AP Microeconomics – Chapter 15 Outline I. Learning Objectives – In this chapter students should learn: A. Why falling birthrates mean that we are not likely to run out of natural resources. B. Why using a mix of energy sources is efficient, even if some of them are quite costly. C. Why running out of oil would not mean running out of energy. D. How the profit motive can encourage resource conservation. E. How to use property rights to prevent deforestation and species extinction. II. Resource Supplies: Doom or Boom? A. There is concern that the world is running out of resources. 1. World population has risen from 1 billion in 1800 to 6.8 billion today. 2. Since 1800, living standards have also increased, by 12‐fold in the United States. 3. More people and higher living standards mean that we are consuming many more resources than we were 200+ years ago. 4. Some question whether this pattern is sustainable; an examination of both resource demand and resource supply is necessary to answer this question. B. Population Growth 1. In 1798, Thomas Malthus (An Essay on the Principle of Population) argued that when living standards (food supply) increase above subsistence, people have more children, and as a result, per capita living standards return to subsistence. 2. As living standards have risen, however, birthrates have fallen, checking the geometric population growth predicted by Malthus. 3. The total fertility rate is the average number of children that a woman is expected to have during her lifetime. If that rate falls below about 2.1, population can be expected to decline. 4. In many industrial economies, birthrates have fallen below the replacement rate necessary to keep the population from falling over time (Table 15.1). 5. Demographers expect the world population to peak at 9 billion or fewer people, sometime around the middle of the 21st century. a. Population continues to grow even in some countries with industrializing economies. This occurs because when birthrates begin to decline, death rates AP Microeconomics – Chapter 15 Outline are typically falling faster, as better living standards mean better health, so the population will continue to rise for a time. b. Demographers are surprised by how far fertility rates have fallen, in part because couples typically report in surveys that they want at least two children. c. Despite the reported desire for children, changing attitudes toward religion, much wider career opportunities for women in modern economies, and the expense of raising children in modern societies have promoted declines in fertility. 6. A decline in the birth rate reduces the demand placed on society’s scarce resources. 7. CONSIDER THIS … Can Governments Raise Birthrates? a. Low birthrates and falling population create a problem for governments in that over time, there are fewer workers to support a growing number of retirees, and a lack of soldiers makes national defense more difficult. b. In response to falling birthrates, countries such as Russia, France, Italy, and Australia have implemented payments to encourage families to have more children, so far without apparent success. C. Resource Consumption per Person 1. In 1968, Paul Ehrlich (The Population Bomb) made his own Malthusian prediction that mass starvation would occur in the 1970s and 1980s. 2. Ehrlich’s prediction was wrong because: a. Population growth slowed dramatically as living standards rose. b. Resource supply grew faster than resource demand, as revealed by The Economist magazine’s commodity price index (Figure 15.1). AP Microeconomics – Chapter 15 Outline 3. Two factors have increased commodity demand over time: a. Population has grown. b. Living standards (consumption per person) have grown. 4. Despite growing resource demand, resource supply has grown faster. 5. Water Use in the United States (Figure 15.2) a. Total daily water use has been relatively constant since 1985. b. Per capita daily water use has steadily declined since 1975 (to about 1430 gallons per person per day in 2000). 6. Energy Use in the United States (Figure 15.3) AP Microeconomics – Chapter 15 Outline a. Total energy use has grown by only about 0.9 percent per year since 1990. b. Per capita energy use has declined a bit and been relatively stable (340 million BTUs per person per year) since it peaked in 1979. 7. Trash generation in the United States (Figure 15.4) a. Total trash generation has steadily increased. b. Per capita trash generation has been relatively stable (4.5 pounds per person per day) since 1990. 8. Despite decreases or leveling off of resource usage in some parts of the world, global demand will continue to rise as lower income economies industrialize and grow. As these developing nations advance and their population growth declines, however, resource demand may peak. 9. Even if global resource supplies are adequate to satisfy resource demands, the distribution of those resources relative to the location of those demanding resources can pose problems. III. Energy Economics A. Energy economics studies how people deal with energy scarcity (supply and demand). 1. On the supply side, economies try to find low‐cost methods of producing energy. 2. On the demand side, all else equal, we would expect buyers to want the cheapest energy source, but some production processes are overall less costly using a more expensive energy source (energy is only one input in production). B. Energy Demand 1. Per capita energy use has leveled off in developed countries (Figure 15.3 – see prior page). AP Microeconomics – Chapter 15 Outline 2. Real GDP per million BTUs has steadily increased, meaning that energy use has become more efficient (Figure 15.5). 3. Better technology means that more output can be produced with the same amount of energy input, so rising standards of living in the future will not necessarily depend on using more energy. C. Efficient Energy Use 1. Energy efficiency is achieved by using a mix of energy inputs, rather than a single source. This is paradoxical because some of the inputs are more expensive. 2. Illustration: Electric Power Generation a. Power plants serve tens of thousands of homes and businesses and are expected to deliver uninterrupted service 24 hours a day, seven days a week. b. Electricity demand fluctuates greatly over the course of a day—low at night, rising in the morning and during the workday, falling a bit during the evening commute, rising again as households turn on lights in the evening, and falling again at night as people go to bed. c. Firms attempt to minimize the cost of providing uninterrupted electrical service, but they face a dilemma: i. Energy generating processes with the lowest operating costs (e.g., coal) have high fixed costs, and can only achieve the low cost with economies of scale operating at full capacity (which is not always necessary). ii. Processes with low fixed costs tend to have higher operating costs (e.g., natural gas). d. A mix of sources (e.g., coal to satisfy the baseline demand and natural gas to cover peak demand) is often the cheapest way to provide uninterrupted power at the lowest overall cost. AP Microeconomics – Chapter 15 Outline 3. The United States generates electricity using a variety of sources: coal (48%), natural gas (21%), nuclear (19%), hydroelectric (7%), renewables (3%), petroleum (1%), and other (Figure 15.6). D. Running Out of Energy? 1. Some are concerned that the world will run out of energy because we appear to be running out of oil. However, running out of oil doesn’t mean running out of energy, just running out of cheap energy. 2. As oil becomes increasingly scarce and its price rises, other fuel sources become economically viable (Table 15.2). a. At oil prices of $40 per barrel, tar sands and natural gas conversion become profitable. b. At $50 per barrel, shale oil is viable. c. At $60 per barrel, United States corn‐based ethanol is profitable to produce. d. At $80 per barrel, biodiesel becomes economically viable. e. Together, these prices effectively form a supply curve for energy; as energy prices rise, suppliers respond by increasing production. AP Microeconomics – Chapter 15 Outline 3. An important caveat about our energy supply curve is that it does not account for externalities. Some energy sources are less environmentally friendly than others, and in order to produce the optimal mix of energy for society, we need to account for all of the costs, including the external costs. 4. CONSIDER THIS … Developing Alternative Fuel Sources Is Both Risky and Costly a. Changing World Technologies opened a factory in 2005 to turn organic matter into oil. The firm’s cost of production was much higher than expected, and the firm went bankrupt in 2009. b. Dozens of firms that converted corn into ethanol met the same fate, despite government subsidies to cover part of the production cost. c. As long as the costs of fossil fuels remain low, it will be difficult for alternative energies to be produced at a lower cost. IV. Natural Resource Economics A. Natural resource economics studies what strategies will maximize the net benefits from natural resource extraction or harvesting. Net benefits (gains or losses) are expressed in dollar terms. B. Present and future extraction and harvesting decisions are interdependent. Extracting more in the present means less is available in the future. C. Strategies for maximizing net benefits depend on whether the natural resources are renewable or nonrenewable. 1. Renewable natural resources can replenish themselves in a reasonably short period of time. a. Forests, wildlife, oceans, aquifers, the atmosphere, and solar energy are all considered renewable natural resources. b. If harvested at moderate rates, renewable natural resources can be used in perpetuity. 2. Nonrenewable natural resources are fixed in supply or replenish so slowly that for practical purposes they are fixed. a. Coal, oil, and metals are all examples of nonrenewable natural resources. b. Once nonrenewable resources have been exhausted, they can only be replaced, if possible, with substitutes. D. Maximizing net benefits from resource extraction requires incentive structures that consider both present and future resource extraction, including benefits from conservation. Properly constructed incentive structures allow decision makers to properly weigh the costs and benefits of present versus future use. Present value is critical to correctly measuring the costs and benefits. V. Using Present Values to Evaluate Future Possibilities A. Present value allows us to compare the benefits and costs of present versus future extraction or harvesting of a natural resource. If we discover a new oil field, should we pump out more today, tomorrow, in one year, or in five years? B. A given amount of money today is worth more than that same amount of money in the future. If faced with different net benefits (say $50 today versus $60 in five years), present value helps us compare by expressing those future payments into a present equivalent. (See Chapter 14 for a more detailed explanation, including formulas.) AP Microeconomics – Chapter 15 Outline 1. Example: At a 5% rate of interest, one would have to invest $47.01 today to have $60 in five years. 2. Using the above example, present value calculations tell us that we would rather have $50 today than $60 in five years, because the $50 can be invested today and leave us with more than $60 in five years. C. Present value allows decision makers to apply cost‐benefit analysis to situations where costs and benefits occur at different times. 1. Example: If given the choice to invest $1000 to earn $125,000, it is clear one should invest. However, what if the $1000 investment (the cost) must occur 100 years prior to receiving the $125,000 (the benefit)? 2. At an interest rate of 5%, the present value of $125,000 received in 100 years will be only $950.56. Given that, the cost of this investment outweighs the benefit, and should not be undertaken. 3. Present value calculations help ensure that resources will be extracted when it is most valuable to do so. D. There is a temptation to use a resource as quickly as possible; present value calculations help to measure future benefits and provide an incentive for conservation when those future benefits are sufficiently high. Ignoring future benefits leads to overuse in the present. VI. Nonrenewable Resources A. Nonrenewable resources must be extracted (mined or pumped) before they can be used. Extraction is costly and must be managed carefully, with consideration given to market prices, in order to maximize profits. B. All reserves cannot be removed immediately, so the firm’s focus is to maximize the stream of profits over time rather than the profit in a single period. C. There is a tradeoff between extracting today and extracting in the future. Revenues generated from extracting today come at the cost of having fewer resources available for extraction tomorrow. User cost is the cost of not being able to extract and sell a resource in the future because it is being extracted and sold today. D. Present Use versus Future Use 1. To determine how much of a nonrenewable resource should be extracted in the current period (“first year” in the example), firms need to know: a. The market price (P) of the resource b. Extraction costs (EC), which are the company’s production costs c. The user cost (UC) of forgoing potential future revenues from the resources extracted today AP Microeconomics – Chapter 15 Outline 2. Choosing the Optimal Extraction Level (Figure 15.7) a. The market price (P) is constant, reflecting that this company has no control over the market price and can sell as much or as little as it wants at that price. b. Extraction costs (EC) are upsloping, reflecting the increasing marginal costs of extraction due to diminishing returns in the extraction process. Extraction costs may rise when the company has to buy more equipment, hire more workers, or pay workers overtime to increase current extraction. c. The user cost (UC) is constant for each unit of the resource extracted. d. The total cost (TC) of extracting and selling the resource in the first year is the sum of the extraction and user costs. e. If the company ignores the user cost, it will extract the quantity Q0. This reduces the stream of profits over time. If the firm instead delays extraction (only extracting Q1 in the present), it can extract those additional units at a lower cost, earning more profit, given the market price. f. The profit‐maximizing quantity to extract in the current year is Q1. At any quantity to the left of Q1, the profit from extracting those units now is greater than the user cost (potential future profits). To the right of Q1, the greater extraction costs make it more profitable to delay extraction of those units. 4. When all costs (extraction and user) are considered, there is an incentive to conserve resources for future use. AP Microeconomics – Chapter 15 Outline E. Changes in expected future profits change the optimal quantity of present extraction (Figure 15.8). 1. An increase in expected future profits will increase user costs and reduce the profit maximizing quantity of present extraction. 2. Expected future profits will rise if: a. The price of the resource is expected to be higher in the future (e.g., greater demand). b. Extraction costs are expected to be lower in the future (e.g., better technology). F. Market failures lead to less than optimal rates of extraction, often encouraging excessive present extraction. 1. Weak or uncertain property rights encourage present extraction, as future profits become less certain. 2. From the perspective of the extraction company, user cost falls to zero. 3. Application: conflict diamonds (diamonds mined by combatants in war zones) tend to be extracted as quickly as possible because of uncertainty as to how long mines will be controlled. VII. Renewable Resources A. With properly structured and enforced property rights, renewable resources will be harvested in a sustainable manner and be available in perpetuity. B. Elephant Preservation 1. Renewable resources can be exhausted if property rights are not properly structured. 2. In nations where villagers have property rights over elephants, they are better protected because there is an incentive to conserve them and profit from the tourists they attract. 3. In countries where elephants belong to the state, locals have no incentive to preserve them for tourists (because the revenue only benefits the state), and the locals can only benefit themselves by killing the elephants. AP Microeconomics – Chapter 15 Outline C. Forest Management 1. Forests provide many benefits, including wildlife habitat, erosion prevention, oxygen production, recreation, and wood. 2. In 2005, about 30% of the world’s land area was forested (about 10 billion acres), and about 33% of the United States’ land was forested (about 748 million acres). 3. Economists attribute the differences in the size of forested areas across countries to differences in property rights (Global Perspective 15.1). a. Where property rights over forests exist and are well‐enforced, there is an incentive to conserve forests for long‐term use. b. Where property rights over forests are weak or nonexistent, the only way to establish a property right is to cut down the trees, resulting in deforestation. c. In the United States and Europe, virtually all wood production is by commercially run forestry companies with property rights to the land from which they harvest timber. When these companies cut down trees, they replant to replenish their stock. 4. Optimal Forest Harvesting a. With well structured and enforced property rights, forestry companies can harvest and replant at rates that sustain their long‐term stream of profits. AP Microeconomics – Chapter 15 Outline b. The optimal time to harvest a tree depends on its age relative to the life cycle of that species (Figure 15.9). i. Trees typically grow slowly as seedlings, then enter a period of rapid growth, followed by old age and the end of growth. For the Douglas Fir, the growth pattern can extend over 100 years. ii. Forestry companies typically want to harvest toward the end of the rapid growth period. During rapid growth, the company gets increasing returns; as that stage ends and diminishing returns set in, the benefits of waiting to harvest typically outweigh the cost. 5. Forests are sustainable because firms replant when they can be assured they will eventually reap the profit of replanting. Where property rights are not secure, firms will not replant because others could harvest the trees. D. Optimal Fisheries Management 1. A fishery is a stock of fish or other marine animal that can be thought of as a logically distinct group, usually identified by location and species (e.g., Newfoundland cod, Pacific tuna, Alaskan crab). 2. Table 15.3 lists the top ten United States fisheries in 2007. AP Microeconomics – Chapter 15 Outline 3. Establishing property rights over fish swimming in open oceans is difficult if not impossible, because fish in the open ocean belong to nobody. a. Property rights are only established once the fish is caught. b. This results in intense competition by fishers to catch as many as possible, leading to overfishing and, in come cases, fishery collapse. 5. Figure 15.10 shows two fisheries (Maine red hake and Atlantic tuna) that have collapsed due to overfishing. Fishery collapse occurs when fish are harvested faster than they can reproduce. 6. Table 15.4 shows that most of the world’s fisheries are either fully exploited or overexploited, some to the point of collapse (depletion). 6. A number of policies have been implemented or considered to limit catch sizes and prevent over‐fishing. a. Limiting the number of days per year that a species can be caught creates perverse incentives; fishers compensate by buying larger boats and harvesting more quickly, increasing their costs. b. Limiting the number of boats in a certain area has only led fishers to use bigger boats, increasing their costs. AP Microeconomics – Chapter 15 Outline c. Total allowable catch (TAC) limits the tonnage of a fishery that can be caught each year. Once the annual limit is caught, fishing for that species is prohibited. i. TACs have succeeded in limiting the overall catch to sustainable levels. ii. The overall limit encourages fishers to buy bigger and faster boats to catch as much as possible before the TAC limit is hit, which increases costs for fishers. d. Individual transferable quotas (ITQs) are permits given to individual fishers, limiting how many fish they can catch. Fishers must buy ITQs from others to fish more. i. By limiting the allocation of ITQs, catch sizes are successfully limited. ii. Assigning ITQs on an individual basis eliminates the arms race that drives up fishing costs. iii. Because ITQs are transferable, those able to harvest at a lower cost have an incentive to buy ITQs from those facing higher costs, profiting both fishers and lowering the overall cost of fishing. VIII. LAST WORD: Is Economic Growth Bad for the Environment? A. Some have argued that environmental degradation is the inevitable result of economic growth. Increased consumption of resources and the creation and use of new toxic chemicals feed this perception. The reality is that measures of environmental quality are higher for richer countries. B. Richer countries spend more money on environmental protection than poorer nations (environmental quality is a normal good). 1. More is spent on reducing emissions, illegal dumping, and water treatment. 2. Ecosystem and habitat preservation efforts are stronger. C. Yale University has constructed an Environmental Performance Index (EPI) that measures environmental performance in terms of 25 environmental indicators. 1. The EPI is positively correlated with living standards (GDP per capita); richer nations tend to have lower carbon emissions, better air and water quality, and more wilderness protection. 2. Economic growth promotes a healthy environment by making people rich enough to pay for pollution‐reduction technologies that poorer countries cannot afford. D. Economic growth and a healthy environment can exist simultaneously, and there need not be a tradeoff between the two.