questions vary greatly in extent but they have been prepared to grasp the
intended lecture objectives. Students should ensure that they try all the questions as they help to
find out what a student understands from what he/she doesn’t.
The list of reference materials and suggested sections of the particular references is also provided
for students to only concentrate on the intended learning outcomes. However students are
advised to read extensively to widen up their understanding of the course. Internet is one of the
main sources of the contents included in this study material. Thus some examples may need
recasting to suit our local situations. if students find some sections in the book are containing
insufficient coverage for the intended learning outcomes, they are advised to refer to the
recommended textbooks and also search on the internet for additional notes. A few web links
have been indicated but there many more.
vii
COURSE DESCRIPTION
Course Weight:
Pre-Requisite:
2 Units
NONE
Course Rationale
Management of natural resources relies on an understanding of how markets work but also how
they fail. In this course students will be introduced to key economic theories and concepts such
as the law of demand & supply, market competition and economic efficiency, and the market
failure paradigm. The students will also be introduced to approaches and techniques used to
analyse environmental aspects such as environmental policy and decision making, environmental
and sustainable development as well as such aspects as cost-benefit analysis, cost-effectiveness
analysis and multi-criteria analysis.
Learning Outcomes
After completion of the course, students are expected to explain:
• The fundamentals of economic theory with reference to the use and management
environmental aspects
• Economic techniques that can be applied to support business and policy decisions about the
conservation and management of the environment ,
• Internal and external costs, market approaches to environmental resource management and
cost-benefit analysis.
• Sustainable economic growth and development and implications on environmental resources
at national and global levels
Mode of Assessment
Timed test
Final examination
30%
70%
KEY REFERENCE BOOKS, READING MATERIALS AND INTERNET SOURCES
Lecture Title
Lecture One: Introduction Environmental
Economics
Lecture Two: The Theory of Demand
Lecture Three: The Theory of Supply
Lecture Four: Elasticity of Demand and Supply
Lecture Five: Fundamental Economic Concepts
for Environmental Policy Analysis
Lecture Six: Market Structures
Lecture Seven: Market Failures for
Environmental Resources
Lecture Eight: Valuing Environmental Benefits
Recommended Textbooks and other reference materials
1. Tietenberg Tom (1998) Chapters 1 & 12
2. David Pearce and Turner Kerry (1990) Chapter 1
3. Perman Roger, Mar Yue et al (1999) Chapter 1
4. Burningham David and Davies John (2004) Chapters 1&2
5. Internet sources
1. Samuelson P.A. and Nordhaus (1992)
2. Any introduction to economics textbook
1. Samuelson P.A. and Nordhaus (1992)
2. Any introduction to economics textbook
1. Samuelson P.A. and Nordhaus (1992)
2. Any introduction to economics textbook
1. Samuelson P.A. and Nordhaus (1992)
2. Any introduction to economics textbook
3. Tietenberg Tom (1998) Various Chapter sections
4. Internet sources
1. Samuelson P.A. and Nordhaus (1992)
2. Any introduction to economics textbook
3. Internet sources
1. Perman Roger, Mar Yue et al (1999) Chapter 6
2. Burningham David and Davies John (2004) Chapters 3
3. Internet sources
1. Tietenberg Tom (1998) Capter 4
2. Perman Roger, Mar Yue et al (1999) Chapters 14 & 15
3. Burningham David and Davies John (2004) Chapters5
4. Internet sources
viii
Lecture Nine: Cost-Benefit Analysis of
Environmental Policy
Lecture Ten: National Income
Lecture Eleven: Economic Growth and the
Environment
Lecture Twelve: The Environment in
Developing Countries
Lecture Thirteen: Sustainable Development
Lecture Fourteen: Free Trade, Trade
Agreements and the Environment
Lecture Fifteen: Exhaustible Resources
1. Tietenberg Tom (1998) Capter 4
2. Perman Roger, Mar Yue et al (1999) Chapter 14
3. Burningham David and Davies John (2004) Chapter 6
4. Internet sources
1. Samuelson P.A. and Nordhaus (1992)
2. Any introduction to economics textbook
2. David Pearce and Turner Kerry (1990) Chapter 2
3. Burningham David and Davies John (2004) Chapters 1&2
4. Internet sources
1. Tietenberg Tom (1998) Chapter 19
2. David Pearce and Turner Kerry (1990) Chapters 3 & 20
3. Perman Roger, Mar Yue et al (1999) Chapters 2 & 16
4. Burningham David and Davies John (2004) Chapters 4, 7 &8
5. Internet sources
1. Tietenberg Tom (1998) Chapters 8-10, & 19-21
2. David Pearce and Turner Kerry (1990) Chapters 20 & 22
3. Perman Roger, Mar Yue et al (1999) Chapters 2 & 10
4. Burningham David and Davies John (2004) Chapters 4, 7, 8 & 9
5. Internet sources
1. Tietenberg Tom (1998) Chapters 19 & 20
2. David Pearce and Turner Kerry (1990) Chapters 3, 20 & 22
3. Perman Roger, Mar Yue et al (1999) Chapters 2 & 4
4. Burningham David and Davies John (2004) Chapters 4, 7, 8 &9
5. Internet sources
1. Tietenberg Tom (1998) Chapters 19 & 20
2. David Pearce and Turner Kerry (1990) Chapters 3, 20 & 22
3. Perman Roger, Mar Yue et al (1999) Chapter 13
4. Burningham David and Davies John (2004) Chapters 4, 7, 8 &9
5. Internet sources
1. Tietenberg Tom (1998) Chapters 7
2. David Pearce and Turner Kerry (1990) Chapters 16-19
3. Perman Roger, Mar Yue et al (1999) Chapters 8 & 9
4. Internet sources
LIST OF RECOMMENDED REFERENCES
1. Burningham David and Davies John (2004) Studies in Economics and Business:
Environmental Economics. 3rd Ed Heinemann UK
2. David Pearce and Turner Kerry (1990) Economics of Natural Resources and the
Environment. The John Hopkins University Press, GB
3. Perman Roger, Mar Yue et al (1999) Natural Resource and Environmental Economics. 2nd
Ed Prentice Hall England
4. Samuelson P.A. and Nordhaus (1992) Economics. McGraw Hill
5. Tietenberg Tom (1998) Environmental Economics and Policy. 2nd Ed Addison-Wesley
Educational Publishers Inc.England
6. Example of internet sources
http://classes.maxwell.syr.edu/ppa777/envilect.html
www.varsitynotes.com/economics/environment_economics.html
www.colorado.edu/Economics/money/4545/4545lnts.html
ix
LECTURE ONE
INTRODUCTION TO ENVIRONMENTAL ECONOMICS
1.1.
What is Environmental Economics?
Economics is the study of the allocation of scarce resources. Note that the theories of economics
can be applied to any scarce resource, not just traditional commodities. Economics is not simply
about profits or money. It applies anywhere constraints are faced, so that choices must be made.
Environmental and natural resource economics is the application of the principles of economics
to the study of how environmental and natural resources are developed and managed. Natural
resources refer to resources provided by nature that can be divided into increasingly smaller units
and allocated at the margin. Environmental resources are all those resources provided by nature
that are indivisible. Natural resources serve as inputs to the economic system. Environmental
resources are affected by the system (e.g. pollution).
At the end of this lecture you are expected to be able to:
1. Define and explain justification for studying environmental economics
2. Define economics and explain its importance
3. Differentiate between microeconomics and macroeconomics
4. Explain the problem of scarce resources and opportunity cost
5. Explain the basic functions of any economic system
1.2 Why do we use economics in environmental policy?
The main reason is that in our society the environment has become a scarce resource. Since
economics is about how to tackle scarce resources, it can often be useful when dealing with
environmental problems.
One way of using economics is to ensure that the costs and the benefits of environmental
measures are well balanced. Although it is difficult to estimate costs and benefits, there is an
increasing demand that this is done before new environmental policy is decided on a European
level. With the use of market-based instruments, environmental goals can sometimes be reached
more efficiently than with traditional command and control regulations.
Economic and environmental objectives are often perceived as being contradictory. It is believed
that a choice must be made between one and the other and that both cannot be achieved
concurrently.
1
1.3
Why Study Environmental Economics?
In general, prices reflect the relative scarcity of goods. However, in environmental economics,
markets, and thus prices, often do not exist. The following aspects of environmental and natural
resource economics make it unique:
•
Market failures - When market failures exist, government intervention may be
appropriate.
•
Dynamics - The decision to consume a good today typically does not affect the ability to
consume it tomorrow. However, the decision to use natural resources today does affect
what will be available tomorrow.
•
Irreversibility - Damage to natural resources has long-term effects. This is not as large a
problem for normal consumer goods.
Thus an interdisciplinary understanding of the environment, political science, etc. is necessary to
be a good environmental economist.
1.4
Key questions for environmental economics
a)
Market failure - Typically, externalities are a problem hence need for various appropriate
types of remedies. For example, imperfect competition leads to regulated utilities.
b)
Difficult to forge best type of intervention- The problem in environmental economics is
often that there is no market for environmental resources. Thus, one option is to create a
market. However, economists realize that this is not always the best solution.
c)
How to evaluate environmental programs is critical - Ideally, we need to know what level
of environmental protection is desired. Economists focus on decisions at the margin:
equating marginal costs and marginal benefits. The choice is not between clean air and
dirty air, but rather between levels of pollution. Note that this requires placing a value on
environmental protection. However, this valuation is complicated by the lack of market
prices for environmental goods.
d)
Efficiency versus equity - We need to remember that even when an efficient solution
occurs, it might not be desirable. The fundamental theorem of welfare economics says
nothing about the distribution of resources in an efficient solution. Equity issues are also
important. Policymakers need to consider how various groups will be impacted. This can
be complicated in environmental economics. For example, how should the welfare of
future generations be weighed when making global warming policy?
2
1.5 Introduction to the theory of economics
In this lecture, students are introduced to aspects that make economics one of the most distinctive
and interesting social science fields of study. The functions of economic systems as well as
importance of economics are also highlighted.
1.5.1 Definition of Economics
Economics is a social science which deals with the study of how people allocate their
limited/scarce resources to satisfy endless human wants. There are basically three key points for
us to note in this definition:
(a) Economics is a social science concerned with human behaviour.
(b) It deals with allocation of scarce resources which include land, labour, capital and
management/entrepreneurship.
(c) It is concerned with satisfaction on human wants which are endless, and this involves the
problem of choice among alternatives.
Since resources are scarce in relation to their demand, the study of economics has become a major
discipline over the past three centuries. The question of how resources should be allocated for
production of different products and different time and between private and public uses are some
basic economic problems which give rise to the study of economics. Economics as a science has
many branches. Some of the branches are classified as “Economic Theories” whereas others are
referred to as “Applied Economics”. In general Economic Theories can be grouped into
microeconomics and macroeconomics, whereas Applied Economics comprises environmental
economics, industrial economics, development economics, agricultural economics, health
economics, etc.
1.5.2 Microeconomics and Macroeconomics
It is appropriate at this point to distinguish between microeconomics and macroeconomics.
Microeconomics is derived from a Greek word “Mikros” meaning “small”. Thus microeconomics is
concerned with economics of small units such as individual farmers, individual households,
individual households, food processors, individual commercial bank etc. The process of price
determination and the process of profit maximisation by individual farmers is part of the study of
microeconomics. Macroeconomics, on the other hand, deals with the study of economic aggregates.
The word macroeconomics comes from the Greek word “Makros” which means “large”. Therefore
macroeconomics focuses on the national or the aggregate economy. It covers national income and
employment, general price level, international trade theory, government budgets, public finance etc.
3
Note that despite the contrast between microeconomics and macroeconomics,
there is no conflict between the two branches of economic theory. This is so
because the economy of the aggregate is nothing, but a summation of individual
units that make the aggregate economy. Microeconomics deals with allocation
of resources among individual economic units such as farmers, food processors,
and household members or consumers whereas Macroeconomics focuses on
broad aspects of the aggregate economy such as Gross Domestic Product
(GDP), money and banking, inflation, balance of payments and policy issues.
1.5.3 The Problem of Scarcity and Choice
The problem of scarcity and choice is fundamental to the study of economics. Resources which
are also known as the factors of production or inputs are usually needed for the production of
goods and services to satisfy human wants or ends. These include natural resources such as land,
minerals, forest wildlife, etc; human resources such as labour, capital and management or
entrepreneurship.
Most resources are limited in supply, and usually they are scarce, because their demand per unit
time far outstrips supply. Any good that is scarce is called an “economic good”. Since most
resources are scarce, it means they can also meet a small fraction of people’s demand for these
resources. If resources are abundant and can meet all people’s demand, there is no problem
hence no need to study economics. However most resources are scarce because they are limited
in supply in relation to their demand. The problem of scarcity, therefore, arises because of
inadequate resource to produce goods and services for all human wants.
Given the above situation, we have to make a choice as to what needs are to be met, what goods
and services are to be produced; and what goods should not be produced; whose wants are to be
satisfied, and whose wants should not be satisfied. Since resources are limited, they must be
managed rationally among many competing uses for which they are required. The question of
optimum resource allocation is, therefore, a major problem that must be addressed by various
economic units such as households, producers, government and the entire nation.
All societies face this problem of resource scarcity and choice. In general we can however say
that resource allocation within any society depends on the type of the economic system in
existence. For instance in a market economy like that of USA and Japan, the price mechanism
4
plays a major role in rationing goods and services. Price helps in determining what goods and
services to produce and in what quantities. In a centrally planned economy like that of the former
Soviet Union (USSR), the central government plays a major role in rationing goods and services
among the various units in the society. Under a mixed economic system like Tanzania and most
Sub Saharan economies, both price and government play major roles in resource allocation.
1.5.4 Choice and Opportunity Cost
The economic term for expressing costs in terms of foregone alternative is the “opportunity
cost”. For example, if a newly recruited company’s economist earns a monthly salary of TShs 5
million, and he is interested in buying a car, a music system and a house plot from his month’s
salary. Given his limited monthly income, he cannot satisfy all his wants and, therefore, has to
decide which want has to be satisfied and which to be postponed. In order to decide on which
choice, he has to arrange his wants in order of importance i.e. according to his “scale of
preference” from the most important going down to the least important one. Let us assume that
the scale according to his preference is house plot, car, music system etc.
From the above ranking, he is likely to choose to buy a house plot and forego the car and the
music system. Thus, if he decides to buy the house plot, the opportunity cost of the house plot is
the car, which is the next best choice he decides not to buy. The sacrificing or foregoing of one
choice in order to attain another is called “principle of opportunity cost”. Therefore the
opportunity cost concept in economics can be defined as the cost of foregone best alternative in
the process of decision-making. It should be noted that opportunity cost arises in a decision
making process and it is due to the fact that resources are limited and human wants are endless
and therefore, a choice has to be made among competing wants. The concept of opportunity
costs related not only to individuals, farmers and industrialists, but also to businesses,
governments as well as other agencies involved in decision-making.
1.5.5 Functions of Economic Systems
There are basically three types of economic systems; the open market economic systems,
centrally planned economic systems, and the mix of the two i.e. mixed economic systems. In
every economic system there are three basic functions which are to be performed i.e. production,
distribution, and present and future consumption. Let us look at each one.
5
(a) Production
The production, in any economic system, centres on three basic principles, i.e.
•
What goods and services to produce
•
How to produce these goods and services
•
For whom to produce
The question of what to produce is determined by the resources which the society has. There are
many alternative commodities that a producer can produce but since resources are always limited,
producer must choose among alternative commodities. Decision has to base on the expected
income from the products and on the available resource. For instance, a producer may decide to
choose production of cash crops instead of milk production depending on their relative profitability.
Just as there are many possible products to produce, there are many ways of producing them.
The question of how to produce is purely a technical and technological one. It concerns the way
the resources (or factors of production) can be combined to yield maximum output at least cost
of production. So choice of products is not independent of the choice of production method since
a cost of production is influenced by production method.
The question of “for whom to produce” is dependent on tastes and preference of individuals in
the society. Such tastes and preferences dictate the type of goods and services to produce.
However, these tastes and preferences must be backed up by the individual income or the
purchasing power of the consumers.
(b) Distribution
The problem of distributing goods and services among members of the society depends on the
political economic philosophy of the respective government. For instance, a socialist government
aims at equitable distribution of wealth while capitalist government may not pursue this function.
Thus, whether a nation’s wealth is distributed evenly or concentrated in few hands, is determined
by the political economic philosophy of the government.
(c) Present and future consumption
Determining the present and future consumption and saving is another function which most
economies have to perform. Since savings increase a nation’s investment, and this determines the
growth rate of the nation’s economy, this is a major function performed in any society. However,
the decision about how much to consume and how much to save depends on the political
6
economic philosophy of the respective government. For example under a free market economic
system, this depends on market forces, whereas in centrally planned economic system, the
government usually makes the decision.
?
REVIEW QUESTIONS
1.
Giving examples, write short notes on the following concepts as used in
Economics: Scarcity and choice. Opportunity cost, Economic goods, and
Public goods
2.
Discuss the main functions of an economic system.
7
LECTURE TWO
THE THEORY OF DEMAND
2.1 Introduction
This lecture introduces students to the basic principles of demand theory. It is through the study of
this theory that markets can be studied, understood and market prices estimated. The understanding
of this lecture is a pre-requisite for the mastery of the other lectures in this course.
By the end of this lecture, you should be able to:
1. Define and explain demand and its determinants
2. Explain the law of demand and its application in economics.
3. Derive demand schedule and demand curves
4. Explain factors leading to the violation of the law of demand
5. Distinguish between change in demand and changes in quantity demanded
2.2 Demand Theory
Demand is the desire backed by the ability and willingness to have the commodity desired. The
actual buying of commodities is called Effective Demand. Quantity demanded refers to the amount
of commodity which buyers are willing and are able to purchase in the market at various prices per
given period of time. Quantity actually demanded implies that a commodity is available in the
market.
2.2.1 Determinants of Quantity Demanded
(a) Price of the Commodity - Consumers will buy more the commodity if its price falls
because of mainly two reasons. First, they leave substitutes and buy more of the cheaper
commodity and secondly, more consumers join the market to buy the cheaper commodity.
On the other hand, when prices rise, quantity demanded of the commodity falls.
(b) Prices of other Commodities - These may lower or raise the quantity demanded of a
commodity or leave it constant. There are mainly two types of other commodities. First,
the substitutes where two commodities may meet the same demand e.g. maize and
sorghum. Increase in the price of substitutes increases quantity demanded of the commodity
and vice-versa. Second, the complements where commodities are jointly demanded e.g.
bread and butter. Increase in price of complements decrease quantity demanded of a
commodity and vice-versa.
8
(c) Income - For normal goods, the rise in income is expected to lead to the increase in quantity
demanded of such commodities. For inferior goods, as consumer's income increases, the
quantity demanded of such commodities falls because consumers opt for those which are
more expensive and inferior good look too cheap for them. For necessities, quantity
demanded remains the same after certain level even if consumer’s income increases e.g. salt,
foodstuffs etc.
(d) Tastes and Preference - These depend on habit, age, sex, education, time, religion etc. The
quantity demanded may increase when the favourable to the commodity and vice-versa.
Tastes and preferences may be permanent or temporary. For example, the temporary
favourable taste is increase in meat consumption on Christmas.
(e) Sociological factors - These include education, marital status, age etc.
2.2.2 Demand Function
The technical relationship between quantity demanded and the determinants of the quantity
demanded of a given commodity is termed as Demand Function. This is summarised as follows;
given other factors constant:
QTY = f(P0, P1 ....... Pn-1, Y, T/P, E)
Where QTY = Quantity demanded of commodity Y, P0 = Price of commodity Y, P1...Pn-1 = Price
of other commodities, Y = Income, T/P = Taste and Preference and E = Sociological and other
factors.
2.2.3 Demand Schedule
It is the numerical representation of quantity demanded at various price levels of a given
commodity. Example:
Table 1 Potato's Demand Schedule
Price per kg (TShs)
Quantity demanded (Kg)
50
2
30
10
10
30
5
50
Individual household demand schedule differs from market demand schedule in that the earlier
shows the quantity demanded by one household only at various prices whereas the later shows the
total demand of a commodity by all households in the market of a commodity.
9
2.2.4 Demand Curve
It is the graphical representation of the demand schedule. It is drawn on the assumption that the
higher the price, the lower the quantity demanded, other things being constant.
Price
D
P1
P0
0
D
Q0 Q1
Fig. 2.1 Demand Curve
Quantity
Figure 2.1 shows that as price increases e.g. from P0 to P1 the quantity demanded decreases from
Q1 to Q0. As with demand schedule, the demand curves can be drawn for individual household
i.e. individual household Demand Curve as well as for all the households in the market of a
commodity i.e. Market Demand Curve. The demand curve slopes downwards from left to right.
This demonstrates the Law of Demand, which states that, “given other factors constant, the
higher the price, the lower the quantity demanded and vice-versa”.
2.2.5 Market Demand
This is referred to as the total demand of a commodity by all households in the market of that
particular commodity. Individual household demand differs from market demand in that the earlier
is the demand of a commodity by one household only. There are many factors affecting market
demand depending on the market conditions and availability of the commodity. However common
ones include price of the commodity, price of all other commodities, total household income,
income distribution among households i.e. high demand when income is equally distributed among
household but less demand if income is owned by few households, population size and composition,
tastes and preference, government policies etc.
Give a description of the shape of the market demand curve in relation to
that of an individual. Draw them to illustrate their shapes.
The existence of the Law of Demand is due to the following factors:
10
(a) The Law of Diminishing Marginal Utility - This law assumes that as one consumes more
of a certain commodity after a certain level, the satisfaction derived from additional units of
that commodity (Marginal Utility) reduces/diminishes. So as the consumer purchases more
a commodity, the marginal utility reduces. The consumer can continue doing so if only the
commodity is given free. It should be noted that the price of a commodity depends on its
Marginal Utility of the last unit consumed rather than total utility (total satisfaction).
(b) Income Changes - As the price rises, the real income of consumers decrease i.e consumers
can't purchase more units of the commodity with the same money income. The reverse is
also true. Real income measures the purchasing power of a household's money income
whereas money income is a measure of income in terms of money e.g. shillings, dollars,
pounds etc.
(c) Substitution Effect - If the prices of the substitute commodities remain constant, consumers
will purchase more of a commodity if its price falls and purchase less of the substitutes and
vice-versa.
(d) The Price Effect - When the price of a commodity falls consumers buy more of it because
of the income and substitution effects. When the price falls, even the poor can purchase the
commodity hence increasing demand.
(e) Different uses of certain commodities- When a price of a commodity whose uses are
many are high, consumers use it for important purposes only and when prices falls,
consumers use them even for luxurious purposes.
(f) Presence of low-income groups - These can only afford to purchase a commodity at low
prices and buy less when prices increase. With rich groups the Law of Demand cannot hold
because these can afford to purchase the same amount of commodity at any price.
Other than price-demand curve and price-demand law discussed before, there are other demand
curves such as:
(a) Income-demand curves - Relationship between quantities demanded and changes in
income.
(b) Cross-Demand Curves - Relationship between quantities demanded and changes in prices
of substitute commodities.
(c) Abnormal Demand Curves - These are also called Regressive Demand Curves. These are
price-demand curves which violate the Demand Law.
11
2.3 Factors leading to the violation of the law of demand
(a) Luxurious goods - These are termed as articles of ostentation. They are demanded to
maintain one's status such that if their prices rise, people buy more of them e.g. gold rings.
When prices rise the demand goes high.
(b) Price expectations - When prices are expected to rise, consumers will buy more of a
commodity as price increase in order to avoid effects of further expected price increase. On
the other hand, sellers also increase prices following the increased demand.
(c) Giffen Commodities - These commodities take large portion of one’s income in such a way
that if their prices increase, one tends to purchase more of them and less when prices fall. If
the prices of such commodities increase, the consumer buys less of the Geffen commodities
and buys more the commodities previously foregone. However this is so much popular with
poor people.
(d) Ignorance effect - Some commodities may be of high value due to their high prices,
package, labels etc. So as the price rise the quantity also may increase.
(e) Effects of a depression period - This is a period of low prices, low incomes, low
purchasing power and low economic activity. During this period demand is also low.
Discuss the essence of the argument that “The law of demand does not exist
if other factors (other than price) are not held constant”.
2.4 Change in Quantity Demanded and Change in Demand
Change in quantity demanded differs from Change in Demand in that the earlier refers to the
increase or decrease in the amount of the purchased commodity in the market due to changes in
price, given other factors constant. On the other hand Change in Demand refers to an increase or
decrease in quantity demanded at constant prices brought about by changes in other factors
influencing demand
12
Price
D1
D2
P1
D1
D2
0
Q1
Q2
Quantity
Fig. 2.2 Change in Quantity Demanded Vs Change in Demand
Figure 2.2 shows that at P1 quantity demanded can increase or decrease due to changes in other
determinants of quantity demanded. Increase in demand is shown by shift of the demand curve
to the right from D1 to D2 where the quantity increases from Q1 to Q2 at the same price, P1.
2.5 Types of Demand
These are also called interrelated demand, which is the situation where demand for one commodity
affects the demand for another commodity positively or negatively. This interrelated demand
denotes 5 types of demand:
(a) Joint/Complementary Demand - Demand for commodities which are used together such
that increased demand for one increases demand for the other e.g butter and bread, sugar and
tea leaves etc.
(b) Competitive Demand - Demand for commodities which serve almost the same purpose so
that the increase in demand for one of them reduces demand for the other e.g beans and
peas.
(c) Derived Demand - Demand for the commodity not for its own sake but as a result of
Demand for another. For instance, the demand for factors of production is derived from
demand for commodities they are going to produce.
(d) Composite Demand - Demand for commodities which serve several uses such that their
total demand is got by adding up quantity demanded of them by those several uses. E.g
cotton is demanded for making clothes, animal feeds, threads etc.
(e) Independent Demand - Demand for a commodity does not affect and is not affected by
demand for another commodity. However commodities are rare to find.
13
?
REVIEW QUESTIONS
1.
What is the difference between an increase in demand and an increase
in the quantity demanded?
2.
What is the difference between a change in demand and a change in
quantity demanded?
3. Given below is the demand schedule for a 500 mls tin of soda in Dar
es Salaam city observed in a nightclub. Construct the demand curve
Price per 500mls soda tin
(Tshs)
1000
700
650
600
550
500
450
400
Quantity of soda tins purchased per night
00
50
90
100
110
120
130
140
14
LECTURE THREE
THE THEORY OF SUPPLY AND EQUILIBRIUM PRICE
3.1 Introduction
Supply refers to the amount of a commodity producers are willing to bring to the market at various
prices within a given period of time. Quantity supplied is the amount producers would like to sell
but not how much they actually sell (quantity actually supplied).
By the end of this lecture you should be able to:
1.
Define supply and explain factors affecting supply of goods and services
2.
Determine equilibrium price and quantity in a market
3.
Differentiate between changes in quantity supplied and change in supply
4.
Explain and determine price determination and market equilibrium
3.2 Determinants of Quantity Supplied
The analysis of the influence of each of the factors assumes that other factors remain constant.
(a) Price of the Commodity - At high prices the commodities become more profitable to
produce and sell hence the Law of Supply, which states that ‘the higher the price, the higher
the quantity supplied.'
(b) Price of other Commodities - When prices of competing commodities increase, then it
becomes more profitable to produce and sell these competing commodities thereby
decreasing supply of the commodity and vice-versa e.g. when price of beans falls, farmers
shift to peas production which fetch high prices and profits. On the other hand when two
commodities are produced together, the increase in price of one causes an increase in supply
of the other e.g. increased beef price causes increased beef price cattle production thereby
increasing supply of hides.
(c) Goals of the firm - Supply is usually expected to be high if the goal of the producer is sales
maximisation i.e. when the goal is profit maximisation, supply can be low because
producers would want to supply less and sell at high prices.
(d) Government policy - This may be in form of taxation, subsidization and other legislations
(fiscal policies). High taxation leads to high costs of production which eventually leads to
low quantity supplied. On the other hand, subsidization lowers costs of production thereby
increasing quantity supplied of a commodity.
15
(e) Degree of Freedom of entry of firms in production determines quantity supplied in that if
there is freedom (perfect competition), the supply is likely to increase because suppliers
can't restrict supply so as to sell at high prices. Under monopolistic is a dictator of quantity
supplied and would like to sell small amounts at high prices.
(f) Gestation period refers to the production period or maturity period. When gestation is
short (for industrial products), the supply becomes easy to increase in the shortest possible
time. For agricultural production, the gestation period is usually long, thereby restricting
quick supply e.g palm oil supply cannot be increased in a very short period because it takes
some years before the crop matures.
(g) Non-pecuriary means (non-monetary). Therefore changes in non-pecuriary advantages of
work such as improved working incentives may lead to increased production hence supply
whereas the reverse is true for non-pecuriary disadvantage of work e.g. power working
conditions, increasing risks etc.
(h) Climate (Weather) - If weather e.g. rain, wind, sunshine etc are favourable to production is
likely to increase given other factors constant.
Weather factors have much influence
especially on the supply of agricultural products.
(i) State of technology - Efficient technology leads to expanded volume of supply and reverse
is true for inefficient technology of production.
(j) Demand - High demand for a commodity calls for increased supply of the commodity
whereas low demand leads to low supply.
(k) Non-economic factors include political situation in the nation.
Political stability
encourages increased production and thereby supply.
3.3 Supply Function
It is the statement showing the technical relationship between quantity supplied and the major
determinants of quantity supplied of a given commodity.
QSY = f(P0, P1 .......Pn-1, F1 .... Fn, G, T, E).
Where Qsy = Quantity supplied of commodity y, P0 = Price of commodity Y,
P1 ....Pn-1 = Price of other commodities, F1 .... Fn = Factors of production, G = Goals of producer, T
= Technology and E = Other factors (error term)
3.4 Market Supply
Market supply refers to total supply of a commodity by all suppliers in the market of that particular
market. Individual producer supply differs from market supply in that individual producer supply
16
producer supply is concerned with a supply by only one supplier/producer whereas market supply
refers to total supply by all suppliers of a certain commodity in a given market and place.
3.4.1 Supply Schedule
It is the numerical representation showing the amount of a commodity brought to the market at
various prices per period of time. Example of a rice supply schedule is illustrated below.
Table 2 Supply schedule for rice
Price per kg (TShs)
Quantity supplied per period of time (Kg)
5
100
10
250
15
350
20
450
The supply schedule can be an individual supply schedule or market supply schedule.
3.4.2 Supply Curve
It is the graphical representation of the supply schedule. Normally the supply curve slopes upwards
from left to right indicating that the higher the price, the higher the quantity supplied, other factors
being constant. This notifies the Law of Supply.
Price
S
P2
P1
0
Q1
Fig. 3.1 Supply Curve
Q2
Quantity Supplied
When prices increase from P1 to P2 quantity supplied increases from Q1 to Q2. The supply curve
can be a curve or a straight line and it is not necessary that it passes through the origin. Individual
Supply Curves can be used to derive the Market Supply Curve. Therefore the Market Supply curve
is the horizontal summation of the supply curves by all the individual suppliers of the commodity.
17
Using graphs describe the differences in shapes between the individual
and market supply curves.
3.4.3 Changes in Quantity Supplied and Change in Supply
Change in quantity supplied occurs where there is a change in price of a commodity when other
determinants of quantity supplied are assumed to be constant. It is illustrated by the movement of
supply along the same supply curve. Change in supply refers to the change in quantity supplied of
commodity which arises from changes in determinants of quantity supplied at constant price. It is
illustrated by shift of the supply curve upwards or downwards.
Price
S1
S2
P1
0
Q1
Q2
Quantity supplied
Fig. 3.2 Change in Quantity supplied Vs Change in supply
At P1, quantity supplied can increase or decrease due to changes in other determinants other than
price. Increase in supply is demonstrated by shift of supply curve from S1 to S2 i.e. from left to right
where quantity supplied increase from Q1 to Q2. Decrease in demand is shown by the shift of the
supply curve to the left i.e. from S1 to S2 where quantity supplied decreases from Q1 to Q3 at
constant price, P1. Each determinant can cause increase or decrease of quantity supplied.
3.5 Price Determination and Market Equilibrium
In our discussion of supply and demand concepts we made reference several times to “price”
without mentioning how this market price or “equilibrium price” is determined. This is the
primary focus of this section.
In the process of buying and selling, a lot of bargaining takes place between buyers and sellers.
The bargaining continues until both parties agree about the quantity and the price. It is only when
the quantity demanded is equal to the quantity supplied that actual purchase takes place. The
price of which the supply and demand are equal is called the market price or “equilibrium price”.
18
As a means of enhancing our understanding of how that equilibrium price is determined let us
consider the hypothetical supply and demand schedules for rice in Mbeya market as presented in
the table below. From the schedules we can observe that the equilibrium is established at TSh.
25,000 per 100 kg bag. At this price quantity supplied is equal to quantity demanded.
Table 3 Supply and Demand schedules for rice in Mbeya market
Price of rice (TShs per 100kg
bag)
5,000
10,000
15,000
25,000
35,000
40,000
Quantity of supply (100kg
bag)
1
3
6
9
12
15
Quantity demanded (100kg
bag)
24
19
15
9
4
1
We can plot figures in the above table to reveal the supply and demand curves as shown in
Figure 3.3. It can be observed that the equilibrium price is TS. 25,000 per 100kg bag and the
equilibrium quantity is 9 bags each weighing 100kg.
Price
(TShs)
50,000-
D
S
25,000-
5,000-
S
D
0
1
9
15
Quantity in 100kg bags
Fig. 3.3 Market equilibrium price and quantity
3.6 Changes in equilibrium price
Usually equilibrium can be disturbed and the disturbance can be in form of price distortion
which can be examined under two scenarios. First, the case of shortages and second the case of
market surplus.
(i) Case of supply shortages - This occurs when the demand outstrips supply and example can
be illustrated from the example in table 3 and fig 3.3. Suppose the government decides to set the
price of rice at TShs.10,000 per bag, the demand for rice far outstrips the supply and since the
19
consumers demand is not met we have a situation of excess demand or supply shortages. Under
such a situation, sellers of rice would raise their prices and this will reduce demand until the
equilibrium is established at TShs. 25,000 per bag.
(ii) Case of market surplus - This is a situation where the quantity supplied in the market would
be greater than quantity demanded by consumers, leading to excess supply or market surplus.
Following the market surplus, sellers would reduce their prices in order to reduce the market
surplus. This is illustrated by a situation where a price is set that is higher than the equilibrium
price. In our rice example, suppose the price is set at TShs. 35,000 per bag, consumers will
demand less than supplied until the unless the price is lowered. The reduction in price will
induce consumers to demand more. The decrease in price will continue until an equilibrium price
is reached i.e. TShs 25,000 per bag where demand and supply are equal.
You should note that only the equilibrium price of Tshs 25,000 per bag is the stable equilibrium
price, as a price higher or lower than the equilibrium price will create a market surplus which
will set forces in motion to bring back the price to equilibrium level. It should be noted that
changes in equilibrium price can also be brought about by shifts of supply or demand curves. For
example a shift in demand curve can bring a new equilibrium level.
?
REVIEW QUESTIONS
1.
How is the equilibrium price of the commodity determined?
2.
Using appropriate diagrams illustrate the concepts of excess demand and
the concepts of excess supply
3
Given below are supply and demand data for a farmer’s bags of maize
Price per bag
Quantity
supplied Quantity
demanded
(000’ Shs)
(bags)
(bags)
3
100
500
4
200
400
5
300
300
6
400
200
7
500
100
(a) What is the equilibrium price and quantity? Illustrate using supply and
demand curves
(b) How many bags of maize will be produced if the government sets a price
support at Shs 6 per bag? How many bags will the government have to
purchase at Shs 6?
20
LECTURE FOUR
ELASTICITY OF DEMAND AND SUPPLY
4.1 Introductions
Elasticity is the degree of responsiveness of dependent variables to independent variables.
Dependent variables may be quantity demanded or supplied while independent variables are factors
which influence the demand or supply. Due to this categorisation there are two main types of
elasticity i.e. elasticity of demand and elasticity of supply.
By the end of this lecture you should be able to:
1. Calculate and interpret price, income and cross elasticities of demand for and
supply of goods and services
2. Discuss various determinants of elasticity of demand and supply
4.2 Elasticity of Demand
Elasticity of Demand is the degree of responsiveness of quantity demanded to factors which
influence the quantity demanded namely price, income and prices of other commodities. Therefore
there are 3 types of elasticity of demand i.e. price elasticity of demand, income elasticity of demand
and cross elasticity of demand.
4.2.1 Price Elasticity of Demand (η
η)
It is the measure of the degree of responsiveness of quantity demanded to changes in the
commodity's price. It can be expressed as follows:
η = Percentage Change in quantity demanded
or
Percentage Change in price
∆Q • P
∆P
Q
where ∆Q = Change in quantity demanded of a commodity, ∆P = Change in price of the
commodity,
P = Original price of the commodity and Q = Original quantity demanded of the commodity.
21
P
10
A
∆P
5
B
∆Q
0
3
5
Fig. 4.1 Price Elasticity of demand from A to B
Q
From figure 4.1; ∆P = 10 – 5 = 5, ∆Q = 3 - 5 = -2 units, P = 10/-and Q = 3
Thus; ηd = -2/ 5 x 10/3 = -1.3
The elasticity does not have units and it is expressed in absolute values i.e. it is always positive.
The negative sign which can appear indicates the negative slope of the demand curve i.e.
downward sloping. Elasticity ranges from zero to infinity.
4.2.2 How to Interpret Price Elasticity of Demand
(a) Perfectly or completely inelastic - This is when price elasticity of demand is zero i.e
quantity demanded does not respond to change in price at all e.g. demand for cigarettes.
(b) Inelastic - This occurs when the price elasticity of demand is greater than zero but less than
one i.e. 0< η <1. This implies that quantity demanded changes by smaller percentages than
the price.
(c) Elastic - When the price elasticity of demand is greater than one but less than infinity i.e.
1<η<∞. This implies that change in quantity demanded is greater than that in prices.
(d) Unit Elasticity - This occurs when the price elasticity of demand equals one. This leads to a
rectangular hyperbola demand curve i.e. η = 1.
(e) Perfect elastic - Occurs when the price elasticity of demand is equal to infinity. This means
that buyers are prepared to buy all they can at or below the same price and none at all even
at slightly higher prices.
22
It should be clear that if elasticity of demand is calculated at various points along
the same demand curve, the elasticity varies from zero to infinity. This implies that
the slope of the Demand Curve may be the same at all points whereas the elasticity
of demand varies at various points. This is explained by the fact that the slope
depends on the absolute changes in Price and Quantity demanded whereas elasticity
of demand depends on the percentage changes of Price and of quantity demanded.
4.2.3 Determinants of Price Elasticity of Demand
(a) Availability of Substitutes - If a commodity has many substitutes its demand would tend to
be price elastic i.e. when its prices increases, consumer shift to substitutes immediately.
When it has no substitutes or few, its demand would tend to be price inelastic i.e its price
increases, the quantity demanded remains more and less the same because consumers have
to purchase it as they have no substitute to shift to.
(b) Degree of necessity - The price elasticity of demand for necessities tends to be inelastic
because they are indispensable. For example, ever if the price of salt increase, consumers
will buy almost the same quantity since most of them can't do without salt. Dispensable
commodities such as luxuries have high price elasticity of Demand, because when their
prices increase, consumers leave then since they can do without them.
(c) Joint (Complementary) demands - When goods are used together (complementary), their
demand is inelastic because the demand for one may not reduce even if the price of other
increases so long as people still demand the second commodity e.g price of bread and
demand for butter.
(d) Cost of the Commodity - If a commodity takes a small fraction of the consumer's income,
its demand tends to be inelastic e.g a match box. On the other hand, when the commodity
takes a larger portion of the consumer's income, its demand tends to be price elastic since
the increase in price can easily be felt.
(e) Consumer's income - Price elasticity of demand for a commodity tends to be high when
there are many poor people. When the price increase, they leave the commodity or buy less
of it. When there are many rich people, price elasticity of demand tends to be very low
because they can afford to buy the same at any price.
(f) Price Stability - If there are price instabilities or expectations of price increases, demand
tends to be price inelastic. As the price increases, consumers keep on buying almost the
same quantity because they expect the prices to rise in the future. In such circumstances,
they can even buy more of the commodity as its price increases.
23
(g) Durability of the Commodity - Durable commodities like cars, radios, refrigerators,
milking machines etc have low price elasticity of demand, because even if the price of such
commodities falls, one may not demand for another one when he already has one.
Agricultural products which are easy to store e.g grains have a high elasticity of demand i.e
when their prices fall consumers buy more and store then for future use. Demand for
perishables e.g milk is inelastic because when the price falls, consumers may not buy more
because they cannot manage to store them for a long time.
(h) Alternative Uses of the Commodity - When a commodity has several uses, its demand
tends to be price elastic. When its price increases, consumers use less of it for only
important purposes.
(i) Demand for the commodity whose use can be postponed its demand tends to be more
elastic, for instance when prices of building materials increase, people can postpone
purchasing them until some future date. When a commodity has an immediate use, its
demand tends to be price inelastic.
4.2.4 Income Elasticity of Demand (η
ηY )
This is the measure of the degree of responsiveness of quantity demanded to changes in consumer
incomes i.e.
ηY = Percentage Change in quantity demanded
Percentage Change in consumer's income
= ∆Q⁄Q x 100
∆Y⁄Y x 100
= ∆Q⁄ ∆Y x Y⁄ Q
Where ∆Q = Change in quantity demanded of a commodity
∆Y = Change in income of the consumer
Y = Original consumers’ income
Q = Original quantity demanded of the commodity
2.2.5 Interpretation of Income Elasticity of Demand
(a) Income elastic - This occurs when the income elasticity is greater than one i.e quantity
demanded changes more proportionately than change in incomes, keeping other factors
affecting demand constant. This means that a slight increase in the money income of the
consumer, leads to a very large increase in quantity demanded. Whereas the slight decrease
in consumers income leads to a drastic decrease in quantity demanded.
24
(b) Income inelastic - This occurs when income elasticity of demand is less than 1 but greater
than zero (0<ηY<1). This means that slight the increase in quantity demanded.
(c) For inferior commodities, the income elasticity of demand is negative i.e. when incomes
increase, people buy the commodity in fewer quantities.
(d) When the income elasticity of demand is zero, it means that the commodity is a necessity;
as quantity demanded remains constant e.g. demand for salt.
(e) Normal goods have positive income elasticity of demand since their demand increases as
incomes increase.
It should be noted that a commodity can be a normal good, necessity or an
inferior good depending on the income level of the household. The consumer
may buy more of the commodity as his income increases (for a normal good).
Later the consumer buys the same amount even if his income increases (for
necessity good). Finally he/she can start purchasing less of the commodity
(inferior commodity) and consuming more of the more expensive
commodities as his income increases.
4.2.6 Importance of Income elasticity of Demand
(a) It is important in distinguishing necessities (when ηY is low) and non-essential/necessities
(where ηY is high). This is essential for taxation purposes.
(b)
It helps producers to estimate future demand as consumer's income change. If ηY is high,
then as incomes increase, producers should supply more.
4.2.7 Cross Elasticity of Demand (η
ηC)
This is a measure of the degree of responsiveness of quantity demanded of a commodity to changes
in prices of other commodities.
ηCX= Percentage change in quantity demanded of Commodity(Qx)
Percentage change in prices of other commodities (Py)
= ∆Qx ⁄Qx x 100
∆Py ⁄Py x 100
= ∆Qx⁄ ∆Py • Py ⁄ Qx
Where ∆Qx = Change in quantity demanded of commodity X, Qx = Original quantity demanded of
commodity X, ∆PY = Change in prices of other commodities (Y), PY = Original price of other
commodities (Y) and ηCX = Cross elasticity of demand of commodity X.
25
4.2.8 Interpretation of Cross Elasticity of Demand
(a) When ηCX is positive, their commodities X and Y are substitutes. This means that the
increase in price of other commodities (Y) leads to an increase in quantity demanded of the
commodity. For example, when the price of peas increases, quantity of beans demanded
increases because consumers shift to the substitute cheap beans.
(b) When it is negative, then commodities X and Y are complements (joint products). This
means that the increase in prices of other commodities (Y) leads to a decrease in quantity
demanded of commodity (C). For example, if the price of bread increases, the quantity of
butter bought may decrease. Similarly if the price of cars increases, the quantity of petrol
demanded may fall because of the fall in quantity of cars.
(c) When ηCX is zero, the two commodities are not related at all i.e. quantity demanded of
commodity X is not affected by change in price of commodity Y.
4.3 Elasticity of Supply (εε)
This is a measure of the responsiveness of quantity supplied to changes in determinants of
quantity supplied. Since other determinants of quantity supplied of commodity are difficult to
measure, we only talk of price elasticity of supply to mean the elasticity of supply.
ε = Percentage Change in quantity supplied
Percentage Change in the price of the commodity
= ∆QS ⁄ QS x 100
∆Px ⁄ Px 100
= ∆QS • Px
∆Px
QS
Where ∆QS = Change in quantity supplied of the commodity, QS = Original quantity demanded of
the commodity, ∆Px = Change in own price of the commodity, Px = Original price of the commodity
and ε = Price Elasticity of supply.
4.3.1 Interpretation of Price Elasticity of Supply
(a) Perfectly Inelastic - This is when elasticity of supply is equal to zero.
(d) Inelastic supply - When elasticity of supply is greater than zero but less than one.
Percentage change in price is greater than percentage change in quantity supplied.
26
(e) Elastic - This is when elasticity of supply is greater than one but less than infinity.
Percentage change in quantity supplied is greater than percentage change in price.
(f) Unit Elasticity of Supply - This is when elasticity of supply is equal to one i.e. percentage
change in quantity supplied is equal to percentage change in price.
(g) Perfectly Elastic - This is when at, or above a certain price. Below that price, sellers do not
supply at all.
4.3.2 Determinants of Price Elasticity of Supply
(a) Cost and Availability of factors of production - When cost of production is low and when
factors of production are available, elasticity of supply is high because when the price
increases producers increases production and supply immediately. When cost of production
is high and the factors of production are scarce, elasticity of supply is low because the price
increases, producers cannot easily increase supply.
(b) Nature of the Commodity - Durable commodities have greater elasticity of supply because
they can be stored for a long time such as the price increases, suppliers supply more.
Perishable products such as milk have low elasticity of supply because they can't be stored
for a long period to be brought to the market even if their prices increases, supply then
cannot be increased.
(c) Gestation period - A commodity with a short production cycle, has a very high elasticity of
supply because when its prices increase, supply can be increased within a short time. When
gestation period is long, supply cannot be increased easily to correspond to the increased
price because it takes long to produce a commodity.
(d) Method of production (technology) - Commodities which can be produced with simple
technology have a high elasticity of supply because they can be easily produced when prices
increase.
(e) Time –There are three time periods in which supply can be varied:
•
Very Short run - Elasticity of supply is very low. Time is very short such that
suppliers can only increase supply by drawing from stocks in stores.
•
In the short run - Elasticity of supply is low. Time is short and producers can
increase production by varying only the variable factors.
•
In the long run- Elasticity of supply is high. Time is long enough for producers can
vary both fixed and variable assets of production to increase production and thereby
supply.
27
(f) Government Policy - Elasticity of supply may be low when the government restricts
importation of commodities. In such case the supply may not increase even if prices
increase. When trade is free, elasticity of supply tends to be high because more of the
commodity is imported as the price increases.
(g) Price Expectations - Price elasticity of supply may be low if there is expectation of price to
change. Producers usually hesitate to supply more despite the increase in the price until the
increase in price is permanent.
(h) Ease of entry of new firms in the market - When new firms are restricted from joining the
market (as with Monopoly), elasticity of supply is likely to be low because output is
restricted by few (or a single) suppliers so as to keep price high. With perfect competition
elasticity of supply is likely to be high because if the price of a commodity increases, then
supply increases since more firms join the market.
4.3.3 Point Elasticity and Arc Elasticity
Point elasticity refers to elasticity at one point on the Demand or Supply Curves. All along we have
been talking of point elasticity, so unless mentioned when calculating price elasticity of Demand or
Supply, it is meant for point elasticity which is given as (-) ∆Q⁄ ∆P x P⁄ Q. Arc elasticity refers to
the elasticity between two points on the demand or supply curve. The formula is:
(-) ∆Q ⁄∆P x P”⁄ Q”
Where P”(Average Price) = [P1 + P2] ⁄ 2 and Q”(Average Quantity) = [Q1 + Q2] ⁄ 2
P
10
A
∆P
5
B
∆Q
0
3
Fig.4.2 Arc Elasticity of demand
5
Q
Arc elasticity from A to B is given as (-)2⁄5 x [20 + 10] /2 = -0.5
[4 + 8] /2
28
The advantage with the formula for arc elasticity is that price elasticity from A to B is equal to that
from B to A. This isn’t the case with the formula of point elasticity.
?
1.
Why do we always insert a negative sign in front of demand elasticity?
2.
What is meant by perfect inelasticity and infinite elasticity?
3.
Describe and illustrate the five categories of supply elasticity
4.
Mr. Juma is a butcher who recently raised the price of steak at his market
from Tshs 2000 to 2500 per kilo. Correspondingly, his sales dropped from
500 kilos to 400 kilos per day. Is the demand for steak at mr. Juma’s
market elastic or inelastic? Show your workings
5.
At Tshs 250 a piece, Mr. Mwema sells 100 chocolate bars per week. If he
drops his price to Tshs 200, his weekly sales will increase to 110 bars. Is
the demand for chocolate bars elastic or inelastic?
29
LECTURE FIVE
FUNDAMENTAL ECONOMIC CONCEPTS FOR ENVIRONMENTAL
POLICY ANALYSIS
5.1
Introduction
The main goal of this lecture is to introduce you to the application of the principles of
microeconomic analysis to environmental policy questions. We have seen above that Economics
is the study of the allocation of scarce resources. Economics is a theory of how markets can be
used to allocate scarce resources. However, note that markets are not the only way to allocate
scarce resources (e.g. command economy). Microeconomics studies the interaction among
individual economic units.
The two key questions are therefore:
•
How to utilize resources most efficiently - What to produce? - How to produce it? E.g.
how much capital and how much labor
•
How to allocate the goods and services that is produced - In a market economy, goods
and services are allocated based on ability to pay.
Key concepts in economics we are going to discuss in this lecture are those concepts that we will
come back to throughout the course, as they are fundamental to the way economists think. I
introduce them now to highlight their importance.
At the end of this section you are expected to be able to define and explain the
following concepts:
1.
Marginal analysis
2.
Sunk costs
3.
Opportunity costs
4.
Scarcity and models of scarcity
5.
Positive Economics
6.
Normative Economics
5.2 Marginal analysis
Economists focus on things at the margin – that is, what is the benefit of the next good that is
bought or sold. Once you have purchased something, what matters is what you will do next. Can
you make yourself any better? Our goal is to maximize total net benefit: the value of the good
minus the cost. To do this, we focus on the marginal benefits (MB) and marginal costs (MC).
•
If MB > MC, total benefit will increase. You should purchase.
30
•
If MC > MB, total benefit will decrease. Do not purchase.
•
The only time that total benefit will not rise or fall is when MB = MC. This is where total
net benefit is maximized.
5.3 Sunk costs
Sunk costs are expenditures that have been made and cannot be recovered. Following from
marginal analysis, sunk costs should be ignored. Since sunk costs cannot be changed, they
should not influence decision-making.
5.4 Opportunity costs
Opportunity cost is the value of the best alternative use of a resource. It is the cost of forgone
opportunities. For some students who could have been working and earning a salary, the
opportunity cost of foregoing their jobs by undertaking university studies is tuition fees plus the
salary they forgo by not working. Opportunity costs are important to consider, but often ignored.
Opportunity costs relate to the key concept of scarcity (this is covered well in net section). Once
a resource has been used, it cannot be used for something else.
5.5 Scarcity: The Key Problem in Economics
Scarcity is the key problem in economics Economists study how incentives affect individual
behavior. Due to scarce resources, individual behavior is constrained. Economists study how
incentives affect the choices people make when faced with these constraints. Although
economists often discuss prices as the incentive mechanism, the incentives can be offered in
other ways as well.
5.6 Positive Economics Vs Normative Economics
Note that there are two types of economic analysis:
•
Positive economics – studies how the economy actually functions. It is purely
descriptive, e.g. how do people respond to higher energy prices?
•
Normative economics – the study of whether or not the economy produces socially
desirable results. This requires value judgments, e.g. what is the best way to reduce
gasoline consumption (e.g. tax, oil import tariff)? Even though we cannot prove
scientifically which values are correct, we can have rational discussions about them, and
can evaluate what goals are being met – leaving it to politics, etc. to decide which goals
should be met.
31
When economists discuss how people respond to incentives, it is positive analysis. For example,
when we say that firms maximize profits, we are describing behavior we observe, not stating
whether or not we think it is correct. Contrast with a moral approach to the environment – that
polluting is the result of unethical behavior, and the solution is to increase awareness and
morality. Thus, an important question is why do we wish to protect the environment? Is it so that
environmental resources can provide us with benefits, or are there more basic ethical reasons?
The answer to this question can affect the level and types of protection desired.
5.7
Models of Scarcity: The Key Problem in Economics
Popular models of scarcity include among others the following:
5.7.1 Malthus Model: because land is fixed, scarcity is inevitable.
Malthus noted that, since the supply of land was fixed, scarcity was inevitable. Because land was
fixed, Malthus argued that diminishing returns to labor must set in as population grew.
Population would grow faster than the marginal product of labor. He noted that population grew
geometrically (1,2,4,8…), but food grew arithmetically (1,2,3,4…). Malthus predicted that
population growth would stop when the limits of the food supply were met. There are reasons as
to why Malthus was wrong.
•
Malthus ignored factors other than labor.
•
Technological change made inputs more productive.
•
It may be that we simply haven't reached the point in which population growth passes
food growth, but perhaps that point is coming.
5.7.2 IPAT : Devised by biologist Paul Ehrlich in 1971
According to Ehrlich, environmental Impact = Population*Affluence*Technology. The concern
is that growing population puts increased pressure on the environment. He advised two ways on
how increased impacts can be avoided:
•
Increases in technology
•
Increase the effect of affluence by providing alternatives. For example reducing the
impact of cars by increasing public transportation.
5.7.3 Doomsday Models: computer models that predicted severe shortages of resources
The most famous is The Limits to Growth. A key feature missing from these models is prices i.e.
as resources become scarcer, prices rise. This leads to: increased conservation, the development
32
of new technologies, and exploration for new resources. As an example, Limits to Growth
predicted there were 550 billion barrels of oil reserves, and predicted they could be used up in 20
years. Instead, between 1970 and 1990, 600 billion barrels of oil were used. In 2007, there were
740 billion barrels of known reserves in the Middle East alone. Globally, there are about 1.3
trillion barrels of known reserves. As oil became more expensive, more exploration was done,
and previously underutilized sources of oil, such as the North Sea and the Northern Slope of
Alaska, became viable. Because of new technologies and new resource discoveries, the price of
most resources has actually fallen over time! In addition, food prices for example, have fallen by
50% worldwide since 1960, and 90% since 1800. However, do note that the prices established by
the market may not be correct, because they do not account for environmental damage. This
leads to the question of market failure which we are going to cover later in this course.
5.7.4 Lomborg Model: pessimistic predictions get more attention than reality
Lomborg discusses why he thinks that pessimistic predictions get more attention than reality. For
instance:
•
Funding for scientific research goes to areas with many problems
•
Environmental groups need to be noticed by both the mass media and by potential
donors.
•
Attitude of the media- bad news is more interesting than good news.
•
Poor individual perception - faulty risk perceptions
33
LECTURE SIX
MARKET STRUCTURES
6.1 Introduction
Market structures refer to characteristics of the forms of organizations or firms which enable them
to exercise a strategic influence on the nature of competitiveness and pricing in the market. Such
aspects include the following: size and number of firms, conditions of entry to the market, goals of
firms, the degree of product differentiation and Degree of knowledge about the market. These
aspects are used to mark or explain the difference and similarities among these structures and we
will be referring to them throughout this lecture. Market structures can be classified into four types
according to the number of firms in the industry/market namely Perfect Competition, Monopoly,
Monopolistic Competition and Oligopoly. We are going to discuss them all in this lecture.
By the end of this lecture you should be able to:
1. Explain characteristics of perfect competition, monopoly, price discrimination,
oligopoly and monopolistic competition
2. Discuss the advantages and disadvantages of the market structures
3. Explain factors that may cause a market to be monopolistic
6.2 Perfect competition
This is a market structure with the following characteristics:
(a)
There are many sellers (firms) of the same size and many buyers. Therefore one firm
cannot influence the market price; as such sellers are price takers and not price makers.
(b)
Homogenous products - There is no any product differentiation so competition is centred
on only prices.
(c)
Free entry and exit - when firms earn abnormal profits, other firms are free to join the
market and exhaust the profits. When there are no profits they are also free to leave the
market.
(d)
Perfect knowledge - no ignorance on side of buyers and sellers in the market. There is
perfect knowledge about future trends relevant to their decision making presently.
(e)
Perfect mobility of factors of production - factors of production can move freely from
one firm to another but not monopolized.
34
(f)
No government regulation - no tariffs, subsidies, rationing, price controls etc by the
government.
(g)
Profit and utility maximization - while all sellers aim at profit maximization, consumers
(buyers) aim at buying cheaply to maximize utility.
In practice, there is no perfect knowledge about the market by both sellers and
buyers in pure competition. In addition the assumption that the factors of
production are freely mobile among firms is not fulfilled in pure competition.
So though sellers are also price takers but there is an element of monopoly in
pure competition.
6.2.1 Advantages of Perfect Competition
(a)
In the Long run, there is efficiency in production and full utilization of factors of
production.
(b)
In the Long run consumers enjoy high standard of living because more commodities are
available at cheaper prices.
(c)
There is no wastage of funds in advertising.
(d)
There is improvement in quality of products.
6.2.2 Disadvantages of Perfect Competition
(a)
Consumers cannot enjoy a variety of commodities since commodities are
homogenous.
(b)
In the Long run, expansion of the firm may be very difficult because there are no enough
profits to `plough back.'
(c)
Research may be impossible because profits earned are not enough to cater for research
activities.
(d)
There is a high risk of unemployment when inefficient firms are pushed out of the market.
(e)
Public utilities such as water supply and roads may not survive in perfect competition
hence need for government intervention.
(f)
Assumptions of perfect competition are unrealistic and may be misleading.
6.3 Monopoly
This is a market situation where there is one seller of a product which has no close substitutes. No
persuasive advertising and also entry of new firms is restricted. In Pure Monopoly there is one
firm, which deals in a product that has no substitutes at all. In practice there is no pure monopoly
35
because there is no commodity, which has no close substitutes at all. Monopoly is a market
situation where there is only one buyer of commodity or a factor of production e.g. one employer.
6.3.1 Factors leading to Monopoly
The factors that lead to monopoly include:
(a) Patent rights - examples authors of books, where the law forbids other firms to deal with the
same.
(b) Ownership of strategic raw materials - These are usually under the government control e.g.
minerals.
(c) Exclusive methods of production e.g. Genetically Modified crop production.
(d) Long distance among products - this results to each producer monopolizing the market in his
locality commonly called Spatial Monopoly.
(e) Advantage of large scale of production which makes small competitors unable to compete
successfully with large firms. Also where there is room for only one seller e.g. electricity
supply, railways etc, usually such understanding is controlled by the government since they
are government utilities, thereby creating natural monopolies in the market.
(f) Protectionism - this is when foreign trade barriers are imposed on the product to exclude
foreign competitors. In such way a local producer may become a monopolist.
(g) Take-overs and mergers - `take over' occurs when one firm takes over the assets and
organization of another whereas mergers are formed when firms combine their assets and
organizations into one to achieve strong market position. Both situations usually may
result into monopoly.
(h) Collective (Collusive) monopoly - this occurs when firms come together in a formal or
informal agreement to achieve monopoly power since they can fix quotas, or limit pricing
(setting very low price with the objective of preventing new entry of other firms).
6.3.2 Examples of Monopolies in Tanzania (as of 2004)
(i) Tanzania Electricity Supply Company (TANESCO)
(ii)Tanzania Railways Corporation (TRC).
(iii) Coffee Marketing Board (CMB) - However the monopoly of CMB is gradually being
scaled down by allowing private exporters to participate in the market.
(iv) Dar es salaam Water and Sewerage Authority (DAWASA).
36
It should be noted that a monopolist has no supply curve because he is the
sole controller of the output in the market. So there is no unique relationship
between market price and quantity supplied. This implies that short run and
long run monopoly firms are the same.
6.3.3 Advantages of Monopoly
(i) Resources are saved since there is no duplication of services. This means that if there is one
hydroelectric power (HEP) plant, there may not be a need to set up another one in the same
area.
(ii)
Infant industries can grow up when they are kept from competition.
(iii)
No need of persuasive advertising, which leads to wastage of resources as well as
increased prices.
(iv)
Control by the government of public utilities like roads, telephone etc.
(v)
Research can be carried out using the abnormal profits.
(vi)
There is a possibility of selling the same commodity at different prices which benefits the
low income earners.
(vii)
Firms enjoy economies of scale since they can use the abnormal profits to expand
production.
6.3.4 Disadvantages of Monopoly
(i)
The firm can become inefficient and produce low quality products.
(ii)
Firms produce at excess capacity i.e. they under-utilize their resources so that they
produce less output to boost prices.
(iii)
Shortage of the commodity in case a monopoly firm stops producing.
(iv)
A higher price than in perfect competition is changed.
(v)
Since monopolist firms are controllers of production, they at times exert pressure on
governments thereby influencing decision-making.
6.3.5 Measures to Control Monopoly
Due to the above disadvantages, the following measures can be used to control the monopolist's
activities:
(a)
The government can fix prices of commodities.
37
(b)
The government can impose taxes to tax away the abnormal profits. However, if not taken
with care the burden of taxation may be shifted to the final consumers in form of high
prices.
(c)
Nationalization of monopolists by the government.
(d)
Subsidization of new firms for them to compete with monopolist firms.
(e)
Anti-monopoly (antitrust) legislation - laws are imposed to control monopolies. The laws
can inhibit monopolization and collusion among firms to raise prices to inhibit
competition.
6.4 Price Discrimination under Monopoly
Price discrimination exists when the commodity is sold at different prices irrespective of the cost of
production. Price discrimination may also be used to sell units of the same commodity at different
prices to the same customer e.g. telephone charges being high on first 3 minutes and then low on the
other minutes. There are various forms of price discrimination according to:
(a)
Personal income - rich people are charged higher prices than poor people.
(b)
Sex or age of customers.
(c)
Geographical discrimination.
(d)
Time of service e.g. higher price in the morning and low in the evening.
(e)
Nature of product e.g. higher prices on branded commodities than unbranded ones of the
same type.
(f)
Use of the product - e.g. low transport charges for inputs and high charges for luxuries for
the same means of transport and same distance.
(g)
Differentiation of the commodities - high prices of cold drinks in tourist hotels and low
price of the same type of drinks in non-tourist hotels.
Price discrimination occurs only when a monopolist sells the commodity and it
becomes impossible for buyers to transfer the commodity from where the price
is low to where the price is high. Again the elasticity of demand should be
different in different market segments whereby a higher price should be charged
in the market where elasticity of demand is low than where elasticity of demand
is high.
6.4.1 Advantages of Price Discrimination
(a)
Total output sold increases thereby increasing total revenue of the seller.
(b)
It is the way the rich subsidize the poor thus income distribution.
38
(c)
Enables the poor to get essential services at low prices.
(d)
It helps producers to dispose off surplus commodities e.g. dumping.
(e)
It increases sales and consumption.
Price discrimination has similar disadvantages as those of monopolies.
6.5 Monopolistic competition
This market structure has similar characteristics to those of perfect competition except that the
commodity in question in monopolistic competition is not homogenous. Products, though closely
substituting, are differential in form of packaging, design, quality etc.
So there is need for
persuasive advertising and the seller has some control over the market price due to differentiation
e.g. restaurants, vehicle garages, hair salons etc.
6.5.1 Advantages of Monopolistic Competition
(a)
Consumers get a variety of products because of product differentiation.
(b)
The quality of products is improved.
6.5.2 Disadvantages of Monopolistic Competition
(a)
There is under-utilization of the resources - there is excess capacity and output produced
is lower than that in perfect competition.
(b)
In the long run, there is no profit to make improvements, so the firm may not enjoy
economies of scale.
(c)
The price charged on buyers is higher than in perfect competition.
(d)
No research is carried in the long run because no abnormal profits.
(e)
Need for advertising thereby increasing costs and the price.
6.6 Oligopoly
This market structure is characterised by the following:
(a)
There are few, unequal, competing sellers. Each seller (firm) is faced with competition from
other sellers. However each has got market power and therefore cannot be a price taker.
(b)
There is non-price competition - e.g advertising and quantity of services that if one seller
reduces the price, others may do the same and all end up losing.
(c)
In most cases there is product differentiation.
(d)
Each firm is concerned with activities of other firms so as to act/respond accordingly.
39
6.6.1 Examples of Oligopolies in Tanzania:
(a)
Dealers in beer: Safari, Heinken, Serengeti, Hakuna Matata etc.
(b)
Dealers in petrol: Oilcom, Caltex, BP, Total, Agip, Shell etc.
At times, firms avoid underselling each other (price war), by coming into an agreement (cartel)
whereby they fix quotas and sometimes fix prices to restrain competition. This makes oligopolist
behave like a monopolist.
?
REVIEW QUESTIONS
1) What is pure competition? What are the conditions necessary for the
perfect competition?
2) Is it possible for many firms to sell exactly the same product, and still be
in monopolistic competition?
40
LECTURE SEVEN
MARKET FAILURES FOR ENVIRONMENTAL RESOURCES
7.1 Introduction
A market failure is something that is inherent to the market that causes the market equilibrium
allocation to be inefficient. There is a famous theorem in welfare economics that shows that
under certain conditions the allocation of resources in long-run competitive equilibrium is
efficient. This result is both amazing and fantastic; somehow, everyone doing their selfish best,
ignoring their impacts on others, results in an efficient allocation from society’s perspective.
Wow – Adam Smith’s invisible hand at work. When this theorem is presented, often the details
are passed over and the presenter does not emphasize that the result only holds under certain
conditions. Pure competition only achieves efficiency in the absence of market failures. Market
failures are numerous in the resource and environmental sector of the economy. The market fails
in the allocation of many environmental and natural resources, making the overall allocation of
resources inefficient: Adam Smith’s invisible foot tripping up the allocation of resources.
At the end of this section you are expected to be able to:
1.
Explain the Adam Smith’s invisible hand phenomenon and its implications
on environmental resources
2.
7.2
Describe externalities and other market failures and their categories
The Invisible Hand
The main objective of this lecture is to discuss why the free/competitive market we discussed in
the previous chapter may fail, and to discuss the consequences when that happens. To begin, we
must consider how the market should function. Adam Smith, who coined the phrase "The
Invisible Hand," was the first classical economist to notice that a free market of individuals
acting in their own self interest leads to a socially-desirable result. He explained why this occurs
as follows:
•
Demand = Marginal Benefit (MB)
•
Supply = Marginal Cost (MC)
•
In equilibrium, Price (P) = MB = MC
At equilibrium point no further beneficial transactions are possible. Normally, a free market
brings us to this point. However, there are times when private marginal benefits or costs are not
equal to social marginal benefits or costs. When this occurs, the market is unable to allocate
41
resources efficiently. We call this market failure. The welfare lost because beneficial
transactions do not occur is known as deadweight loss.
7.3 Categories (Causes) of market failures
We now need to examine the different sorts of market failure and see how they prevent the
market from achieving efficiency. Let us identify and briefly explain some of the categories of
market failures (common property, externalities, public commodities, excess market power, lack
of markets, and distortions in capital markets). This classification is arbitrary and probably not
complete. Also, the categories often overlap.
7.3.1 Common property resources are one category of market failure.
The market (or lack of) puts a zero price on common-property resources. A resource is common
property if access to it is not controlled. That is, it is common property if no one effectively owns
the resource. While few resources in this world are pure common-property resources (access to
them is completely uncontrolled), access to many environmental resources is largely
uncontrolled, or controlled to only a limited extent.
Common Property Resources (also called Open Access Resources) are resources or
facilities that are open to uncontrolled access by individuals who wish to use the
resource. The problem is a lack of property rights. Consider someone using a public
grazing area.
•
Individuals equate MB = MC
•
The benefits are the value of using the grass.
•
There are two costs: The cost of obtaining the resource and the opportunity cost
of not being able to use the resource later
The user bears all of the first cost, but only part of the second cost, as it is shared by all
users. As a result, MPC < MSC. Thus, MB = MPC < MSC. This leads to overutilization of the resource.
A common-property fishery causes the market to fail, so will a common property oil
field, a common-property wilderness area, a commonly-owned air space, and a commonproperty rain forest. The common-property nature of many animals is a significant contributor to
their being endangered. Aficionados of inadequate property rights make many subtle distinctions
between different degrees of property rights. Hopefully they will excuse me for lumping them all
together; one needs to start simple.
42
The common-property nature of the air in many places is a major reason for excessive air
pollution from an efficiency perspective. Consider a commercial fisherman. They produce
caught fish, which they sell. Inputs into the production of caught fish include labor, capital and
fish swimming around in water. The capital and labor is used to get the fish out of the water and
onto the dock. Labor and capital are not common-property resources, so must be paid for. If the
fish stock is owned, the fisherman will have to pay the owner for each fish harvested, and the
owner will charge an amount sufficient to cover the decreased value of the stock because it is
reduced in size by the harvest. Put simply, the fisherman will have to pay the opportunity costs
of all of the inputs it uses to produce docked fish.
Contrast this with the meat-packing company that must pay the rancher to harvest his cattle. The
rancher controls access to his herd, so won’t give them up for free. Alternatively, if the stock is
common property with no owner who charges for harvesting from the stock, the commercial
fisherman will not take into account the opportunity cost to society of reducing the stock because
he or she will not have to pay this cost. That is, when an input is free, people will overuse it – not
surprising. Many of the ocean’s fisheries are or have been common-property resources.
Why are some resources common property but many others not?
“In the beginning” there was no need to control access to resources. Most resources are now
scarce but when man first arrived on the scene, scarcity was not a big issue – big garden with
only two residents and a talkative snake. All resources started off as common property but now
access is controlled for many of them. However, even now, after years of private-property
capitalism, there remain resources that are both terribly scarce and effectively common property.
This happens, in part, because the characteristics of some
natural resources make them
expensive for either a private agent or the government to define and enforce property rights.
Think about why cows are not common property, but many ocean fish are? Cows were
bred to minimize the cost of controlling them: stupid, can’t jump over fences, easy to
spot, cheap to brand, kids stand next to mom, and willing to wait in line to be
slaughtered– how convenient. Wild fish, on the other hand, are very difficult to keep
track off. Maybe we need to breed domestic fish which don’t like to run around!!!!
Contrary to popular belief, private property and the market system were not created by
God.
43
There are cultural and historical reasons that some resources remain common property. People
who exploit common-property resources get very upset when someone suggests they should pay
to use the resource. “My father fished here, my grandfather fished here, my great-grandfather
….It is my god-given right.” Selling stuff like clean air to the highest bidder makes many people
queasy, not economists, but maybe they are a different species.
7.3.2 Externalities are another class of market failure
To define externalities let us first define external effects: An external effect exists if the actions of
one or more economic agents enter as direct arguments in the utility or production functions of
other economic agents. That is, an external effect exists if the actions of one economic agent
directly affect one or more other economic agents. Externalities: There is an externality if an
economic agent(s) does something that directly influences (not indirectly through market prices)
some other economic agent(s) and there is the potential to make one of the parties better off
without making some of the others involved worse off. It is important to get the wording just
right. Or, equivalently, there is an externality if an external effect is produced at an inefficient
level. Contrast direct effects with indirect effects. A footballer kicking the ball on you in the face
is a direct effect; but a rich footballers buying houses in Mbezi Beach and driving up housing
prices in the area affects you, but not directly – it is an indirect effect. Effects felt through the
market place are indirect effects. The existence of a negative or positive non-price impact on
others (external effects) is necessary but not sufficient for the existence of an externality. If the
provision of the external effect is at the efficient level there is no externality, even though there
are external effects.
•
Think of examples of negative and positive external effects. Then
speculate on how likely they are or aren’t produced at inefficient levels.
•
What might cause an external effect to be produced at the efficient level?
Or not produced at the efficient level?
44
Consider smoking:
If smokers are allowed to smoke wherever and however much they want (with not
regulation or incentive to cut back) there is likely to be an inefficient level of smoking
–too much. Why, because the private cost to the individual of smoking another
cigarette is less than the cost to society of him smoking another cigarette. If smoking is
taxed such that the efficient amount of secondhand smoke is produced, the efficient
amount of smoke is produced and the amount is positive. There is no externality even
though some individuals continue to be injured by the secondhand smoke. Consider a
second example. If the efficient amount of secondhand smoke is achieved through a
regulation, there is no externality, and people are still adversely affected by the
remaining secondhand smoke.
Elaborating on the definition of an externality:
An externality is an activity of one entity that affects the welfare of another and is not reflected
in market prices. A key feature of this definition is that the welfare of others is not reflected in
market prices. To find the efficient level of activity, we need to know the marginal social cost.
Marginal social cost is the sum of marginal private costs and the marginal external costs, which
represent the damage done by the externally. Note that, without policy, the free market will not
lead to an efficient solution. Prices will reflect private costs, but not the additional external costs.
When the external effect is positive and the economic agents who produced the effect are
compensated to take full account of their actions, there is no externality. It does not matter
whether the funds for that compensation are collected from the agents who benefited from the
action or from some other source. Whether producers of the positive externalities should be
compensated is an equity issue. And, when the effect is negative and the economic agents who
produced the effect are required to fully incorporate the damages produced, there is no
externality. If the negative externality is internalized with a Pigouvian tax (a per-unit tax on
pollution), it does not matter whether the funds collected are paid to the damaged agents.
Whether they should be is an issue of equity. In summary, if the producer of the external effect
has the correct incentive to take the effects into account there is no externality.
Note that if a tax (subsidy) internalizes an externality, the tax revenues collected (total
subsidy paid) will not necessarily equal the total damages to the injured (value of the
benefits received). Efficient taxes/subsidies are, in general, based on marginal effects
rather than total effects.
45
Externalities result when property rights are not well defined. Therefore, one might conclude that
common property and externalities are closely linked. Could externalities exist if all property
rights were well defined?
7.3.3 Public Commodities
Public commodities possess the property that multiple agents can consume the same units of the
commodity. That is, the commodity is noncongestible in the sense that one agent's consumption
of a unit does no preclude or impinge on another agent's consumption of that same unit. Another
term for non-congestible is non-rivalous. Most economists would agree that non-congestible is a
necessary condition for a commodity to be a public commodity, but some economists would
conclude it is not a sufficient condition. Some would add the property of non-excludable,
meaning that once units of the commodity are provided to one agent no other agent can be
excluded from consuming those same units. The definition of a public commodity can be further
restricted by assuming, in addition to non-congestible and non-excludible, that everyone is
forced to consume all units of the public commodity produced. Note that this last condition does
not require that all are affected the same, but does imply non-excludible. A commodity is a
private commodity if one agent’s consumption of a unit of the commodity precludes another
agent’s consumption of those same units – we can’t both eat the same ice cream cone.
Note that paying for a commodity is not a necessary condition for the commodity to be
a private commodity. If it was, a commodity would not be a private commodity if
someone received it as a gift. Thus we can define public commodities as those
commodities that are noncongestible and everyone consumes every unit of the
commodity that is produced.
Public goods that are provided by the government are not necessarily public goods. For example,
roads and public schools are not public goods in our sense of the word. So, we need to
distinguish between public goods and goods provided by the government. The air is not a public
good. It is definitely congestible and no two individuals can consume the same unit of air. If air
was noncongestible, pollution would not be a problem and everyone could breathe the same liter
of air. There are no pure public good, and no pure private goods: consumption always has some
effect, often small, on others. It is probably better to use the word commodity than the word good
when discussing public commodities because many public commodities are goods for some
members of society and bads for other members.
46
Public goods have two key features: First is non-rival i.e. one person enjoying the
good does not keep others from enjoying it. Second feature of public goods is that they
are Non-excludable i.e. people cannot be kept from enjoying the good. This leads to
free-rider problem. Because the goods are non-rival, efficiency requires that the sum of
each individual's marginal benefit equal marginal cost. Underprovision results when
public goods are provided by a free market e.g. climate, clean air, parks etc. The
government can provide public goods and finance them with taxes. This helps to
alleviate the free-rider problem. However, it still may be difficult to get people to
reveal their true preferences for the good.
The market is incapable of efficiently allocating public goods. This is the heart of public
economics. The main reason is that a producer of the public good can’t make all those who
benefit from its availability pay for it. The producer does not have the ability to “tax”, and people
won’t freely pay for something if they can get automatically get it for free when someone else
pays the cost of production. In more detail, society wants public commodities produced up to the
point where the cost to society of the last unit produced (marginal social cost) is just equal to the
benefits to society from the last unit produced (the marginal social benefits). Marginal social
benefits are the sum of benefits all members of society get from the last unit produced. A private
firm will produce units of the public commodity up to the point where marginal private cost of
production (maybe equal to marginal social costs) equals marginal revenue, but for public
commodities marginal revenue will be way less than marginal social benefits: there is no way the
firm can get all member of society to pay the amount that they value the last unit produced
because once a unit is produced everybody consumes it regardless of whether they pay. Only an
entity with the power to tax (the government) can produce public commodities in the efficient
quantities.
Cite as many examples as possible to distinguish between public
resources and common property resources.
7.3.4 Excess Market power (monopoly and oligopoly)
The excess market power in resource and good markets are another category of market failure.
Monopoly power prevents the market from achieving efficiency. In general, excess market
power causes the producer to under-produce from society’s perspective. Under-producing from
47
society’s perspective is how a monopolist makes excess profits. The monopolist can control total
production of the product, so can produce less than would have been produced by a competitive
industry. It does this because the decrease in units sold is more that made up for by the higher
price it charges – doing this increases its profits.
There is a lot of monopoly and oligopoly power in the resources sector, e.g., big oil companies,
big mineral companies, OPEC, etc. Firms that harvest natural resources are often large. Note that
monopolistic holders of scare natural and environmental resources tend to be the
conservationist’s friend, and this is typically not a good thing. If, for example, only competitive
firms owned oil reserves, every year more of each year’s reserves would be extracted than if the
oil reserves were owned by only one or only a few agents (firms, governments, etc.).
7.3.5 Lack of markets
The market cannot efficiently allocate resources if markets do not exist for some of those
resources. If there is no market for beer (places where beer is bought and sold), the market
economy won’t efficiently produce or allocate beer. There is only a very limited market for the
use of air. Water markets are imperfect, at best, and often non-existent, the same is true for many
other environmental resources and amenities.
In the U.S for example., there are tradable permits for SO2 emissions. Many potentially
important futures markets don’t exist. A futures market for commodity X is a market where one
can buy and sell X today for delivery at some specified future data, and payment either now or at
some specified future date. Society wants to achieve intertemporal efficiency in the use of its
scarce natural resources, but the market cannot do it if markets for the future delivery of these
resources do not exist.
Assuming three generations (now, the near future, and the distant
future) define intertemporal efficiency.
If we want the market to efficiently allocate oil between now and 2050, a market has to exist
where one can buy and sell oil now for delivery in 2050 and payment either now or in 2050. If
there are no long run futures markets for oil, producers are more likely to leave too little in the
ground for the future. Markets require well-defined property rights, including enforcement, and
low transactions costs. Lack of these will result in a lack of markets. This suggests that one way
48
to reduce the inefficiencies associated with market failures is to create markets, future or
otherwise, where they do not currently exist. This can be achieved through:
•
Clear up ambiguities with reference to property rights; that is, make sure property rights
are well defined
•
Create institutions and policies that will decrease the cost of trades
Examples of new markets – the U.S. market for SO2 emissions, EBay, and the web in general.
The effect could, in theory, go the other direction, but this is unlikely.
7.3.6 Distortions in capital markets
That is, the market rate of interest is either too high or too low from an efficiency perspective.
The following sorts of factors would cause such distortions:
•
Lack of access to capital markets by some of the players in the market place. For
example, poor farmers in poor countries often have no place they could go to borrow
money for seeds and fertilizer. Micro-credit, a recently new phenomenon, is a program to
fill this gap in credit markets; it proves small loans (a few hundred dollars at most) to
small businesses in developing countries.
•
Racial minorities often have less access to credit than others. For ethical reasons one
cannot use human capital as collateral for a loan. While this is good from an ethical point,
it likely causes inefficiency in the capital market. If human capital was collateral on a
loan and one faulted on a loan, the loaner would then own your capital – this is called
slavery, and it is frowned upon.
7.3.7 Imperfect Information
The market depends on perfect information, so that everyone knows all of the options available
to them. If this is not possible, people may not make optimal choices. Note that imperfect
information is when different parties have different levels of information. If no one realizes an
activity is bad, imperfect information is not the problem. It may be that the result is uncertain.
Uncertainty is an important consideration for environmental policy, which we will discuss later
in the course. However, if all sides have the same knowledge, even if uncertainty exists,
imperfect information is not a problem. Imperfect information is relevant to environmental
economics because people may have imperfect information about things such as health risks or
the dangers of pollution. To overcome or lessen impact of imperfect information the following
can be done:
49
•
Information can be provided by the government or by private individuals.
•
The government may provide services that are not provided by the market because of
imperfect information (e.g. insurance).
One must distinguish between market failure in capital markets and a divergence between
the market rates of interest and the social rate of discount due to intergenerational equity issues.
We have been talking a lot about market failures. The following is a list a set of
conditions that increase the likelihood that there will be no market failures; that is,
conditions under which the competitive equilibrium will be efficient.
i) Well-defined property rights for all scarce resources
ii) Well-developed markets for all scarce resources
iii) Complete set of futures markets
iv) All markets competitive as possible
v) Absence of external effects
vi) Absence of public commodities
We have talked a lot about how the market does or doesn’t do a good job of
allocating resources We need to keep in mind what markets are. The market system
is an institution that developed to allocate resources and allocate goods and service.
There are other institutions that have also evolved to allocate resources and
distribute goods. They include: the government, the family, centrally planned
economies, tribes, dictators, the religious institutions, etc. They all have their
advantages and disadvantages. Note that some of the largest centrally-planned
economies are big corporations such as Microsoft and Wal-Mart.
While, ceteris paribus efficiency is a good thing…..If society had to choose
between a specific efficient allocation that was very unfair and a specific inefficient
allocation that was fairer, a welfare maximizing society might choose the
inefficient allocation over the efficient allocation.
50
LECTURE EIGHT
VALUING ENVIRONMENTAL BENEFITS
8.1 Introduction
The most controversial aspect of analyzing the costs and benefits of environmental aspects is
placing a value on human life. Two questions deserve asking concerning the true meaning of
value: Is it merely the opportunity cost (e.g. foregone wages)? Or Are there other values (perhaps
non-market values) that need to be considered? In this lecture we will consider various ways
used to assign a value and hence willing to pay for the envisaged environmental benefits. First let
us start with the concepts of the value of a life.
At the end of this section you are expected to be able to:
1. Describe the concept of value in relation to the environment
2. Explain different Revealed Preference Approaches (RPA) of valuing
environmental policy and resources
3. Explain Stated Preference Approaches (SPA) of valuing environmental policy
and resources
8.2 Concepts of the value of a life
The most commonly used value is the value of a statistical life. We don't know who will die, but
we expect someone will. The value of environmental protection is lessening the risk of someone
dying. Note that specific deaths capture the attention of individuals. However, that is not what a
statistical life focuses on. We are valuing changes in the probability that a random individual will
die, by asking what the willingness to pay for changes in risk. For policy, this is the most
appropriate measure, because policy does not prevent death, but rather changes the probability
that death will occur. The value can also be put into annual figures as Value of a Statistical Life
Year (VSLY). Contrast this with the optimal insurance and compensation of accident victims.
Here, things such as the opportunity cost of foregone wages and medical expenses make sense,
since now we are focusing on a specific loss. Let us now reflect ourselves to consider what
makes up the value of environmental amenities:
a) Use value
This is the benefits people get from direct use of a good. For most consumer goods, this is what
we care about. For environmental goods, this can include but limited to the value of recreation at
51
a site, the value of open land near a home, the value from better health, and the value of
ecological services provided (e.g. by a wetland)
b) Non-use value
For environmental goods, not all value is use value. Examples of non-use value include the
following:
i) Option value – the amount a person would be willing to pay to preserve the option of
being able to experience a particular environmental amenity in the future. Even if you
won’t go to the Ngorongoro Crater this year, preserving it may have value to you so that
you can visit in the future.
ii) Existence value – a willingness to pay simply to help preserve the existence of some
environmental amenity. Protection of endangered species is an example.
iii) Bequest value – a willingness to pay to leave behind environmental quality for future
generations.
iv) Stewardship value – a value placed on preserving the environment not for human use, but
rather to maintain the health of the environment for all living organisms.
To measure value, economists focus on willingness to pay (WTP). We can see willingness to pay
from a demand curve we covered earlier in this course. WTP is simply the area under the
demand curve. Recall that the difference between what consumers actually pay and the actual
price is the consumer surplus. Willingness to pay includes actual expenditures and consumer
surplus. Thus, simply using a direct measure of expenditures ignores the consumer surplus, and
underestimates the value. Putting these together, the net value is the sum of consumer surplus
and producer surplus. Since policy analysis should focus on marginal analysis, we want to ask
how these change as we have an incremental change in pollution.
Economists typically use one of the following two approaches to measure the benefits of
environmental quality: Revealed Preference Approaches RPA) and Stated Preference Techniques
(SPT). Let us discuss each of these approaches in the rest of this lecture.
8.3
Revealed Preference Approaches (RPA)
RPAs infer the value of environmental goods from other market transactions. Note that revealed
preference approaches get at use values, but not non-use values. The most popular RPAs include
52
aversion costs, travel cost method, and hedonic pricing techniques. We will briefly discuss these
approaches in the rest of this section.
8.3.1 Aversion Costs
This refers to expenditures necessary to reduce risk. For example, how much more will people
spend for a car with airbags, or for bottled drinking water? The main challenge is separating
value assigned to changing risk to other characteristics (e.g. other features of the car, or better
taste for bottled water). Note that, in reaction to environmental harms, people may undergo
expenses to remedy the problem. For example, filters for drinking water, air conditioners so that
windows can remain closed, medication to mask symptoms of health effects, shrubbery to hide a
polluted neighboring site etc. By studying how much people spend on averting expenditures, we
can estimate the benefits they would receive if the harm were removed. Example: a study of Los
Angeles in 1986 found that people would pay $0.97 to avoid shortness of breath to $23.87 to
avoid chest tightness.
In order to reduce risks through increased expenditure requires people to have perfect
information about risks, and to be able to evaluate this information properly. People must take
risks knowingly and willingly?
8.3.2 Travel Cost Method
The travel cost method looks at how far visitors travel to come to a site. By placing a value on
the cost of travel, we can infer the value of the site. The travel cost includes both direct costs
(e.g. airfare) and indirect costs (e.g. the opportunity cost of travel time). We can infer the value
of a change in quality by looking at demand during different days (e.g. in different types of
weather).
Example: Some USA economists surveyed 826 tourists in Florida and asked interviewees the
following questions from which they could derive a demand curve: how many days did you use
the beach? Where are you from? How much did it cost to get there? What is the total length of
your stay? The results were that average tourist spent 4.7 days at the beach and the average
daily expense was $85. To calculate consumer surplus, the economists needed to know the slope
of the demand curve. Using regression analysis, they found that demand for beach days was
inelastic i.e. 10% increase in “price” leads to a 1.5% decrease in time on the beach. Using this,
they could plot the demand curve and found that the consumer surplus for 4.7 days =
53
$179 (average of $38/day). To get a total value of beaches, they note that tourists spend 70
million tourist days/year on the beach, hence concluding that the total value of Florida beaches
= $2.37 billion.
There are some potential problems with the travel cost method ie:
•
What is the opportunity cost of time?
•
Only measures value of those that use the amenity. We need to account for substitutes.
For example, do all beach users in Florida come for the beaches, or are they there for
other reasons (e.g. Disney)?
•
Quality is not always measured.
•
Sampling bias in surveys.
8.3.3 Hedonic Pricing Techniques
Hedonic pricing techniques look at the value that people place on the attributes of a good. That
is, it assumes that people don't value a house itself, but rather the features of a house (e.g.
number of rooms, location, is there a fireplace). One such feature is environmental quality. Using
regression analysis, we can find the correlation between housing prices and environmental
quality in an area. Most studies find an elasticity of housing prices with respect to pollution that
is around 0.1. That is, a 1% decrease in pollution leads to a 0.1% increase in housing prices.
A sample study is "The Determinants of Residential Property Values with Special Reference to
Air Pollution," By Ronald G. Ridker and John A. Henning (Review of Economics and Statistics,
May 1967). If you are interested in reading the article, you can click on the title to be taken to it
in J-Stor (http://jstor.org/cgi-bin/jstor/viewitem)
8.4 Stated Preference Approaches (SPA): Contingent Valuation
SPAs ask individuals hypothetical questions about their willingness to pay to protect
environmental resources. So far, we have studied revealed preference approaches to valuing
environmental amenities. Those approaches look at actual market transactions to infer value.
Unfortunately, there aren't always market transactions that can serve this purpose. For example,
how do we value protection of endangered species? In these cases, economists simply ask people
for their valuation. The most common technique is contingent valuation (CV).
54
Is the CV method capable of providing estimates of lost nonuse or
existence values that are reliable enough to be used in natural resource
damage assessments?
How contingent valuation works:
i) Ask people their willingness to pay (WTP) to bring about a specific environmental
improvement. The problem must be described carefully and it must be specific. Types of
questions:
•
open-ended - ask respondents for maximum WTP.
•
close-ended -ask respondents whether they are WTP a certain amount. This amount is
varied across respondents.
•
bidding games -ask respondents whether they are WTP a certain amount. If they say yes,
ask them about a higher amount, until you find the highest amount they are WTP.
ii) A payment mechanism is specified. The mechanism must be believable (e.g. increase sewer
fees to improve water quality). It should not be controversial (e.g. property taxes). This is
because the survey shouldn't serve as a referendum on the type of payment mechanism
chosen.
iii) Information about the respondent is gathered e.g. income, age, education etc. Allows
verification of results, estimation of income elasticities, etc.
Examples of Results:
a) First CV: Davis (1963) found the value of outdoor recreation opportunities in the Maine
woods to be between $1 and $2 per day.
b) Valuing clean air:
•
WTP to avoid health problems: $10 per asthma day reduced
•
WTP for better visibility: A 10 percent increase in visibility has been valued as
between $7 and $101. Increased visibility at the Grand Canyon has been valued
between $5 and $10.
c) Valuing cleaner water:
• WTP to improve water from "boatable" to "fishable": $12.30
• WTP to improve water from "boatable" to "swimmable": $29.60
However, WTP is a small percentage of income. There could be large substitution effects
between X and Y
55
LECTURE NINE
COST-BENEFIT ANALYSIS OF ENVIRONMENTAL POLICY
9.1
Introduction to Cost-Benefit Analysis (CBA)
The primary goal of CBA is to maximize total net benefits (= total benefits - total costs). CBA
calculates the costs and benefits of a project and finds the total net benefits. Note that some costs
and benefits can be observed directly from market data. Others will need to be inferred from
data.
At the end of this section you are expected to be able to:
9.2
1
Explain important steps of carrying out CBA of any environmental aspect
2
Explain how environmental uncertainty can be handled when undertaking CBA
3
Describe discounting methods of Costs and benefits of any environmental aspect
4
Describe Various concepts of environmental cost and its computation
5
Explain main categories of environmental cost.
Steps to cost-benefit analysis
i) Specify clearly the project or program - For environmental economics, this is usually a
physical project such as a dam or wastewater treatment plant, or a regulatory program, such
as pollution control standards.
ii) Determine quantitatively the inputs and outputs of the program - This can be difficult – for
example, general equilibrium effects. Also, it is important to distinguish between transfers of
resources due to substitution and the creation of new resources. For example, jobs created by
a project should normally not be included as a benefit. Jobs created are a transfer of
resources. If the project wasn't done, the workers could have been used elsewhere.
iii) Estimate the social costs and benefits of these inputs and outputs.
iv) Compare these costs and benefits - Here; one can also include other considerations, such as
equity.
9.3 Dealing with Uncertainty
The first step in dealing with uncertainty is risk assessment. Risk has two components:
a) stochastic – depends on chance and
b) systematic – depends on circumstances (e.g. a smoker is more likely to get cancer)
56
In addition, assessing risk involves two concerns: the probability of an event occurring and how
serious the event will be. We can assess risk through the following:
a) Focusing on finding the probability of an event occurring. Risk can be determined by looking
at past records. However, it is important to be aware of changes that occur over time. For
example, increased safety features reduce the risk of death from auto accidents. This is a
change in systemic risk.
b) We can also assess risk by component analysis which is a tool often used to assess the risks
of new technologies. The problem with this tool is that components may be related.
c) Risk by analogy- Often, time lags make perceiving risk difficult. For example, cancer may be
caused after exposure to a toxin, but only after many years. As a result, studies on animals
are often used to extrapolate human risks. The problems with risk by analogy approach are:
•
Animals are exposed to unrealistically high doses of toxins in the laboratory.
•
Need to extrapolate risk of humans from low exposure from calculated risk based on high
exposure.
•
Physiology of animals and humans may be different.
•
The risk may be different for different people.
A complication for policy makers is that, even after risk assessment is complete, people have a
hard time perceiving risk accurately. Risk assessments are hard to understand, as they typically
involve low probability events. Thus control is important. Consider that most people worry more
about air travel than auto travel, although the likelihood of dying in a car accident is greater.
People may pay more to avoid unpleasant deaths. For example: what should the standard for
ammonium perchlorate in groundwater be? This example shows how different criteria for risk
assessment suggest different answers by US environmental stakeholder:
a)
Environmental Protection Agency (EPA) proposes a standard of 1 part per billion (ppb).
They look at sensitive populations, including the risk to fetuses. They also make use of
laboratory studies.
b)
Pentagon - Proposes a standard of 200 ppb. Note that this standard would release the
Pentagon from most cleanup responsibility. They base their figure on a study of exposure
to human adults.
Thus, one study focuses on more sensitive populations, whereas the other focuses on exposure to
a typical person.
57
Both environmental stakeholders (EPA and Pentagon) can be justified.
Which is correct?
Once risk has been assessed, policy makers face several alternatives for using the information:
a) For CBA purposes, pieces of information needed to deal with risk include:
•
The risk probability - The governments often use conservative estimates (e.g. 95%
percentile).
•
The population exposed - For example, USA’s superfund regulations consider possible
future populations on a site.
•
The value of a life
b) Avoid upper bound of risks - Government agencies, such as EPA, often use conservative risk
estimates (e.g. 95% percentiles). However, this adds up If 95% percentiles is used for several
estimates, actual percentile is above 99% (.95 x .95 x .95). Consider two chemical hazards
scenario: Chemical A poses a known risk of 2 in 100,000 and chemical B is uncertain. 9 out
of 10 scientists believe no risk 1 out of 10 believe risk is 6 in 100,000. Government policy
says risk of B is greater, since focuses on upper bound – that is, greatest potential risk.
However, chemical A has a higher expected value of risk.
c) Cost-Effectiveness analysis - Rather than compare costs and benefits, simply show that the
agency has adopted the cheapest way possible to achieve its goal. This analysis takes the
policy objective as worthwhile. We can then ask if the costs justify the benefits received,
without needing to place a dollar value on the benefits.
d) Risk-risk analysis - Compare risk after regulation to risk before. Notes that regulation will
affect behaviors, and could even increase risk. Let us consider special attention in risk-risk
analysis:
•
Substitution risks - If substances that replace banned substances are also risky, net gain
from banning the substance is not as great as it seems.
•
Risk of other economic behavior - For example, what is the additional risk of industrial
accidents from workers who manufacture scrubbers for power plants?
•
Opportunity costs of diverted resources - What do we give up in other expenditures (e.g.
health care) by spending more on regulation?
58
9.4 Discounting methods
The costs and benefits we've discussed often occur at different times. To compare them fairly, it
is important to discount costs and benefits that occur in the future. The idea is to compare a flow
of benefits and costs into a single value. The present value of a future amount of money is the
maximum amount you would be willing to pay today for the right to receive that money in the
future. Present value accounts for the opportunity cost of not investing the money elsewhere.
For example: Suppose you have $100 now, if you put it in the bank, you will get 5% interest.
Next year, that money is worth (1 + 0.05) x100 = $105. After two years, it is worth
(1.05)(1.05)(100) = (1.05)2(100) = $110.25.
General rule of the discounting method: FV = PV(1 + r)t
Whereby FV = future value, PV = present value, r = interest rate. As a result, you wouldn’t give
up $100 now for $100 next year, because you could invest the money and get $105 next year.
The present value of $100 next year is the most you would give up today to get $100 next year
i.e.
FV = PV(1.05) = $100(1.05)
PV = FV/r = 100/1.05 = $95.24
General rule PV = FV/(1 + r)
For a stream of payments: PV = x + X/(1+r) + X/(1+r)2 + … + X/(1+r)t.
For payments forever: PV = X/r
“Rule of 70” is normally used to get the number of years needed to double an investment, divide
70 by 100 times the growth rate. Example: if money is invested at 10%, it doubles every 7 years
[= 70/(0.1x100)]
9.4.1 Discount rate, r
To proceed, we need to know what value to use for r. This is the discount rate. The discount rate
reflects the relative value a person places on future consumption compared to current
consumption. Lower values show a greater preference for future consumption. If your discount
rate is greater than the interest rate, you will be willing to borrow money. A high discount rate
says that current consumption is important to you. If your discount rate is lower than the interest
rate, you will be willing to loan money. A low discount rate says that future consumption is
important to you. Since the market interest rate reflects equilibrium of lenders and borrowers, we
59
can use the market interest rate as a measure of the discount rate. Let us explain briefly as to why
the discount rate matters:
a)
Discounting affects the value placed on future benefits and costs.
b)
Higher discount rates place less importance on future returns. - Note, for example, how
this is a particular problem for long-term problems such as climate change. A very low
discount rate suggests we would give up virtually all consumption today to protect the
future. However, a higher discount rate suggests very distant benefits have little weight in
decision making.
c) There are several market interest rates. Which should we use? Typically, economists use a
risk-free rate. In USA fir example, investors looking for a safe return invest in U.S. Treasury
bills. Thus, the return on T-bills is a measure of the nominal risk-free rate. To purchase
assets that are riskier, investors need to be compensated with a higher rate of return. This
additional return is known as a risk premium.
d) Note also how the discount rate relates to economic growth theory
Discount rate = pure rate of time preference + growth rate of income x elasticity of marginal
utility for income. The first term captures the relative weight placed on the future versus
today and involves ethical judgments The second term acknowledges that, due to economic
growth, we expect future generations to be richer. If the marginal utility of income falls as we
get richer, then additional money is less valuable when we are richer.
e) Might the social discount rate deviate from the market rate?
The above estimates use market data to determine the discount rate. Are their reasons to
believe that the market rate is flawed? Some economists argue that the opportunity cost of
foregone future consumption might differ from the opportunity cost revealed in the markets.
In this case, it might make sense to use a social discount rate which is lower than the rates
observed in the marketplace.
9.4.2 Social discount rate
The social discount rate represents the willingness of society to trade off present and future
consumption. If there are market failures, this may differ from discount rates observed from
market behavior. Let us ask ourselves as why market rates might not be appropriate. Although
long term projects involve benefits or costs for future generations, the future generations are not
represented in the market. People may be myopic, and thus not save sufficiently. There may also
be other externalities that cause the market rate of return on investments to deviate from the
social discount rate, such as positive externalities from research and development. Uncertainty
60
may be a concern, therefore, risk aversion may justify using a lower discount rate. However,
uncertainty is not an excuse to do nothing. Let us suggest what can be done to select appropriate
discounting rate
•
Compromise view: Use the market rate for the first 30 years of a project, and a lower
social discount rate afterwards. The intuition is that, for the first 30 years or so, the
market rate is a reasonable guide to individual preferences. However, since the market
rate may ignore future generations, a lower rate is used for benefits and costs affecting
future generations.
•
Alternatively, analysis can be done without discounting. Note that this is a controversial
view in economics. Most mainstream economists would disagree with a zero discount
rate.
9.5
Concepts of Cost
9.5.1 Important concerns on how costs will be conceptualized
a) Establishing the baseline - We want to compare costs with regulation versus without
regulation, not before and after regulation. Even without regulation, we expect some
things to change over time.
b) Distributional issues - Note that costs will often be focused on a few individuals (e.g.
affected firms or communities). Benefits are more likely to affect a wider range of
people. Thus, equity concerns will be an issue.
9.5.2 Broad categories of costs
a) Opportunity costs
Opportunity cost is the value of the best forgone opportunity. It is what we give up by using a
resource for this use, rather than the next best alternative use. Example: an opportunity cost of
going to school is foregone salary. It is also very important to distinguish between costs and
transfers.
b) Environmental costs
Because most regulations focus on a single pollutant, regulating one pollutant may increase the
use of another pollutant. Example: using scrubbers to clean SO2 emissions leaves behind a
sludge that must be disposed of.
c) Enforcement costs
For enforcing laws, regulations and standing orders. For example court levies, policing costs,
rents etc
61
d) Implicit costs
Non monetary costs of inconvenience, time searching for substitutes, lost product variety, etc.
Few studies include implicit costs
9.5.3 Estimating Costs
a) Costs of a single facility
For some projects, such as building a wastewater treatment plant, we need only consider the cost
of a single facility. In other cases, we may need to aggregate the costs per facility to get industry
totals. Estimation depends primarily on engineering estimates. After regulations are in place,
survey data is available. Two types of costs can be obtained:
•
Fixed cost of building a facility (considered capital costs by accountants) - Expenditures
for plant, equipment, construction, and making process changes. These costs won’t
change as the level of abatement changes.
•
Variable costs of operation (operating and maintenance costs) - Costs incurred in the
operation and maintenance of abatement processes, such as labor, energy, and R&D.
These costs will vary with the level of abatement. The present value of costs over the life
of a facility is needed.
b) Estimating the cost of lost jobs, lost income to merchants, etc.
If the workers will be absorbed into the economy, these are not a cost to society. Certainly the
workers themselves are affected, but the resources are still being employed. For larger scale
regulations (e.g. an entire industry), we cannot assume that resources now unused will be used
elsewhere. The US Department of Labor regularly surveys firms for the reasons for mass
layoffs. Less than 0.1% are attributed to environmental regulations.
c) Abatement cost data
These are costs incurred normally by governments in order to decrease/lessen the perceived
environmental risks. For example US spent 121.8 billion on Pollution Abatement and Control
Expenditures
(PACE)
in
1994.
This
was
equivalent
to
about
1.7%
of
GDP
(http://www.census.gov/econ/overview). The amount was spent as follows: 96.6% on abatement,
8.0% personal spending, 62.9% business, 25.6% government, 1.8% on monitoring, and 1.6% on
R&D. A 1999 pilot survey (http://www.census.gov/prod/2002/pubs/ma200-99.pdf) focused on
USA’s PACE in manufacturing industries found out that $5.8 billion was spent on PACE capital
expenditures and $11.9 billion on PACE operating and maintenance expenditures.
62
9.5.4 How Accurate are Cost Estimates?
a) Sources of error – One difficulty is that errors can come in many ways. The most obvious is
incorrectly estimating the costs of control. However, even if the cost of control is estimated
correctly, predictions about emissions levels, number of plants, etc. can also be wrong.
b) Evaluation of estimates
Harrington et al.1 study 25 estimates of the cost of regulation. They compare pre-regulation
estimate to actual costs after the regulation is in place. They label an estimate as “accurate” if it
within 25% higher or lower than the actual costs. They find that the costs more likely to be
overestimated as shown in the following table of results:
Accurate Overestimate Underestimate Unable to Determine
Quantity Reduction
10
9
4
Unit Pollution Reduction Cost
7
12
6
Total Cost
5
12
2
2
6
Source: Harrington et al (2000)
Discussion of Harrington’s results: The two underestimates were for rather “minor” regulations:
EPA2 aldicarb ban and OSHA’s3 powdered platform regulation. EPA and OSHA tend to
overestimate reductions, but not per unit costs. As a result, total costs are overestimated. State
and foreign agencies were more likely to overestimate per unit costs. For market-based polices,
seven of the eight estimates overestimated costs! Note that this is where we would expect
technological innovation to be most important.
c) Why do errors occur?
•
Many estimates ignore the possibility of technological innovation.
•
Regulators have an obligation to identify a means of complying with the regulation,
which usually means considering current technologies.
•
Future technologies are much harder to predict.
•
Quantity errors - misestimating baseline emissions. However, keep in mind that this also
means that benefits are wrong. For example, overestimating emissions reductions
overestimates costs, but also overstates the benefits.
1
Harrington, W., et al. (2000) ‘On the Accuracy of Regulatory Cost Estimates’, Journal of Policy Analysis and
Management, Vol. 19, Spring 2000 (No. 2), 297-322.
2
Environmental Protection Agency
3
Occupational Safety and Health Agency
63
•
Regulations may change during the public comment period. Thus, cost estimates aren’t
for the final regulation.
•
Estimates may focus on maximum values, rather than means. This is so especially if
analyses rely on industry for data.
•
Asymmetric correction of errors. Firms are likely to bring underestimates to the attention
of regulators. There is no similar group with strong incentives to bring overestimates to
the attention of regulators.
64
LECTURE TEN
NATIONAL INCOME
10.1 Introduction
It is important to explain how the overall production performance of the economy is measured.
This is referred to as national income accounting. By definition national income refers to the
total of all incomes, including wages, rents, interest payments, and profits received by
households.
By the end of this lecture, you should be able to:
1.
Define and appreciate the use of the national income accounting
2.
Understand computation of national income accounts
3.
Correlate the relationship between national product, expenditure and
national income.
10.2 National Income Accounting
National income accounting is the recording of the nation’s economic activity over time. The
department of the government ministry in charge of gathering economic activity data publishes
these accounts. National income accounting measures the level of production at some point in
time and it explains immediate causes of that level of production.
10.3 Uses of National Income accounts
Uses of national income accounts include, among others, the following:
(a) National income accounts help us to assess the economic performance. It enables us to
understand better the pattern of our economic activity and explain the reasons behind the
pattern.
(b) It is possible to track the long run flow of the economy and observe whether it has grown,
been steady or stagnated.
(c) Governments use national accounts data to formulate appropriate medium and short-term
stabilization policies.
(d) They are used to measure the standard of living of a country, for example income per
capita.
(e) They are used to compare the wealth of different nations.
65
(f) The accounts are used by business to anticipate market trends and subsequent investment
expenditure.
10.4 Measurement of national Product
In lecture 11 we defined Macroeconomics as the study of the economic aggregates and the
relationships among the major aggregates, which constitute the economy. For example studies on
total employment, the unemployment rate, national product and the rate of inflation fall under
macroeconomics. One way of judging the performance of the economy is to measure the
aggregate production of goods and services. Measuring aggregate production implies adding up
a range of product into a single measure of national product (e.g. cars + cement). Markets
provide an answer to the measuring of national product.
Table 10.1 Determination of market value
Item
Quantity
Unit Price (million)
Market Value
Cement
20
3
60,000
Tractor
10
15
150,000
Table 10.1 illustrates the procedure used to compute market value of goods and services. It is
indicated for example, that one tractor is worth 5 tons of cement. When market prices are used it
should be possible to compare cement and tractors and it is possible to add cement and tractors
(in terms of their values). Thus in our complex economy, the total value of output can be found
in a similar way as follows:
•
By taking quantity times the market price, it is possible to find expenditures on a particular
product.
•
Adding up expenditures for many goods produced we can get a monetary measure of
National Product.
•
Adding up incomes of the different factors of production, we can also get a measure of
National Product.
•
Thus national product can be measured by either expenditure approach or income
approach
66
10.5 Expenditure Approach to GNP
Measuring national product through the expenditure approach requires that only expenditures on
the final product be added. Adding expenditures on final products avoids double counting e.g.
bread and cars are final products but wheat and steel are intermediate products. Thus to avoid
double counting national product is found by adding up only expenditures on final products.
Double counting in this case is adding up the expenditure on intermediate product purchase and
final product purchase. Value added is the difference between the value of a firm’s product and
cost of intermediate product bought from outside suppliers.
Table 10.2 Illustration of Value Added
Wheat
Value Added
Flour
Bread(Wholesale)
Bread(Retail
100
250
450
600
100
150
200
150
National product in the expenditure approach is the money value of final goods and services
produced in the economy. Expenditure on final goods/products falls into the following
categories:
(a)
Government purchases of goods and services (G). Transfer payments such as subsidies are
not included.
(b)
Personal consumption expenditure (C) on durable goods, non durable goods and on
services
(c) Private domestic investment (I) in Plant and equipment (new and renovations) and Changes
in inventories (increases in inventories or decreases in inventories).
(d) Exports of goods and services (X). This includes services demanded by foreigners e.g. Hotel
accommodation
(e) Imports of goods and services (M). This is subtracted in expenditure because these products
have not been produced in the country.
Gross National Product (GNP) = Personal consumption expenditures (C)
plus Government purchases (G)
plus Private domestic investment (I)
plus exports of good and services (X)
less imports of goods and services (M)
Or GNP = C + I + G + X – M.
67
10.6 Income Approach to GNP
Each time something is produced and sold, someone obtains income from producing it. More
precisely, each unit of expenditure will find its way partly into wages and salaries, and partly into
profits, interest or rents. It follows that if we add up all incomes we should get the value of total
expenditure. It would be most convenient if we could simply say that the total expenditures upon
the economy’s annual output flows to households as wage, rent, interest and profit incomes.
Unfortunately this is complicated by two non-income charges against the value of total output,
that is, against GNP. These are (i) a capital consumption allowance, and (ii) indirect business
taxes.
Capital consumption allowance refer to the depreciation charge made for the economy as a
whole against the total receipts of the business sector in order to accurately state profits and total
income for the economy.
Indirect business taxes refer to certain taxes levied by the government such as general sales
taxes, license fees, excise and business property taxes, and customs duty – which business firms
treat as costs of production. These taxes are called indirect taxes because they are not levied
directly upon the corporation, partnership, or proprietorship as such but rather, upon their
products or services.
In national accounts, profit is broken down into two basic accounts namely proprietor’s income
or income of unincorporated businesses and corporate profits. Three things can be done with
corporate profits:
(i) A part will be claimed by, and therefore flow to, government as corporate income taxes
(ii) A part of the remaining corporate profits will be paid out to stockholders as dividends
(iii) The remaining part of corporate profits after paying (i) and (ii) above is called
undistributed corporate profits.
GNP can therefore be determined by adding up the following: Capital
Consumption allowance (CA), Indirect business taxes (IT), Wages (W), Rents
(R), Interest (I), Proprietor’s income (PI), Corporate income taxes (CT),
Dividends (DP), and Undistributed corporate profits (UP).
68
10.7 Other Social Accounts
(a) Gross Domestic Product (GDP)
National product is usually measured either by the GDP or by the GNP. GDP is defined as the
value of the gross output of goods and services produced in the country. GNP is the same as
GDP except that GNP includes income earned abroad and excludes income transferred out of the
country by foreign owners.
(b) Net National Product (NNP)
Gross National Product (GNP) refers to the total market value of all goods and services produced
in any economy over a given period of time, usually one year. GNP as measure of national
product tends to give an exaggerated picture of the year’s production because it fails to make
allowance for that part of the year’s output that is necessary to replace capital goods consumed in
the year’s production. Due to wear and tear of plant and equipment, an allowance has to be
made on depreciation. Subtracting the capital consumption allowance (depreciation) from GNP
gives NNP. Thus, NNP = GNP - Depreciation
(c) National Income
National Income is the income earned by resource suppliers for their contributions of land,
labour, capital and entrepreneurial ability, which go into the year’s net production. The only
component of NNP, which does not reflect the current productive contributions of economic
resources, is indirect business taxes. If indirect business taxes are subtracted from the NNP, the
resulting figure is the National Income
(d) National Disposable Income (NDI)
It may happen that a country/individual receives or sends substantial remittances. National
Disposable Income becomes national income plus net transfer receipts/payments. National
Disposable Income (NDI) measures the aggregate resources available to the nation for
consumption or saving.
10.8 GNP, Expenditure and National Income
We have seen that GNP is the value of output of goods and services produced during a given
period of time. The types of prices used are market prices. Market prices have two components
i.e. Market prices = Factor costs + Indirect taxes
69
Factor costs are payments to factors of production. Indirect taxes are taxes such as sales taxes
levied by government. They are included in prices paid for goods and services.
It should be noted that:
(a)
If all income is to be presented by payments to factors of production then this income is
known as national income at factor cost (i.e. we assume that all expenditures and
commodities go to suppliers of factors of production).
(b)
If it happens that the government imposes taxes on commodities purchased, by simply
summing up such expenditures we obtain national expenditure at market prices.
Inclusion of indirect tax does not amount to additional output since the tax accrues to the
government and not paid to factors of production supplied. Indirect taxes are those taxes
levied on goods and services.
(c)
If subsidies are included, they perform a negative function of indirect taxes, which will
mean that market prices are lower than the factor cost of the goods and that factors of
production receive incomes from sale of goods in excess of consumers expenditure on
them.
(d)
Combining indirect taxes and subsidies, one can obtain net indirect taxes. If net indirect
taxes are positive then national expenditure at market prices exceeds national income
at factor cost by this amount.
National Expenditure at market Price
MINUS
Indirect taxes
PLUS
Subsidies
EQUALS
National Income at Factor Cost
70
Fig 10.1 Determination of National Income
•
Net factor income paid abroad EQUALS factor income obtained from abroad minus
factor income paid abroad.
•
Excluding net indirect taxes from market prices gives factor cost. Exclusion of
depreciation (allowing for) reduces gross values to net values.
In this lecture we have explained various national income accounts and how they are
measured. The understanding of all these accounts is necessary because they can help us
assess the performance of our national economy and be able to give explanation on the
differences. It can as well be possible to make comparison between national economic
performance and those of other nations. We have also learnt that two approaches are
commonly used to assess national product: the expenditure approach and the national
income approach. Both approaches give the same final value of GDP. It was also realised
that national product can be measured using input cost hence called GNP at factor cost or
using market price hence called GNP at market prices.
71
?
REVIEW QUESTIONS
1.
Are the national income figures good indicators of genuine socioeconomic welfare? Explain your answer
2.
Compare the output or expenditure approach with the income approach in
national income determination. Which one is more effective? Why?
3.
Review your understanding on the meaning of the following terms
National income, National product, National disposable income, Personal
disposable income, Gross national product, Gross domestic product, and
Value added
4.
The following are the items of the income statement of the economy for
the year 2005 (in billion of US dollars):
Rents…………………………………………………...24
Personal consumption expenditures………………..1,080
Corporate income taxes………………………………..65
Undistributed corporate profits………………………..18
Net exports……………………………………………...7
Dividends……………………………………………...35
Capital consumption allowance……………………...180
Interest………………………………………………...82
Indirect business taxes…………………………… ..163
Gross private domestic investment…………….…….240
Compensation of employees……………………….1,028
Government purchases of goods and services.………365
Proprietors’ income…………………………….……..97
Determine the Gross National Product using:
(a) Expenditure approach
(b) Income approach
72
LECTURE ELEVEN
ECONOMIC GROWTH AND THE ENVIRONMENT
11.1
Introduction
Up to now, the analysis of environmental resources has focused on microeconomic issues. That
is, how individual actors do behave, and what incentives do affect this behavior. This analysis
allows us to find the optimal level of various activities. However, all of these activities affect the
economy as a whole. Consider, for example, the effect of higher energy prices on the economy
during the 1970’s. Also, we need to know how economic growth affects the environment. Is
economic growth good or bad for the environment? To begin, we must distinguish between
economic growth and economic development. Growth refers to increases in aggregate level of
output. Development refers to sustained increases in population’s welfare, lessened inequality,
poverty and unemployment. Thus population is more important when discussing development.
At the end of this section you are expected to be able to:
1. Explain the difference between economic growth and economic development
2. Explain fundamental environmental issues in GDP
3. Discuss how the environment affects the economy
4. Describe historical development of environmental policy in Asia and Africa
5. Describe Environmental Kuzinet’s Curve (EKC) and its implications on
economic growth
11.2 The fundamental issues of environment in GDP
We saw in the previous chapter that the traditional measure of macroeconomic performance is
Gross Domestic Product (GDP). We found that GDP is the sum of the money values of all final
goods and services produced in the domestic economy during a year. This implies that in
computing GDP does not include sales of intermediate goods and services. Only market activity
is included. Since there isn’t a market for most environmental goods, they are not included in
GDP. In contrast, defensive expenditures (e.g. repairs after an auto accident) are included. The
following environment related problems that result include:
•
The value of environmental amenities is not included in GDP.
•
Depleting a stock of natural resources (e.g. oil, minerals, forests) increases GDP, since it
results in new sales.
•
For comparison, depleting the capital stock hurts, as capital won’t be there for future
generations (measured in net domestic product, or NDP).
73
•
Similar reasoning should follow for natural resources. Example: Repetto4 recalculated
Indonesia’s growth rate including natural capital. The growth rate is 7%. Recalculating
to include the degradation of resources such as timber lowers the growth rate to 4%.
•
Growth that comes from the consumption of capital, including natural capital, is not
sustainable.
•
Defensive expenditures are included. Defensive expenditures are expenditures made to
eliminate, mitigate, or avoid damages caused by other economic activity. For example,
after a car accident, the costs to repair the car, provide medical treatment to the victims,
pay for lawyers, etc. all add to GDP. But, has the car accident really increased welfare?
A study of Germany found that 10% of the countries GDP consisted of defensive
expenditures.
11.3
How Does the Environment Affect the Economy
To see how the environment can affect the economy, we proceed with a more detailed model of
the economy. Economists usually model output by using a production function. From this, we
can derive a growth equation, as we discussed in class. The basic form of the equation is:
Rate of growth of output = A + a*(rate of growth of capital) + b*(rate of growth of labor) +
c*(rate of growth of energy) + d*(rate of growth of materials).
In this model, A represents changes in technology. With this model, we can address two
questions:
a) How does environmental policy affect economic growth?
•
Environmental regulations divert inputs from the production of output to other goals,
such as reducing emissions.
•
Since environmental benefits are not measured in GDP, they are not part of measured
output. Thus, resources diverted to environmental protection cannot be considered in the
equation. GDP falls, so economic growth, as traditionally measured, slows.
•
In 1994 (the last year with available data), PACE were $121.8 billion, which was 1.7% of
GDP
•
Environmental regulations may also prohibit certain resources, such as timber, from
being used at all. This lowers rate of growth of output.
4
environment.research.yale.edu/documents/.../0-9/04_Indonesia.pdf -
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•
Environmental policy can affect technological change, which affects A. Whether this is
good or bad for growth is a debated topic.
b) How does the environment benefit economic growth?
There are positive effects of the environment on the economy. Even though most environmental
benefits are not included in GDP, there are some benefits to have tangible monetary values. For
example:
•
Environmental resources are an input to production. If clean water is not available, it
cannot be used. Environmental regulations that protect water thus benefit GDP.
•
Environmental quality affects the quality of other inputs. For example, reduced air
pollution makes agriculture more productive and provides healthier workers. Not only are
healthy workers more productive, but health care is a large portion of GDP spending. If
average costs are rising, reducing the number of sick people reduces the costs of treating
them.
Note that this raises the question of how to incorporate the environment into GDP. We’ll discuss
that during the lecture on sustainable development.
11.4 Income and the Environment: Case study of the environment in East Asia
The article from Environment magazine focuses on the evolution of environmental policy in
three East Asian countries: Japan, South Korea, and China. Let us briefly discuss the history of
environmental policy in East Asian countries.
11.4.1 History of Japan’s environmental policy
Early concerns arose in 1868, in response to damage from copper mining. Government did not
pay serious attention to the environment until after Second World War (WWII). National
economic development was the central government’s top priority. Pollution was originally
thought of as a local government problem. Rapid growth in the 1950s led to increases in
pollution. In response to disease outbreaks from water pollution, the National Diet passed two
water quality laws in 1958. These are the first laws at the national level. International pressure
played a role. Before hosting the Tokyo Olympics in 1964, there was international pressure to
improve water quality in the Sumida River in Tokyo. Led to the creation of the Pollution Control
Division of the Ministry of Health and Welfare (1964) & the Basic Law for Environmental
Pollution Control (1967). More recently, policy focus shifted to global issues. Global warming
became part of agenda in mid-80s. There is now more of a focus on “quality of life” issues.
75
11.4.2 History of environmental policy in South Korea
Environmental policy was not an issue in South Korea until after Korean War.During 1960s,
Korea was under an authoritarian regime (President Park). Focus was on Five-Year Economic
Development Plan of 1962. In 1963, Pollution Prevention Act passed, but it was ineffectual due
to lack of resources. Rapid growth led to greater water and air pollution in 1970s. Environmental
Preservation Act passed in 1977. Set water quality standards in 1978, and SO2 standards in 1979.
Reducing air pollution became a priority before the Seoul Olympic Games in 1988. Government
supplied lower sulfur oil beginning in 1981. Strengthened vehicle emission standards in 1987.
Made clean fuels such as liquefied natural gas mandatory for large cities in 1988.
11.4.3 History of environmental policy in China
Under Mao Zedong (beginning in 1949), the government insisted pollution was a capitalist
problem that did not exist in socialist countries. In 1972, water pollution began to attract the
government’s attention, so the government sent a representative to the 1972 Stockholm
Conference on the Human Environment, and a national conference was held in 1973.
Environmental protection was introduced into the Chinese Constitution in 1978.
The
Constitution stated that protecting the environment was the responsibility of the state.
Environmental Protection Law passed in 1979. Included the responsible that polluters should be
held responsible for pollution treatment, including a polluter pays fee system. Despite increased
institutional attention, positive results for the environment are limited by a lack of resources.
11.4.4 Convergence of environmental policy
In each country, economic growth came first, followed by a reaction to resulting environmental
problems. International pressure played a role in each case. The Olympics were important for
Japan and South Korea, as they were important for China in2008. Note that for all three
countries, attention first focused on water and air pollution on a sector by sector basis. Broader
environmental regulation came later.
11.4.5 Differences
Latecomers had the advantage of learning from other nations' environmental policies. In Japan,
local governments played a bigger role in policy. This makes it easier for citizens to influence
the decision making process. Market forces played a bigger role in Japan. Levels of democracy
differ in each country.
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11.5 The Environmental Kuznets Curve (EKC)
The Environmental Kuznets Curve (EKC) hypothesizes that the relationship between per capita
income and the use of natural resources and/or the emission of wastes has an inverted U-shape.
According to this specification, at relatively low levels of income the use of natural resources
and/or the emission of wastes increase with income. Beyond some turning point, the use of the
natural resources and/or the emission of wastes decline with income. Reasons for this inverted
U-shaped relationship are hypothesized to include income-driven changes in the following:
a) Composition of production and/or consumption
b) Preference for environmental quality
c) Institutions that are needed to internalize externalities; and/or
d) Increasing returns to scale associated with pollution abatement.
The term EKC is based on its similarity to the time-series pattern of income inequality described
by Simon Kuznets in 1955. A 1992 World Bank Development Report made the notion of an
EKC popular by suggesting that environmental degradation can be slowed by policies that
protect the environment and promote economic development. Subsequent statistical analysis,
however, showed that while the relationship may hold in a few cases, it could not be generalized
across a wide range of resources and pollutants.
Some forms of pollution appear first to worsen and later to improve as countries’ incomes grow.
The world’s poorest and richest countries have relatively clean environments, while middleincome countries are the most polluted. Because of its resemblance to the pattern of inequality
and income described by Simon Kuznets (1955), this pattern of pollution and income has been
labelled an ‘environmental Kuznets curve’ (EKC).
Empirical studies of the relationship between per capita income and pollution typically find one
of three patterns:
•
For some problems (e.g. access to drinking water), income growth always leads to less of
a problem.
•
For many pollutants (e.g. SO2), the level increases as per capita income begins to grow,
but then falls as income continues to grow. Initially, growth leads to industrialization that
causes pollution. As income grows more, the country becomes more willing to devote
resources to pollution control.
•
For still other problems (e.g. CO2 emissions), the problem gets worse as income grows.
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Environmental damage
Income per capita
Figure 11.1 Kuzinets Curve
Typically, studies look at cross-country data using Global Environmental Monitoring Systems
data (GEMS). This seems to only fit for a subset of pollutants. Results are sensitive to the
specification.
Important Issues to note:
• Data availability is a problem. Current research focuses on criteria pollutants,
because that is where the best data is available. What about toxins?
• More time series studies needed. Cross-section studies do not capture dynamics.
Time series studies of Netherlands, Germany, the UK and the US find that
economic growth has a positive effect on emissions of CO2, NOX, and SO2
(meaning emissions increase), although technological change may offset this.
11.5.1 Theoretical requirements for EKC
•
Marginal utility of consumption falling or constant. So that cost of giving up
consumption falls as incomes are higher
78
•
Marginal disutility of pollution rises. As problems get worse, it is more valuable to do
something about them
•
Marginal damages rising
•
Marginal abatement costs rising. It is expensive to do a lot.
11.5.2 Implications of the EKC
While EKC relationships have been observed using the data above, critics raise concerns that
suggest other possibilities:
a) Revised EKC: proposes that the curve could shift downward over time
b) Might the peak be lower for newly developing countries, since they can use technologies
first developed elsewhere?
c) Race to the Bottom: promoted by globalization.
d) Intuition: once everyone’s income rises, where does the pollution go? New Toxics
e) Over time, countries shift away from traditional pollutants, but use more of pollutants
that are more dangerous.
Note that there is little empirical evidence for the last two theories.
79
LECTURE TWELVE
THE ENVIRONMENT IN DEVELOPING COUNTRIES
12.1 Introduction
One of the main objectives of this lecture is to discuss what is considered to be different about
environmental problems in developing countries, as compared to developed countries.
At the end of this section you are expected to be able to:
1.
Explain the meaning and use of Environmental Sustainability Index
2.
Explain the causes of environmental problems in LDCs
3.
Describe root causes to difficulties in access to clean water in LDC
4.
Explain causes of air pollution and deforestation in developing countries
5.
Discuss the impact of agricultural activities on the environment and how to
make agriculture more sustainable in developing countries
Let us begin with a discussion of key issues pointed out in one of the US Economists article on
the Environmental Sustainability Index (ESI)5:
•
Unlike the environmental Kuznets curve literature we discussed before, this article
attempts to address causation, that is, what factors lead to better environmental quality.
•
Income is particularly important when there are immediate health effects.
•
Income is less important when the environmental impacts are long term, or when they do
not directly impact human health.
•
Good governance is important.
According to the 2005 Environmental Sustainability Index (ESI) produced by a team of
environmental experts at Yale and Columbia universities, Australia was rated 13th in the world
in environmental sustainability out of 146 countries, just ahead of Gabon, but behind New
Zealand and Latvia. The Index released earlier in 2009 at the World Economic Forum in Davos,
Switzerland, ranks Finland, Norway, Uruguay, Sweden and Iceland as the top five sustainable
nations, respectively. Their high ESI scores are attributed to substantial natural resource
endowments, low population, and successful management of environment and development
issues.
5
www.highbeam.com/doc/1G1-132774446.html
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Discuss reasons why countries like Tanzania, Nigeria and DRC, which
are endowed with natural resources, do have their respective ESIs very
low?
12.2 Causes of environmental problems in developing countries
Let us outline the causes of environmental problems in developing countries. Our list includes
abut not limited to the following problems:
•
Higher population growth rates in developing countries as compared to industrialized
countries
•
Industrialization - Developing countries are moving from agrarian societies to
industrialized societies, which results in more pollution.
•
Increasing urbanization - As industrialization occurs, people move to the cites, as that is
where jobs are. Environmental problems become problems when people are close
together, so that their actions affect others nearby. Also, infrastructure to support
increased populations is lacking in many cities.
•
Weak governance - Not only are regulations often weaker, but when they do exist
enforcement limits compliance. Corruption and lack of democracy are also problems.
•
Lack of information/education - Demand for environmental regulations depends on
awareness of the problems
•
Poverty/pressures for economic growth - As a result of lower incomes, developing
countries place less weight on future considerations. With lower incomes, current needs
take precedence.
•
Poorly defined property rights
•
Technological constraints - Technologies used may be less efficient than those used in
developed countries, leading to more energy and resource use.
12.3 Access to clean water in LDCs
Access to clean water is a major concern in developing countries. 90% of sewage in developing
countries is discharged without treatment. Causes of the problem include the following:
a) The costs of the necessary infrastructure are high.
b) The price of water is subsidized. As a result, infrastructure is allowed to decay and
utilities are reluctant to connect new customers.
c) Water utilities may be bureaucratic, inefficient, and corrupt. However, these problems
may continue with privatization, since the companies have monopoly power.
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Although pricing water at its true cost is efficient, is it fair?
•
One suggestion is to have a low base price for a basic unit of water, but
to price additional access at a higher rate.
•
Another alternative may be to price water correctly, but also provide
subsidies to low-income people.
Take time to suggest potential solutions to this problem
A possible solution to the subsidy problem is block pricing ie charging a lower rate for the first
units of water used, but high rates to those that use more. Note that this requires infrastructure to
monitor usage.
12.4 Air pollution in LDCs
The most important air pollution problems in developing countries are:
a) Indoor air pollution - One-third of energy in developing countries comes from burning
wood, crop residues, and animal wastes in stoves.
b) Lead emissions
c) Small particles
Note that subsidies are a major problem. Because electricity is subsidized, utilities are reluctant
to hook up new customers. If few people have access to electricity, they turn to burning fuel in
stoves for energy. In addition, transportation policy is also important.
12.5 Timber and deforestation in LDCs
Problems caused by deforestation:
a) Soil erosion
b) Water quality and supply both decrease
c) Loss of biodiversity
d) Loss of animal habitat
e) Carbon emissions increase - because forests serve as carbon sinks
Note that the last three are likely to be important to people in developed countries, but less so to
developing countries. This is due to that fact that;
•
Developing countries are reluctant to devote resources to problems such as biodiversity
or global warming, as the benefits are long-term.
82
•
If people in developed countries want to protect these resources, they need to make it
desirable for developed countries to do so. Demonstrating local benefits, such as
reducing soil erosion, is important.
12.5.1 Reasons why deforestation is a problem
a) Pressures from population growth and migration
b) Lack of income
c) Exporting timber products provide income - Developing countries are more concerned
with current consumption than future consumption. Sustainable policies are not desirable
if they don't provide enough income in the present.
d) Lack of other energy supplies leads to using timber as a fuel.
e) Lack of property rights - People who do not own the land have little incentive to
preserve it. Note that, despite laws in Brazil to discourage deforestation (e.g. limiting
harvest to 20% of trees on the land), enforcement is difficult due to poorly defined
property rights.
f) Subsidies - For example, Brazil offered tax breaks for development of forested land (such
as for cattle ranching).
g) Enforcement is also a problem because it is costly. Countries do not have the resources
necessary to enforce existing environmental regulations.
h) Demand from developed countries
i) Certification can be time consuming in developing countries.
One solution that might help enforcement is labeling. Using barcodes, logging firms
can prove that timber has been harvested sustainably. This allows firms to differentiate
themselves in market. Currently, the price premium is low: about 2-3%. Also makes it
possible for developed country consumers to differentiate. For example, developed
countries can ban illegal timber for construction projects financed by government.
Timber importing countries cannot ban all imports of uncertified timber due to WTO
rules. However, legal logs are more expensive, because royalties must be paid to
governments. Illegal logging cost governments $15 billion in 2002.
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12.6 Resource management
•
Many developing countries have abundant natural resources, yet their populations are poor.
Resource-rich countries grow more slowly than other poor countries, even after controlling
for other variables. This paradox is known as “Dutch Disease.” Increase in natural
resources (e.g. oil) leads to appreciation in domestic currency. This makes non-oil sectors
less competitive on world market. As a result, the oil sector dominates the economy.
•
Moreover, oil-rich countries do worse on issues such as child mortality, nutrition, and
education. Oil employs few unskilled workers. Volatility of oil prices hurts poor the most,
as they are unable to hedge risks. Ownership of resource concentrated. Thus, revenues pass
through few people, making it easy to redirect funds. Oil revenues allow governments to
keep taxes low. Thus, population has less incentive to demand change.
•
Possible solutions:
a) Set aside revenues when prices are high. Alaska’s fund that is redistributed to
households is an example. However, it is easy to dip into fund for other purposes.
Particularly a problem in developing countries, such as Zambia & Venezuela in 1970s.
b) ExxonMobil has invested in an oil project in Chad and Cameroon in which funds are
deposited in an offshore escrow account. An oversight committee evaluates proposed
spending from the account. Ten percent are to be held in a trust fund for future
generations. Eighty percent will be devoted to education, health and social services,
rural development, infrastructure and environmental and water resource management.
However, there have been reports of Chad diverting funds from the account.
c) Tony Blair proposes the Extractive Industries Transparency Initiative (EITI). This is a
voluntary effort between governments and oil companies to promote transparency.
From their website (http://www.eitransparency.org/): “The EITI aims to ensure that the
revenues from extractive industries contribute to sustainable development and poverty
reduction.” Over 20 countries have joined.
12.7 Agriculture in LDCs
Since WWII, agriculture in developed nations has become increasingly intensive, using more
capital and fertilizer. This system has spread to developing countries, succeeding in producing
more abundant, less expensive food.
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12.7.1 Costs of increased agricultural productivity
a) Soil degradation - Soil is compacted from machines being used on it. There is also water
and wind erosion. Depletion of minerals from overcropping and overgrazing are
escalating.
b) Pollution - Runoff from fertilizers and pesticides is a major non-point source pollution.
Pesticide use has doubled over the past 30 years. Pesticides such as DDT are still used in
developing countries. Even organic materials, such as manure, cause pollution problems.
c) Water scarcity - 40% of the world’s food comes from 5% of the agricultural land that is
irrigated. Water is being pumped from the ground faster than it can be replenished.
Inefficient use leads to waste of water. Part of the problem is that water is usually
provided below cost.
d) Biodiversity loss - Intensive agriculture leads to species loss. For example, 13 million
hectares of forest are lost to agriculture each year. 7,000 crop species are available for
cultivation. 90% of the world’s food comes from 30 of them. Focus is on high-yielding,
pest-resistant crops.
12.7.2 Can biotechnology be a solution?
Growth of biotech crops has been rapid (44% increase in 1999). Most of the use is in the U.S.
Crops are bred to resist herbicides or to be pest resistant. Note that, where used, herbicide
applications per acre have fallen by 9% to 14%. However, total applications are up because
acreages have also expanded. Yields have not increased. Consider the following concerns:
•
Access to seeds - GM seeds can be designed so that they cannot be reused. Farmers
would thus need to purchase new seeds each year.
•
Reductions in biodiversity
•
Genetic resistance – will the surviving weeds be resistant to herbicides? Can the gene be
transferred to other crops?
•
Lacks of consumer demand - Some countries are reluctant to use GM seeds because they
are afraid that consumers will not buy crops from their country.
85
Throughout examples cited in this lecture, we have observed following set of
common problems:
•
Lack of property rights leads to overexploitation of resources.
•
Subsidies encourage inefficient use of resources, but, because of equity
concerns, may be difficult to remove.
•
Poverty is part of the problem. Many of these problems require large capital
expenditures.
•
The pressures of population growth often contribute.
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LECTURE THIRTEEN
SUSTAINABLE DEVELOPMENT
13.1 Introduction
The concept sustainable development has ever since included notions of weak sustainability,
strong sustainability and deep ecology. Thus sustainable development does not focus solely on
environmental issues. The United Nations 2005 World Summit Outcome Document refers to the
"interdependent and mutually reinforcing pillars" of sustainable development as economic
development, social development, and environmental protection. Indigenous people have argued,
through various international forums such as the United Nations Permanent Forum on
Indigenous Issues and the Convention on Biological Diversity, that there are four pillars of
sustainable development, the fourth being cultural. The Universal Declaration on Cultural
Diversity (UNESCO, 2001) further elaborates the concept by stating that "...cultural diversity is
as necessary for humankind as biodiversity is for nature”; it becomes “one of the roots of
development understood not simply in terms of economic growth, but also as a means to achieve
a more satisfactory intellectual, emotional, moral and spiritual existence". In this vision, cultural
diversity is the fourth policy area of sustainable development.
At the end of this section you are expected to be able to:
1.
Explain the four pillars of sustainable development
2.
Define and explain the concept of environmental sustainable development
3.
Discuss the differences between neoclassical and ecological economics as far as
development sustainability is concerned.
4.
Demonstrate how to incorporate the environment in economic analysis
5.
Explain the meaning of green GDP and how green GDP can be measured
6.
Explain the likelihood of sustainable development occurring in market
economies
13.2 Definition of environmentally sustainable development
a) The Brundtland Report (1987), part of a World Commission on Environment and
Development, proposed the following definition of sustainable development: “Sustainable
development is development that meets the needs of the present without compromising the ability
of future generations to meet their own needs.” Note that this definition is quite vague.
•
How do we know what future generations will need?
•
What are the needs of the current generation?
87
b) Consider too the following quotes from UNESCO report:
•
“…every generation should leave water, air, and soil resources as pure and unpolluted
as when it came on earth.”
•
“each generation should leave undiminished all the species of animals it found existing
on earth.”
These definitions imply no use of natural resources. Is this possible? If not, can you have a
moral obligation to do something impossible?
c) An economist, Robert Solow defines sustainable development as: “an obligation to conduct
ourselves so that we leave the future the option or the capacity to be as well off as we are.”
Solow's definition is an example of weak sustainability. This is the approach taken by most
neoclassical economists. This is a weak sustainability because any loss of natural capital should
be balanced out by creation of new capital of at least equal value. It also assumes natural capital
and man-made capital are substitutes.
d) Herman Daly (Beyond Growth 1996) distinguishes the definitions of sustainable development
for renewable and nonrenewable resources:
•
For renewable resources: “Keeping the annual offtake equal to the annual growth
increment (sustainable yield) is equivalent to maintenance investment.”
•
For non renewable resources: “The general rule would be to deplete non-renewables at a
rate equal to the development of renewable substitutes.”
These definitions can be summarized as: “Never reduce the stock of natural capital below a level
that generates a sustained yield unless good substitutes are currently available for the services
generated.” (Goodstein 1999)
These guidelines are examples of strong sustainability – natural systems should be maintained
whenever possible.
Critical natural capital should be preserved under all circumstances.
Assumes natural capital and man-made capital are compliments.
This approach is taken by most ecological economists.
13.3 Neoclassical vs. ecological economics
Neoclassical economists view man-made capital and natural capital as substitutes. Neoclassical
economists view sustainability as a need for dynamic efficiency. Thus, a measure of welfare
88
needs to be maximized. Ecological economists on the other hand, view man-made capital and
natural capital as compliments. Note that Daly does acknowledge technological progress, but
says that knowledge does not simply substitute capital for nature. Rather, he argues that it makes
the uses more efficient. Thus, a key concern for ecological economists is the carrying capacity of
the environment. Economics is driven by scarcity. The key question, according to Daly, is how
big is the economic subsystem relative to the natural subsystem. Daly claims we are moving to a
world in which natural capital is the limiting factor.
As noted in our discussion above, clearly defining a sustainable path is difficult. Three
dimensions of sustainability are important:
The existence of a positive sustainable level of welfare,
The magnitude of the ultimate sustainable level of welfare vis à vis current
welfare levels, and
The sensitivity of the future welfare to actions by previous generations.
Both intergenerational and within-generation equity are also issues. Solow notes a paradox:
Sustainability says that you should be thinking about poor people today, but helping poor people
today requires more consumption, which hurts sustainability.
13.4
How to Incorporate the Environment in Economic Analysis
As mentioned earlier, GDP does not give a complete picture of the effect of the environment on
the economy, since it ignores the value of natural resources. Desired solution is to adjust GDP to
account for natural resources – “Green GDP.”
First attempt: Nordhaus/Tobin (1972):
•
Adjusted GDP to account for amount of welfare-reducing environmental damage done by
pollution. Measured as a portion of the difference in wages between wages in urban and
rural areas.
•
They also make other adjustments to GDP:
•
Add value of leisure
Subtract capital purchases, add capital services used.
Subtract non-beneficial spending, such as commuting to work.
End result: measure of economic welfare (MEW). MEW grew at 1/2 the rate of NNP
from 1929-1965.
China has begun to incorporate green GDP into its decision making. The motivation is that
previous targets focused on economic growth, leading local officials to ignore environmental
89
concerns. Local leaders are evaluated based on an elaborate point system. Points are rewarded
for meeting specified targets (e.g. a certain level of GDP growth). GDP growth is a “veto” target:
failure to meet the target ensures that the cadre is considered underperforming. This has led to
abuse of environment and human rights to meet GDP growth goals. A pilot program in 10
regions began in February 2004. The hope is that a green GDP target will help local leaders
focus on environmental concerns. The challenge is coming up with green GDP numbers. One
study said growth from 1980-2000 falls from 9.6%/yr to 6.8%/yr if green GDP used. However,
the National Bureau of Statistics is skeptical about whether appropriate numbers can be devised.
Because of such difficulties, the effort was abandoned in 2006. Instead, China will use what is
known as a “satellite system.”
Satellite system separates accounts that try to integrate environmental and economic measures.
Green accounting data will be provided alongside GDP data. Guidelines for satellite systems
were published by UN in 1993. Satellite systems relate economic activity, measured in cash
terms, to environmental magnitudes measured in physical units. E.g. tons of CO2 emitted by each
sector of the economy. Satellite system measures the effect of economy on environment, but
doesn’t adjust values.
13.5 How should Green GDP be measured?
The goal is to measure what is enjoyed or consumed.
•
Traditional GDP uses quantities of goods and services, and prices of these.
•
Some resources, such as timber or minerals, have market values. However, most
environmental benefits do not have market values.
The analog for the environment is ecosystem services. “Ecosystem services arise from – and
depend on – the broader sets of ecological components, processes, and functions but they are the
aspects of the ecosystem that society uses, consumes, or enjoys to experience those benefits.”
(p.7 of Boyd et al (1998)6 article)
13.5.1 Principles to measuring green GDP
a) Services are nature’s end products, not everything in nature.
6
Boyd, M.T, T.J Montgomery, and BJ. Spargo (1998)"Ecosystem Level Evaluation of Intrinsic Biodegradation at
Naval Shipyards and Impact on Adjacent Ecosystems: A Preliminary Report,"NRL Technical Memorandum Report,
NRL/MR/6115-98-8140
90
For example, we measure a car in GDP, not the steel, tires, leather, and workers used to produce
the car. The value of the car embodies all of these other values. Thus, what we want for the
ecosystem is what matters directly to people. It’s not that other things aren’t relevant, but that
they should be embodied in this value.
b) Ecosystem-services are benefit-specific.
Flood protection from wetlands should be counted. They substitute for flood control. Wetlands
are not services for the water quality they provide. Instead, this quality should be valued directly.
Including it again as a wetland service would be double counting.
c) Counts what we can count, not what should be counted.
Boyd argues this is what we do for other goods. We consider the price of the car, not the
satisfaction from owning it. That is, we use price, rather than consumer surplus, as the value.
d) Ecosystem services should be ecological.
Recreation itself is not a service. Things in nature that make recreation possible are.
e) Ecosystem services should be counted with greatest possible spatial and temporal resolution.
People benefit in specific places and times. For example, when and where clean water is
available matters. The amount of pollution will have different effects depending on location.
May make placing dollar values on these a bit more difficult.
Note that key to these principles is marginal analysis. The question isn’t
the cost of destroying all trees, but the cost of destroying one additional
tree
13.6
Will Sustainable Development Occur in Market Economies?
Valuing environmental benefits and costs is the most challenging task when considering
sustainable levels of development. In some cases, markets are beginning to appreciate the values
provided by ecosystems. Good values depend both on good science and good economics. Early
studies often gave implausibly high values, leading to the work being discredited. For example
the Panama Canal Crisis - the issue is that deforestation is harming the canal:
•
Water supply has been drying up. Most freshwater stored upstream in Gatún Lake, an
artificial lake created during the canal’s construction, where it accumulates from rainfall.
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52 million gallons of water is released into the ocean each time a ship uses the canal.
Deforested slopes around the lake do not absorb rainwater. Thus, rain runs into the lake
too quickly, causing it to overflow and run into the sea. This is important, because while
the area gets 10 feet of rain per year (3x more than Seattle), most rain comes in the rainy
season from May to December. If the land were forested, the water would be absorbed
and would flow into the lake more slowly.
•
Much of the deforestation has occurred since the 1950s, when a highway made the land
accessible to loggers. Sediment and nutrients get into the canal. Nutrients lead to growth
of weeds. This leads to expensive dredging
•
There have been some reductions in deforestation since the 1990s. Leading Panamanian
bankers stopped financing cattle ranchers who cut down forests for pasture. When the
canal was turned over to the Panamanian government in 1999, government agencies had
incentive to protect the watershed.
•
Still, the agencies do not have enough money for thorough monitoring and enforcement,
and reforestation needs to be done.
•
As a result, a private insurance firm, ForestRe has stepped in with a proposal. The plan
would have shipping companies that use the canal underwrite a 25 year bond to pay for
reforestation. These companies would ask their big clients, such as WalMart and the
Asian auto companies, to buy the bonds. These companies would get discounts on
insurance premiums they currently pay to insure against closure of the canal.
Other examples
a) Catskill Mountains, NY
New York City gets its water from the Catskill Mountains watershed. In 1997, the city faced
building a water filtration plant to clean water from the watershed. This had an up-front cost of
$4-6 billion, plus $250 million/year operating costs. Instead, the city made payments to preserve
the Catskill watershed. $250 million was spent to buy land to prevent development. $100 was
spent million/year to farmers to minimize pollution.
b) Cape Town, South Africa
Found that it was cheaper to restore the local watershed than to divert water supplies from
elsewhere or build reservoirs.
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c) Cauca Valley, Columbia
Large agriculture producers pay fees for watershed management projects. Note how the fees
address the public goods problem
d) Costa Rica
Hydro-electric producers, private customers, and the government contribute $57 million/year to
protect a local watershed.
•
Services provided for hydro-electric producers include: Stream-flow regulation, sediment
retention, and erosion control.
•
Service provided by private consumers is irrigation and the government ensures water
supply for towns and maintain scenic beauty for recreation and ecotourism
13.7 Audits for resource-rich countries
•
These focus on providing information to allow market forces to work. Like many other
policies we've discussed, the effectiveness of the audits depends on the reactions of the
developed world
•
The proposal would subject resource-rich countries to financial audits of the revenues and
resulting spending from sales of natural resources
•
While corrupt countries may not wish to be audited, the hope is that pressure from
consumers would encourage multinational companies to insist on audits.
•
Records of revenues raised would make it easier to save gains from boom years for later
use. Harder to steal funds if there is a public record.
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LECTURE FOURTEEN
INTERNATIONAL TRADE, TRADE AGGREEMENTS AND THE
ENVIRONMENT
14.1 Introduction
The term international trade is normally interchangeably used with such other terms like free
trade, trade across boarders, global trade, foreign trade etc. In this lecture all these terms will be
referring to the same context. Historically, free trade is as old as civilization. However, it has
assumed great significance after the industrial revolution and is now conducted on a large scale.
Free trade refers to the exchange of goods and services between citizens, business firms or
governments of different countries. Foreign trade is of three types: import trade, export trade
and re-export or entrepot.
(a) Import trade – This means purchasing goods from foreign countries.
(b) Export trade – Refers to selling goods to foreign countries.
(c) Re-exports or entrepot trade – Means first importing goods and then exporting them to
other countries.
Throughout this lecture emphasis will be placed on the need for appropriate global policies on
environmental resources to meet the pace of the desired international trade exchanges.
At the end of this section you are expected to be able to:
1.
Discuss the benefits and disadvantages of international
2.
Explain basic theories governing international trade and their criticisms
3.
Describe the Pollution Haven Hypothesis (PHH)
4.
Categorise and explain various international trade agreements that have impact
on global environment.
14.2 Critical Reasons for International Trade
There are 3 main reasons for international trade: resource endowment, technological gap and
economies of scale. Let us briefly discuss these reasons.
(a) Resource endowment
This explains the fact that all nations posses same resources (raw materials) e.g. minerals, wildlife,
land, labour etc. Mineral resources can obviously be worked only where they
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are found. Also many commodities can be grown only under particular climatic conditions or in
certain soils. As a result most rubber is produced world wide in Malaysia and the East Indies; most
of the world's coffee supply comes from Brazil. This variation in production resources leads to
nation's specialisation in production of particular products of these commodities hence International
Trade. The country imports those commodities which require resources that it does not posses.
(b) Technological Gap
According to this theory, the introduction of new technological processes and new products, gives
the innovative firm or nation a monopoly in the world market. Such monopoly is based on patent
copyrights which are normally granted to stimulate innovations. However as foreign producers
(imitators) acquire the technology, enter the world market. This is a problem with the industrialised
nations whereby the imitators enter the world market and undersell the innovators.
The inhabitants of a region may also develop a special skill for the production of a commodity,
which in time may require a special regulation for quality. For instance, Wines such as Sweet Wine
and Redtops owe their distinctive qualities in East Africa partly due to the special flavour of locally
grown grapes (in Central Tanzania) and partly due to the local method of manufacture that nations
haven't acquired. These technologically differentiated products need to be sold to other countries,
thereby resulting to International trade.
(c) Economies of Scale
While the previous two theories explain the trade between developed and developing countries,
economies of scale explains that even if two nations are identical in every aspect there is still good
reason for mutual beneficial trade baring on the increasing returns to scale (Economies of Scale).
The condition of increasing returns to scale refers to the production situation where output grow
proportionately more than the increase in inputs.
Economies of scale occur mostly through
production specialization in developed countries and in developing countries, ability to have modern
and specialized machineries.
Therefore, it can be observed that most of the trade between Developed and Developing countries is
Inter-Industry Trade based on differences in resource endowment and technological gap. A large
portion of trade among industrialized countries is Intra-Industry Trade where there is trade in
differentiated products from the same industry.
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14.3 Theories explaining basis for international trade
Before we discuss the various theories of international trade, let us point out basic assumptions
governing international trade theory. It is generally widely accepted to consider the following
assumptions in order to clearly describe various aspects of international trade in a simple and easy
way of understanding them:
•
There are only 2 nations in the world producing 2 products.
•
There is pure competition in both resources and production markets.
•
Resources are mobile i.e. they can be moved from one point to another within the nation's
boarders.
•
Liberation of trade i.e. no institution intervention or protection.
•
No transport costs.
As seen before, International Trade seems to arise out of specialisation which results into surplus
commodities and therefore the need for exchange.
The theories explaining this basis for
International Trade can be grouped into three:
14.3.1 Mercantilism
This theory was based on the promotion of Exports and discourage Imports. The outcome of this
was the initial stage of trade barriers. However not all countries would benefit at the same time. So
the mercantilists got criticisms with time.
14.3.2 Absolute Advantage Principle
This theory was put forward by Adam Smith. He reasoned that nations will gain from Free
International trade if each one specializes in the production of that commodity it can produce most
efficiently or in a commodity in which it has absolute advantage over others and then it can
exchange part of that commodity output for others it can produce inefficiently i.e. it has absolute
disadvantages in their production. This principle can be illustrated with the following example:
Assume a case where there are two countries namely Tanzania and Uganda both producing bananas
and maize as tabulated below in Table 4.1
Table 14.1 Hypothetical demonstration of absolute advantage principle
Country
Maize (000’ tones)
Bananas (000’ tones)
Tanzania
10
5
Uganda
5
15
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Table 14.1 shows that using 1 unit of labour, Tanzania can produce either 10,000 tones of maize or
5,000 tones of bananas. Uganda on the other hand can produce 15,000 tones of bananas or 5,000
tones of maize using one unit of labour. Therefore Tanzania can produce maize more efficiently
than Uganda and Uganda can produce bananas more efficiently than Tanzania. So Tanzania should
specialize in production of maize while Uganda should specialize in bananas and then exchange
their surplus. From the example Tanzania has absolute advantage in the production of maize while
Uganda has absolute advantage in the production of bananas.
Adam’s shortcoming is that as time went on, it was discovered that one can't base International trade
on absolute advantage. The absolute advantage occurs between developed and least developed
countries only.
14.3.3 The Law of Comparative Advantage
This law was put forward by David Ricardo in 1817 to improve on Adam Smith's principle of
absolute advantage. He argues that even if a nation is less efficient i.e. it has absolute disadvantage
with respect to the other nations in the production of both commodities, there is still a basis for
mutual beneficial free trade. The less efficient country should specialise in the production of both
commodities, there is still a basis for mutual beneficial free trade. The less efficient country should
specialise in the production and export of that commodity in which its absolute disadvantage is less
(i.e. this is a commodity of its comparative advantage), and import the commodity in which its
absolute disadvantage is greater (This is the commodity of its comparative disadvantage). To
illustrate this law, let us use the case of Tanzania and Mozambique over the production of cloves
and cotton.
Table 14.2 Hypothetical demonstration of absolute advantage principle
Country
Cloves (000’ tones)
Cotton(000’metres)
Tanzania
5
20
Mozambique
1
10
Table 14.2 shows that Tanzania has absolute advantage in the production of both cloves and cotton.
By producing 1 tone of cloves, Tanzania foregoes 4(20/5) metres of cotton while Mozambique
foregoes 10 (10/1) metres of cotton by producing 1 tone of cloves. On the other hand, if Tanzania
produces one metre of cotton, it foregoes ¼ (5/20) tones of cloves, while Mozambique foregoes
1/10 tones of cloves by producing 1 metre of cotton.
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From the above analysis, it should be noted that Tanzania incurs less Opportunity Cost (real costs)
in producing cloves than Mozambique, while Mozambique incurs less Opportunity Cost in
producing cotton than Tanzania. Therefore, we say that Tanzania has a comparative advantage over
Mozambique in the production of cloves while Mozambique has a comparative advantage over
Tanzania in the production of cotton. A country has a comparative advantage over others if it can
produce one or more commodities at less Opportunity Cost than others.
The Law of Comparative Advantage can also be stated that, even if a country has absolute
advantage in the production of 2 or more commodities, it should produce that commodity where it
incurs less real costs (Opportunity Cost).
From an example, Tanzania should specialize in
producing cloves and Mozambique should specialize in producing cotton, then the 2 nations can
benefit by exchanging surpluses.
14.4 Criticisms of the Law of Comparative Advantage
(a) The assumption that there are only 2 nations producing 2 commodities is unrealistic because
Modern International Trade is multi-lateral and countries produce more than 2 commodities.
(b) This law assumes that less developed countries should specialize in the production of primary
products where they have a comparative advantage. However, this would lead to unfavourable
terms of trade since prices of primary products are always lower than prices of primary products
are always lower than prices of manufactured products.
(c) This law assumes that a nation cannot exploit more resources and improve on efficiency in the
production of a commodity where it incurs more real costs.
(d) It assumes that technology is constant and a country cannot reduce production costs in the long
run after technological changes and after reaping economies of scale.
(e) It does not take into account the need for diversification and self reliance which tend to disagree
with specialization.
(d) The law assumes that trade is free, but in practice there are restrictions and trade barriers.
(e) The law does not take into account transport costs which increase costs and reduce benefits of
international trade.
(f)With this law, it is difficult to determine the country which should specialize in the production of
that commodity which is produced by both countries at the same costs.
(g) Once trade begins, a country that becomes specialized has no choice to continue. Thus, critics
of globalization ask if diversification has value.
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(h) Daly notes that the basic principle of comparative advantage depends on immobile factors. If
factors are mobile, absolute advantage matters. E.g. all capital can go to the country with
lowest costs. The quality of a factor (e.g. skilled vs. unskilled labor) also matters. Factor
mobility increases the opportunity set, so should make the country better off. However, a
country with monopoly power in world factor markets can make itself better off at the
expense of the rest of the world by limiting factor mobility.
In sighting of all such limitations, Godfried Haberter wrote a book "Theory of International Trade"
in which he argued that the Optimum pattern of production and trade of a country would appear to
be determined from the comparison of the Opportunity Cost (real costs) of producing a given
commodity with the price at which the commodity can be imported or exported. Haberter’s
improvement on the Law of Comparative advantage has made this law a more useful one in basing
arguments on the international trade.
14.5 Pollution Haven Hypothesis
Does free trade make protecting the environment more difficult?
Pollution haven hypothesis – the idea that firms will move from countries with strong
environmental standards to those with weaker standards. Developing countries may even be
able to attract industry with low standards. Esty notes that, while expanded trade and
economic growth need not hurt the environment, there is no guarantee that it won’t. Three
effects of economic growth on trade:
a)
Technique: Higher incomes are linked to cleaner production processes.
b)
Composition effects: Higher incomes are linked to preferences for cleaner goods.
c)
Scale effects: Higher incomes lead to increased pollution due to greater
consumption. If scale effects dominate, the environment will be worse off.
Empirical evidence of the pollution haven hypothesis is however weak.
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Examples of a test of pollution haven hypothesis:
a) The Heckscher-Ohlin model of international trade
The Heckscher-Ohlin (H-O) model of international trade states that countries will have a
comparative advantage in goods produced with endowed factors that are in relative abundance.
Countries with hydroelectric resources trade goods that require a lot of electricity to produce
(e.g. aluminum). Countries with cheap labor produce labor-intensive goods (e.g. clothing).
Countries with large capital stock produce capital-intensive goods (e.g. autos). Thus, the theory
predicts that countries with a large capacity to assimilate pollution will produce pollutionintensive goods. As well as the physical ability to assimilate pollution, income matters. Citizens
of wealthier countries are more likely to demand cleaner environments.
To determine if lax environmental regulations attract dirty industries, economists use the
Heckscher-Ohlin model to explain trade in goods associated with pollution. Controlling for other
resource endowments, one can test to see if environment variables are significant, i.e.
Net Exportsij = ai + b1Ej1 + b2Ej2 + …+bKEjK + dRj + eij
Ejk = endowment in country j of factor k (e.g. capital, labor, land, natural resources)
Rj = strictness of environmental regulations in country j (e.g. pollution control expenditures)
In general, economists fail to find a significant relationship between environmental regulation
and trade. One criticism of such models is that stocks of capital change slowly, as they represent
years of accumulation. Thus, measuring flows of capital may be a better alternative. This is done
by using foreign direct investment (FDI) as the dependent variable, i.e.
FDIij = ai + b1Fj1 + b2Fj2 + …+bKFjK + dRj + eij
Fjk = level of variables affecting FDI in country j, such as tax policy
Rj = strictness of environmental regulations in country j
b) Xing and Kolstad extension of H-O model
Using such a model, Xing and Kolstad (1997) find that foreign direct investment (FDI) for dirty
industries, such as chemicals, does flow to countries with lax environmental regulations, but find
no effect for low polluting industries, such as electronics. There has been more growth of toxicintensive industries in developing countries. A recent paper by Ederington, Levinson and Minier
offers explanations for small effects:
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i) They argue that aggregate data misses effects in specific industries.Their work proposes
three reasons why others find little effect:
•
Most trade is between similar countries (North/North). If one looks specifically at
North/South trade, find an effect. They divide countries into low and high
environmental costs. When US environmental costs rise, net imports to low cost
countries increase. Elasticity is 0.2 (10% increase in US costs 2% increase in
imports)
•
Not all industries are mobile. Industries are mobile if there are low benefits to
agglomoration and also if there are low transport costs involved.
•
Indstries that are mobile are more sensitive to environmental costs
ii) Not all industries are pollution intensive. Surprisingly, they do not find a bigger effect of
environmental costs on pollution intensive industries, unless they control for mobility. It
appears that pollution intensive industries are also less mobile! However, this also means
that the argument that there is no pollution haven effect because most PACE costs are
insignificant is not sufficient.
iii) Other explanations for the weak evidence of pollution haven hypothesis
•
In general, other factors are more important in choosing location: Skills of
workers, proximity to markets, political stability, and availability of materials
•
As a result, even when evidence of the pollution haven hypothesis is found, the
magnitudes are often weak.
•
The Bureau of Labor Statistics collects data on total layoffs and the reasons. Few
mass layoffs are due to environmental regulations.
Total layoff
events
Total people
affected
Layoffs for
environmental reasons
2000
5,620
1,170,427
7
Total people affected
by environmental
reasons
1,142
2001
8,350
1,751,464
3
445
2002
7,295
1,546,976
3
718
2003
7,346
1,502,825
5
1,044
The most frequent reason for mass layoffs is completion of seasonal work (2,370 layoffs in
2003) and internal restructuring (1,437 layoffs in 2003). Other major reasons are contract
completion and slack work. In 2003, 111 were due to import competition.
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14.6 International Agreements: GATT
The World Trade Organization (WTO), and its predecessor, the General Agreement on Tariffs
and Trade (GATT), provide a framework of rules and procedures to be followed in international
trade relationships. GATT began in late 1940’s. The WTO was established in 1995 after the
Uruguay round of GATT (1986-1994). GATT covers trade in goods, and still exists as a subset
of WTO. It aims to reduce barriers of trade. It also does allow exceptions to protect “human,
animal or plant life” and to conserve natural resources. Such import restrictions must be done in
a non-discriminatory way. Examples:
a) GATT upheld the US tax on luxury cars and gas guzzlers because they applied equally to all
autos (Europe protested the taxes).
b) Denmark placed a ban on nonrefillable drink containers. Imports of such containers were
prohibited. Other European countries felt that this was done to give Danish beverage producers
an advantage, rather than protect the environment. The European court ruled in favor of
Denmark, since it was non-discriminatory.
c) In the 1990’s, the U.S. banned imports of tuna caught in nets that kill dolphins. Mexico
complained to GATT & won. GATT accepted America’s aim of protecting dolphins, but
objected to the use of discriminatory trade sanctions. Suggested labeling of dolphin-friendly tuna
instead.
d) The WTO also ruled against a U.S. ban against shrimp harvested with technologies that harm
sea turtle because it gave preference to Western Hemisphere countries. The ban gave Western
Hemisphere countries more time to comply and provided financial aid for new technologies.
India, Malaysia, Pakistan, and Thailand protested to WTO. However, the WTO noted it was the
preferential treatment that violated GATT article 20. The ruling made clear, however, that
countries did have the right to take trade action to protect the environment, as long as it is nondiscriminatory.
The issue becomes cloudier when we consider pollution from production. Consider a firm in a
country such as the U.S. that has strong environmental standards, but has a competitor in a nation
with weak standards. The competitor has lower costs, so it has an advantage. However, it isn’t
clear that the U.S. can do anything legally under GATT. GATT gives the U.S. the authority to
protect the health of its citizens. However, imposing stronger environmental restrictions on the
second country affects the health of those citizens, not Americans.
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An important question is whether we should do something. Whose
standards should matter?
A World Trade Organization (WTO) report in the fall of 1999 admitted that trade can harm the
environment. Report says that environmentally damaging subsidies for farming, fishing, and
fossil fuels should be eliminated. Report says more product labeling should be allowed.
The discussion above leads to a bigger question: is it fair for developed
countries to expect developing countries to strengthen environmental
regulations? Discuss this
14.7 Climate Change and International Agreements
Throughout the world discussing are underway on the results of the climate change simulation,
in which some of the difficulties of reaching an agreement on international environmental issues
are revealed. Important issues include:
a) Compensation for developing countries - Developing countries want to continue to grow
economically. To willingly accept limits on their emissions (which they often perceive, rightly
or wrongly, as limits on growth), they need compensation in return.
b) Enforcement of an international agreement - Is there a body that can collect permit fees, for
example? Note that bodies gain legitimacy when actors have a stake in the outcome. For
instance, the UN body that ratifies Clean Development Mechanism (CDM) projects provides
value to the project sponsors
c) What balance should be struck between mitigation and adaptation? - Would it be more
valuable to spend money on adaptation in developing countries?
d) Is an international agreement even necessary? - Pizer notes that global agreements don’t seem
to be working for climate change. U.S. is not participating. Developing countries not involved in
meaningful discussions. Kyoto participants are not meeting targets. What individual countries
have done?
•
EU Emissions Trading Scheme (ETS)
•
Canadian Large Final Emitter Program. Tradable permit system with C$15 safety
valve
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•
New Zealand announced NZ$15 carbon tax, however, it did not follow through on
announcement
•
Clean Development Mechanism (CDM) board has approved 50 projects worth more
than 100 million tons for the 2008-2012 period.
14.8 Lessons for design of global agreement
Three suggested lessons for design of global agreement include:
a) More flexible architecture that accommodates quantity, price, and technology policies
needed.
b) There is support for project-based crediting in developing countries. Can these be expanded
and improved?
c) Global agreements need to consider how to measure and value domestic policy actions.
Based on this, Pizer suggests a new approach based on three principles:
•
The need for domestic policy development - Because of domestic policies, there is not a
global price for carbon. However, the implied carbon prices in the domestic policies are
similar. Countries don’t want to put themselves at a disadvantage. Moreover, compliance
with Kyoto depends on domestic implementation. In the case of the Montreal Protocol,
domestic policies came first. International agreements were based on these policies.
Domestic policies can be consistent with domestic pressures. Enabling domestic policies
allows for variety in policy types. E.g. more technology policies to help develop new
technologies.
•
Credits in developing countries - Because developing countries want to protect growth,
this may be the only way to involve developing countries. Key question is baselines:
what would have happened. Can have big transfer of income effects.
•
Evaluating actions - Participation in public good provision depends on a perception that
others are doing their share. Moving beyond simple price and quantity policies
necessitates new means of evaluation. What credit should countries get for enhancing
technology or providing international aid?
14.9 The Montreal Protocol
The Montreal Protocol which outlines the phase-out of chlorofluorocarbons (CFCs), offers an
example of a successful international agreement which was signed in 1987. Let us highlight key
aspects of the protocol;
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a) Prohibits exports of controlled substances (CFCs) from any signatory nation to any
state not a party to the protocol, and signatory nations may not import any controlled
substance from a non signatory state.
b) India and China did not sign on until a 1990 revision that provided a $260 million
fund to finance the transition in developing countries.
c) Goal: to make sure that CFCs and other ozone-depleting chemicals do not simply
migrate to nonsignatory nations.
Reasons why the Montreal Protocol was successful, even though most international agreements
aren’t:
a) Only six main companies produce CFCs, so monitoring is simple.
b) Clean technological substitutes have developed quickly. This helped keep the costs of
compliance low. One substitute, hydrochlorofluorocarbons (HCFC) also depletes the
ozone layer, but at a slower rate. It will be phased out by 2030.
c) Publicity surrounding the ozone hole over Antarctica provided public pressure.
d) Moreover, progress is visible, whereas for climate change, the effects of today's policies
won't be experienced for a generation or two.
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LECTURE FIFTEEN
EXHAUSTIBLE RESOURCES
15.1 Introduction
Exhaustible resources are resources that even if left alone do not reproduce themselves – at least
over any time scale relevant to humankind. Exhaustible resources include minerals like copper, iron,
manganese and most carbon based forms of energy such as oil, coal and gas. The purpose of this
lecture is to explain why exhaustible resources are seen as an important issue in economic terms and
to answer the following question: will we ever run out of resources? The lecture also aims to explain
how the market depletes natural resources over time and how changes in the market for natural
resources affect their depletion rates. The question of whether Governments should intervene to
alter the rate of depletion is addressed. The lecture then looks at how different market structures
deplete resources.
At the end of this section students are expected to be able to:
1. Explain various concepts such as renewable Vs Non renewable resources, reserve
exhaustible resources, economic and non economic reserves, known resvres and yet
to be known reserves etc
2. Explicitly distinguish between arbitrage and exhaustion principles used to
understand resource problems
3. Explain the role of government in management of exhaustible resources
4. Explain the trend prices of exhaustible resources over time
5. Analyse the cost of optimal extraction of an exhaustible resource
15.2 Quantification of exhaustible reserve resources
The quantification of the remaining reserves of exhaustible resources is somewhat difficult.
Reserves can be divided into a number of categories including ‘known’ reserves and ‘yet to be
discovered’ reserves. Known and unknown reserves can be divided into ‘economic’ and ‘noneconomic’ reserves. By ‘economic’ it is meant that they are profitable to extract given prevailing
resource prices. Currently uneconomic reserves might well become economic in the future. Thus
one needs to be careful about reading too much into current reserve-production ratios and
calculating the number of year’s resources which are remaining since these are apt to change. Even
if we were to run out of some resources this does not imply that anything bad would necessarily
happen. For many resources it would be possible to substitute to ‘backstop technologies’ which,
although slightly higher in price, could provide limitless quantities of energy and materials. All that
106
is required is the incentive to innovate. Even if there are commodities without which certain
important forms of economic activity could not occur (and it is difficult to think of examples) it may
be possible to stretch out these resources over all future time and still enjoy increasing economic
standards of living.
It should be noted that exhaustible resources are not destroyed when they are ‘consumed’
but can at least to some extent be collected and used again and again (although a
distinction should be made here between finite-yet-recyclable and finite-and-nonrecyclable resources such as carbon energy). Current economic reserves have increased
through time for many commodities.
15.3 Principles for understanding exhaustible resource problems
There are two key principles necessary for understanding exhaustible resource problems. First of
these is the ‘arbitrage principle’ and the second of these is the ‘exhaustion principle.’ Let us briefly
explain each of these principles independently.
15.3.1 Arbitrage Principle
According to the arbitrage principle the price of the resource should increase at the rate of interest.
Suppose that this were not the case and that the price were rising at a rate less than the rate of
interest or perhaps not even rising at all. In this case each individual mine owner would prefer to
extract all his stock immediately and invest the proceeds. Every mine owner however feels the same
way and consequently the current price falls until prices once more rise at the rate of interest. If
prices are rising faster than the rate of interest then each individual will conserve the resource. Once
again if enough mine owners do this then the current price will until the price once again rises at the
rate of interest. Thinking about exhaustible resources like financial assets explains why mine
owners don’t want to extract and sell the resource as fast as is possible.
15.3.2 Exhaustion principle
The exhaustion principle states that just at the moment when the price reaches the backstop price the
last remaining units of the resources are extracted. The exhaustion principle must hold since at the
point when the price of the backstop is reached the mine owner is left holding a resource which, if
he had extracted it earlier, he could have invested the profits and earned a certain rate of return. As it
is he is left with an asset whose price is now fixed by the backstop. Together the exhaustion
107
principle and the arbitrage principle define the complete path of prices and extraction for the
resource.
Note that a social planner would deplete a finite stock of known size in exactly the same
way, ensuring that the net marginal benefit of the last unit of production is the same in
each time period subject to the total resource constraint. Hence it is difficult to argue
that Governments should intervene to alter the depletion of natural resources. Bear in
mind however that there might be externalities from the extraction of the resource.
There may also be important differences between the rate of discount used in industry
and the social rate of time preferences. Finally there might be market structures that
differ from perfect competition as well as strategic considerations.
When through technical breakthrough extraction costs are reduced the price falls and the time to
exhaustion is shortened. With surprise discoveries of the resource the mine owners all suffer a
capital loss. The asset that they hold in the form of the resource is not as scarce as they had
supposed. In order that the price should reach the backstop just as the last units of the resource are
extracted it must be the case that the current price must fall. This is in order that the stock is all
exhausted. Furthermore if the price path is to fall then it is clear that the time to exhaustion is
increased as well. Repeated and yet unexpected discoveries can cause the price trajectory to take a
scalloped appearance.
How would the extraction plan and price trajectory change when the entire stock of
a resource is in the hands of a monopoly?
Thus far the case of the perfect competition has been dealt with. The question arises of what
happens when the entire stock of a resource is in the hands of a monopoly. The problem of the
monopoly is still to maximise the present value of discounted profits from the extraction of the
resource but unlike in the perfect competition case, the monopoly recognises that it can choose the
price that it faces. The monopoly recognises that additional sales reduce the revenue obtained on
preceding units and because of this fact the extraction rule is modified. More specifically the
monopolist requires the marginal revenue minus marginal cost rise at the rate of interest over time.
Unless this condition is fulfilled, along with the exhaustion principle, it would pay the monopolist to
change his extraction plans.
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How does the extraction plan of the monopolist compare with the extraction plans
of the perfectly competitive industry
The answer to this question actually depends upon the shape of the demand curve and the extraction
cost function. The monopolist can actually deplete the resource faster or slower than the perfectly
competitive industry. In the case of a linear demand curve with no extraction costs it can be shown
that the monopolist depletes the resource more slowly than would a perfectly competitive mining
industry. In this sense the monopolist is the friend of the conservationist. The explanation is that
with a linear demand curve the marginal revenue curve must be steeper than the demand curve.
Hence in order to see marginal revenue rise at the rate of interest a smaller reduction in quantity
extracted is required in each period compared to the quantity reduction necessary to see prices rise
at the rate of interest. Hence the increase in prices must be attenuated in the case of the monopolist
but the initial price must be higher.
15.4 Government taxation on exhaustible resources
Depletable resources have often been targeted for Government taxation. In some situations it is
possible that the taxes levied do not alter the extraction plans of the industry and do not entail any
kind of distortion. This helps to explain why these resources have been targeted. The most obvious
form of tax is simply to remove the rent associated with the resource. This tax obviously must
compute the rent in each time period so the tax per unit extracted will have to rise at the rate of
interest over time leaving resource owners with just a normal profit for extracting it. In this case it is
probably better to regard the state itself as the real owner of the resource and the mining company as
the contractor who extracts the resource.
The existence of large rents associated with scarce resources provides exactly the right incentives
for individual companies to explore for more reserves. A company will explore for new reserves
where it believes that the marginal costs of discovery are equal to the rental value of the resource
that is in turn equal to the marginal social benefit. Although the royalty tax does not alter the time
profile of extraction for a stock of known size it does diminish the incentives to discover more of the
resource. The implication of this is that it might be necessary to combine fiscal incentives for
exploration activities with rent taxes.
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15.5 Exploration and extraction rights
There are problems however if the land that is being explored is common property in this case the
amount of exploratory activity may be excessive rather than gradually increasing (this is called
‘racing’). Imagine a situation in which property rights are granted only once deposits of a resource
have been located. Everyone wishes to ‘stake a claim’ early on. Rather than the marginal costs of
discovery being equated with the rental value of the resource the outcome will be the average
discovery cost being equated with the rental value. Alternatively imagine a situation in which
exclusive property rights are not granted (or if granted cannot be securely enforced) not even when
deposits of a resource have been granted. In such circumstances the amount of exploratory activity
might be inadequate. A lucky strike always leads to others immediately jumping in and staking a
claim nearby. If it is impossible to stop this happening and at the same time impossible to keep quiet
about the discovery then there is little point in exploring in the first place. These problems are
resolved by giving each company exclusive rights to explore an area.
15.6 Prices of exhaustible resources over time
The theory of exhaustible resources makes some quite strong predictions about the movement of
prices of exhaustible resources over time. Does the empirical evidence on resource depletion and
price movements support the theory of exhaustible resources? By examining the movements in the
price of exhaustible resources over time it is clear that there is very little support for the theory of
exhaustible resources, at least not in its simplest format. The evidence from large numbers of
commodities is that prices have either not increased at all or have fallen or describe some U shaped
curve. The implications of this evidence is that either the theory of depletion is itself is wrong or that
the theory makes unreasonable assumptions or that there are other important factors which have not
been taken account of. Alternatively it may be necessary to be more precise about what the theory
actually says.
The theory of depletion does not state that prices should rise at the rate of interest (since
that only holds in the case of zero extraction costs) but rather that economic rent should
increase at the rate of interest. This means that it is possible for prices not to rise at the rate
of interest or even to fall over time provided that technical progress has led to sufficient
reductions in the costs of extraction. Alternatively it may be that mine owners are
continuously surprised by the fact that more of the resource is being discovered
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The theory of depletion also abstracts from the process of actually discovering exhaustible
resources but instead assumes that the reserves are of known size and that the only question is how
to deplete them over time. A more complete theory would consider both processes simultaneously.
Such theories have in fact been developed although they are too complex to be considered here. One
such model of resource discovery and depletion permits prices charged to first fall and then to rise
over time. This would appear to fit the empirical evidence in a number of cases.
15.7 Optimal Extraction of an Exhaustible Resource
Let us outline three classifications of exhaustible resources:
i) Current reserves - known reserves that can be profitably extracted at current prices.
j) Potential reserves - reserves that could be recovered at higher prices.
k) Resource endowment - the entire geological supply of resources (including those not yet
discovered).
Decisions to use exhaustible resources are dynamic decisions, because future availability of the
resource depends on what is used today. Thus, exhaustible resources should be treated as an
asset.
15.8 The Costs of Extraction
There are two costs to using a resource, such as oil, today:
a) Extraction cost
How much does it cost to obtain the resource? Obviously, only sell if P ≥ MEC (marginal
extraction cost).
b) User cost
This is the opportunity cost of not having the resource to sell in the future. As a result, the price
of the resource will be greater than the MEC. Thus the owner of a resource, such as oil, has two
options to make money for next year:
i) Sell all the oil now, and invest the profits at interest rate i. and
ii) Wait and sell the oil next year.
Case A: Expected price next year rises less than the rate of interest:
Present value of marginal profits next year is less than current value this year:
i.e. P1 - MEC > (P2 - MEC)/(1+i)
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The owner of the oil is better off selling the oil now and investing it. Leads to lower prices now
(greater supply) and higher prices next year (lower supply).
Case B:
Expected price next year rises faster than the rate of interest:
Present value of marginal profits next year is greater than current value this year:
i.e. P1 - MEC < (P2 - MEC)/(1+i)
The owner of the oil is better off waiting to sell the oil next year. This leads to higher prices now
(lower supply) and lower prices next year (higher supply).
Prices adjust whenever one option (case A or B) looks better. Thus, equilibrium is reached when
the expected price of the oil rises at the rate of interest.
o
P1 - MEC = (P2 - MEC)/(1+i), or
o
(1 + i)(P1 - MEC) = (P2 - MEC)
15.9 Marginal user cost (MUC)
MUC refers to the present value of the opportunity cost of the last unit of oil used not being
available in the next period.
i.e. P(t) = MUC(t) + MEC(t)
If marginal extraction costs (MEC) are constant, the marginal user cost (MUC) rises at the rate
of interest, i. This implies that the present value of marginal user cost remains the same!
Note that the price of a resource is greater than the MEC. Thus, higher prices
are not, by themselves, evidence of abuse of market power. Rather, they
simply represent economic rent due to scarcity. The mathematical example
shows how the marginal user cost increases as scarcity is more of a problem.
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15.10 Changes in the marginal extraction cost
Up to now, we have assumed the MEC is constant. If marginal extraction costs rise over time,
the marginal user cost will fall.
Intuition: MUC represents the opportunity cost of using the resource now. If it will be more
costly to use the resource in the future, the opportunity cost is not as high.
The theories that have been put forward so far all make the assumption that once the
resource has been extracted and ‘consumed’ it ceases to exist. This of course is
absolutely not the case in some instances (although in the case of energy products it is)
and what happens is actually that the material is transformed and then, when the
product has reached the end of its useful life, is disposed of. This leaves the possibility
for recycling the material in question or taking virgin materials out of the ground. The
effect of recycling is to augment considerably the original stock of the resource. For
example if 90 percent of a particular metal can be recycled then the effective stock of
the resource is multiplied by 10 times. It seems reasonable to assume that as the cost
of virgin materials increases, so the quantity of materials recycled will rise
asymptotically to 100 percent.
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