The Economic Approach to
Environmental and Natural
Resources, 3e
By James R. Kahn
© 2005 South-Western, part of the Thomson Corporation
Part I
Theory and Tools of
Environmental and Resource
Economics
3e
Chapter 2
Economic Efficiency and
Markets: How the Invisible
Hand Works
© 2004 Thomson Learning/South-Western
The Working of the Invisible Hand
 Adam Smith’s The Wealth of Nations argues that
markets lead to socially efficient allocation of
resources. People acting in their own best interests
tend to promote the social interest.
 Anti-globalization protesters counter that free
markets are the root of all social evils.
 The truth probably lies somewhere in between.
4
Market Fundamentals
 Begin by looking at an every-day private
good.
 The goal is to understand the differing
components of a market.
 After we understand how a market works, we
can add the complexity associated with the
impact of market activity on the environment,
and the impact of the environment on market
activity and society in general.
5
Figure 2.1 – Market for Blue Jeans
6
The Market for Blue Jeans
 The marginal costs of blue jeans are reflected in the upward
sloping supply function. These costs include:




Production costs such as labor, energy, capital, and materials.
Traditional “factors of production”:
Land, labor, capital, entrepreneurship
Natural resources subsumed in land
 The downward sloping function is the demand curve which
represents how much people are willing to pay for an additional
pair of jeans.
 Consumer demand is influenced by tastes and preferences, prices
of substitutes and complements, income, numbers of consumers
and consumer expectations.
7
The Market for Blue Jeans
 Equilibrium is the price at which quantity
demanded equals to quantity supplied.
 What happens when price is not at equilibrium?
There is an automatic adjustment back to
equilibrium.
 If price is less than equilibrium (P*), then quantity
demanded will be greater than quantity supplied and
there will be pressure on price to rise (up to equilibrium).
 If price is greater than equilibrium (P*), then quantity
supplied will be greater than quantity demand and there
will be pressure on price to fall (down to equilibrium).
8
Measuring Net Benefits
 If we make two simple assumptions:
 All costs associated with blue jeans are
incorporated into the supply curve.
All the benefits associated with blue jeans are in the
demand curve.
 Then equilibrium in this market also equates
marginal benefits with marginal costs.
 The market maximizes total net benefits.
9
Measuring Net Benefits
 The demand curve can viewed as a marginal
value function based on willingness to pay.
The market demand curve is the sum of all
individual demand curves.
Every individual demand curve reflects a
willingness to pay based on a perceived value (or
benefit) of the good.
 As a result, the market demand curve reflects
private benefits.
10
Measuring Net Benefits
 The supply curve reflects the costs of
producing the good or service.
 These costs are incurred in production and
can be viewed as private, since all these
costs are borne by the suppliers.
 As such, the supply curve embodies private
costs.
11
Maximizing Private and Social Benefits
 Private net benefits are maximized at equilibrium.
 In order for social net benefits to be maximized, it is
necessary that private marginal benefits be identical
to social marginal benefits and private marginal
costs be identical to social marginal costs.
 I.e. no externalities – no external costs or benefits.
 If this condition holds, then market forces will equate
both marginal private costs and benefits and
marginal social costs and benefits.
12
Market Failure: When the Invisible Hand
Doesn’t Work
 Market Failure occurs when the market does
not allocate resources efficiently.
 One possible cause of market failure is a
divergence between private and social costs.
 (External costs and/or benefits)
 Consider a production process which
reflects all the private costs of production
but does not reflect all the social costs
associated with production (for example, if
the process generates air pollution).
13
Figure 2.3. Steel Production Example
14
Market Failure
 Market forces generate an equilibrium
production level and price associated with
private costs (Q1 and P1).
 This output level is greater than the socially
optimal level of Q* (which considers
additional cost from pollution).
 The shaded area in Figure 2.3 represents the
costs to society of having this higher than
optimal level of output.
15
Market Failure
 There are 5 categories of market failure:
1. Imperfect competition.
1. Imperfect information.
2. Public goods.
3. Inappropriate government intervention.
4. Externalities.
16
Imperfect Competition
 Imperfect competition occurs when the individual
actions of particular buyers or sellers have an
impact on market price.
 In imperfectly competitive markets, marginal
revenue diverges from price and marginal social
cost is not equal to marginal social benefit at
equilibrium.
 Market failure due to imperfect competition has an
impact on the study of environmental and natural
resources because of the monopoly power in
extractive industries such as oil and coal.
17
Figure 2.4. Imperfect Competition
18
Imperfect Information
 Imperfect information means that some segment of the market
(either consumers, producers, or both) does not know the true
costs or benefits associated with the good or activity.
 For example:
 High risk occupations where workers do not have complete
information about risks.
 Hazards of using chemicals in your home where you may not
be fully aware of dangers and potential side-effects.
 Potential that farmers in developing countries are not aware of
environmentally-friendly alternatives to clear-cutting.
 Traditional straight-line agriculture promoted rapid topsoil
erosion (generally superseded by contour planting.)
19
Public Goods
 Public goods are distinguished from private goods
by two primary characteristics: nonrivalry and
nonexcludability.
 Nonrivalry means that one individual’s consumption
does not diminish the amount of the public good
available for others to consume.
 Nonexcludability means that if one person has the
ability to consume the public good, then others can’t
be excluded from consuming it.
20
Public Good
 National defense is an example of a pure
public good.
 Nonexcludability holds because in protecting
one citizen in a region from missile attack,
every citizen is protected.
 Nonrivalry holds because one citizen’s
consumption of protection does not reduce
the level of protection available to other
citizens.
21
Public Good
 Village Commons (Tragedy of the Commons)
 Free livestock grazing on field in center of village
 Results in overuse, meaning all vegetation eaten and
too much waste
 Provides individual farmers incentive to use the
resource to exhaustion (effectively destroying it) to
prevent others from doing so
 Solution: private property, or limit access to public
property
22
Public Good
 Not all public goods are pure public goods.
 It is possible to build a long fence around the
Grand Canyon to exclude people.
 It is also true that beyond some point, more
people at the Grand Canyon reduces the
quality of the experience for everyone.
23
Figure 2.5 Spectrum of public goods
24
Inappropriate Government Intervention
 Government intervention is a potential source of
disparity between private and social values.
 Often government action to address an alternative
issue creates this divergence.
 As Figure 2.6 illustrates, government policy
regarding leasing of timbering has created a greater
than socially optimal level of timber harvest.
 NFS builds roads on national forest lands,
externalizing some of the cost for loggers.
 Results in more logging, at lower cost to loggers,
with less of total cost transferred to wood
consumers.
25
Figure 2.6 – Inappropriate Government
Intervention
26
Externalities
 Externalities are best described as “spillover
costs or benefits”, unintended
consequences or side effects, associated
with market transactions.
 These unintended costs or benefits will
result in a divergence between private and
social benefits and costs (as illustrated in
Figure 2.3).
 Externalities are perhaps the most important
class of market failures for the field of
environmental and resource economics.
27
Externalities
 A more complete definition is provided by
Baumol and Oates (1988, p.17)
 “An externality is present whenever some
individual’s (say A’s) utility or production
relationships include real (that is
nonmonetary) variables, whose values are
chosen by others (persons, corporations,
governments) without particular attention to
the effects on A’s welfare.”
28
Externalities
 Key points from this definition:
 Production and Utility
 Real variables
 Unintended effects
29
Unintended Effects
 If you were intentionally blowing cigar smoke
in someone’s face, that is not an externality.
 If your cigar smoke drifts from your table to
someone else’s, then this is an externality.
 Intent is important.
30
Real Variables
 Real variables are not prices.
 Unintended price change is not an
externality.
 Price changes are viewed as “pecuniary
externalities”, not real externality.
 Pecus (Latin) = cattle, used here because cattle
were an early form of money.
31
Production and Utility Relationships
 Air pollution has the potential to impact both
production and utility relationships.
 Air pollution may create a less ideal growing
condition and impact agricultural yields.
 Air pollution may also make outdoor
activities less enjoyable (reduce utility).
 These are examples of technological
externalities.
32
Technological vs. Pecuniary Externalities
 Consider Figure 2.8 which represents a production
possibilities frontier for two goods: cotton and steel.
 The production possibilities frontier shows all
feasible production points.
 Consumer preferences determine the actual
combination of cotton and steel produced.
 A change in consumer preferences will result in a
change in demand, which changes prices and profit
potential, which, in turn, will cause a change in
production levels of both goods (along the same
production possibilities frontier). This is a pecuniary
externality, not a real externality.
33
Figure 2.8- Production Possibilities
Frontier
34
Technical vs. Pecuniary Externalities
 Notice the second lower curve in Figure 2.8.
 This represents a situation where the production of
steel generates pollution (an externality).
 Pollution reduces the yield per acre of cotton with
the existing resource base.
 A new lower production possibilities curve results
from this externality.
 This is a technical externality. (A real externality).
 Solution: Make steel manufacturers compensate
cotton growers. This would result in steel users
indirectly compensating cotton users
 Less steel and more cotton would be produced.
35
Externalities as Public Goods
 Referred to as nondepletable externalities,
these are characterized by the public good
property of nonrivalry.
 The pollution of drinking water is a good
example where one person’s consumption of
the water pollution does not reduce the
amount of water pollution to which others
are exposed.
36
Market Failure and Property Rights
 A special class of externality that is generated by the
lack of property rights (or the inability to enforce
property rights) is the open-access externality.
 Recall the Tragedy of the Commons.
 In this case property rights are insufficient to
prevent general use of a resource and uncontrolled
use leads to destruction or damage of the resource.
 Even when property rights exist, an inability to
enforce them will lead to open-access externalities.
37
The Invisible Hand and Equity
 Market allocation of resources, absent of
market failure, is efficient.
 An efficient allocation maximizes the
difference between social benefits and social
costs.
 An efficient allocation, however, does not
imply equitable allocation.
 The “best” distribution depends on what
view of equity or fairness is held.
38
The Invisible Hand and Dynamic
Efficiency
 A static analysis is only concerned with one
time period.
 If the optimal allocation of resources in one
period depends on the optimizing decisions
of the past or future periods, then a dynamic
analysis must be employed.
39
The Invisible Hand and Dynamic
Efficiency
 Static example – a farmer has 100 acres of
cropland and decides to plant one type of
crop this year and a different crop next year,
in response to changes in market forces.
 Dynamic example – a farmer has 100 acres of
forest land and 100 acres of cropland. A
choice to cut trees this year means that in
the next time period the trees will be gone.
40
Dynamic Efficiency and Exhaustible
Resources
 Since decisions made today can influence
the quality and stock of resources far into
the future, one would expect dynamic
considerations to be important in the study
of environmental and resource economics.
 For example, the decision of how much oil to
take out the ground today effects our ability
to take oil out of the ground in the future.
 This will be based on how much people will
be willing to pay for oil in the future.
41
Dynamic Efficiency and Exhaustible
Resources
 Efficiency requires that you continue to sell
oil today until the point at which marginal
cost equals marginal revenue.
 The way in which the future is represented in
this decision is to incorporate an opportunity
cost (user cost or rent) into the decision
making process.
 The interest rate becomes important also.
42
Dynamic Efficiency and Exhaustible
Resources
 The individual oil owner has two choices for
producing income in the future:
Sell oil today and invest money and earn interest
income.
Hold on to oil, sell in the future.
 Intertemporal efficiency requires that the
producer make a choice that will maximize
the sum of the present values of the earnings
potentially received in each period.
43
Dynamic Efficiency and Exhaustible
Resources
 Assume that oil producers believe that the future
price will be too low, and they will be better off
selling oil now.
 Sales of oil now mean less oil available in the future
(this will cause future oil prices to rise).
 Sales of oil now will also depress current price of oil.
 This combination of prices changes in the future and
now will make holding oil for sale in the future more
attractive.
44
Dynamic Efficiency and Exhaustible
Resources
 As long as one option (selling in the present
versus selling in the future) appears to be a
more attractive option than the other, prices
will adjust.
 The process of price adjustment will
continue until owners of oil are indifferent
between the options of selling in the present
and selling in the future.
45
Dynamic Efficiency and Exhaustible
Resources
 Since the present price is dependent on the
future price, and the future price is
dependent on the present price, there is an
opportunity cost for using a barrel of oil at
any particular point in time.
 This opportunity cost is associated with NOT
having the barrel of oil available in another
time period.
 This opportunity cost is both a social cost
and a private cost and is referred to as a user
cost.
46
Dynamic Efficiency and Exhaustible
Resources
 The price of oil, at any particular time can be
represented by the following equation:
P1 = MUC1 + MEC1
 Where
MUC refers to Marginal User Cost, and
MEC refers to Marginal Extraction Cost
47
Marginal User Cost and Marginal
Extraction Cost
 The most important thing to understand about this
equation is that it is possible to predict the changes
in the price of oil by predicting changes in the
marginal extraction cost and the marginal user cost.
 Your text illustrates this point by considering the rise
in MUC when Iraqi forces invaded Kuwait in early
August 1990. Fear about potential changes in
production levels in Kuwait drove up the opportunity
cost (MUC) of using a barrel of oil. Prices rose
dramatically but fell again when US forces
established dominance and removed concerns about
falling production.
48
Marginal User Cost and Marginal
Extraction Cost
 Two important points:
 The existence of MUC means that price will always
be different from MEC. MUC is a form of scarcity
rent (not monopoly profit).
 In order for an owner of oil to be indifferent as to the
period in which he or she sells, the present value of
the MUC must be the same in all periods. This
means that MUC of an exhaustible resource will
increase with the discount rate.
49
Other Examples of Dynamic Problems
 Persistent pollutants, chronic pollutants, or
stock pollutants that accumulate in the
environment.
Today’s decision to generate a stock pollutant has
an effect on environmental quality far into the future.
 Changes in land use patterns can change
environmental resources that can never be
restored.
Over-grazing of grasslands has allowed the Sahara
desert to move south at an alarming rate.
50
Conclusion
 The bulk of this chapter focuses on markets
and how markets efficiently allocate goods
and services.
 When market failure occurs, marginal private
benefits diverge from marginal social
benefits and marginal private costs diverge
from marginal social costs.
 Market failure results from externalities,
public goods, imperfect information,
imperfect competition, and inappropriate
government intervention.
51