CHAPTER 4:

THE ECONOMICS OF
ENVIRONMENTAL QUALITY
 I. ENVIRONMENTAL QUALITY AS
ENVIRONMENTAL GOODS

What is economics good?

• A consumable item that is useful to people but scarce in

relation to its demand, so that human effort is required to
obtain it.
• In contrast, free goods (such as air) are naturally in
abundant supply and need no conscious effort to obtain
them
 ENVIRONMENTAL GOODS

• Environmental quality are typically non-market

goods

• Including clean air, clean water, landscape, green

transport infrastructure, public parks, rivers,
mountains, forests, and beaches.

• Environmental goods are a sub-category of public

goods
 LIMITATIONS AND DIFFICULTIES IN DEFINING
ENVIRONMENTAL GOODS

• Almost prices of environmental goods are not

available
• If there are prices of environmental goods, they show
only the minimal payments at which the consumers
and the producers have agreed to enter into
transactions.
• At these prices, there may be substantial CS/PS that
may go unaccounted.
• The price of environmental goods do not reflect their
worth
 ESSENTIAL FACTORS FOR ENVIRONMENTAL QUALITY
TO BE ENVIRONMENTAL GOOD

• There are needs to the environmental quality.

• There are markets for Environmental goods.

+ Environmental quality must be reproduced

+The cost of reproducing environmental quality must

be calculable
 BECAUSE THEY ARE GOODS SO…

• Environmental goods are related to the production

function of marketed goods.

• Most economic theories are able to be applied in

analyzing environmental goods and services
 II. ENVIRONMENTAL GOODS AS
PUBLIC GOODS

• 1) A public good is non- rivalrous in consumption (e.g.

your breathing of the clean air or looking at the scenic

view, does not affect other people to do so)

• 2) A public good is also non-excludable in consumption

(e.g. we cannot be prevented from seeing the view or

breathing the air).

 ENVIRONMENTAL QUALITY IS
A PUBLIC GOOD
• Public goods are characterized by non-rivalness
and non-exclusion—there is joint consumption of
the good and, once provided, everyone can enjoy
the good whether they pay for it or not.

¡Excludability: can you be excluded from consuming the

good?
¡Rivalry: does my consumption hinder your consumption?

• Environmental quality is a public good

 RECALL: DERIVING AGGREGATE DEMAND
FOR PRIVATE GOOD

Why Private Goods Are Summed Horizontally:

• Exclusive: once you buy it, you own it and can consume it as you
please.
• Rival: a good taken off the shelf isn’t there for other people to
consume.
P=P1=P2; Q= Q1 + Q2
 DERIVING AGGREGATE DEMAND FOR
PUBLIC GOOD

Public Goods Are Summed

Veriticallly:
• Demand is summed vertically,
because all individuals can
enjoy the same.
• Therefore, for each marginal
unit of water quality:
Aggregate demand = the sum
of individual value for the unit
P=P1+P2; Q=Q1=Q2
 CONSIDER TWO GOODS WITH IDENTICAL
AGGREGATE DEMAND

• The first good is a private good (i.e. sandwiches)

• The second good is a public good (i.e. Water

Quality at Ho Guom Lake)

 PRIVATE GOOD: NOTICE THAT THE MARKET
PRICE IS AN EFFICIENT MECHANISM

• The equilibrium price of

a sandwich is P=MC, so
that each sandwich
costs $P.
• Consumers compete for
the consumption of
sandwiches, and, at a
price of $P, will self-
select socially optimal
quantities.

• Consumer (1) eats Q1* sandwiches, consumer (2) eats Q2*

sandwiches and Q1* + Q2* = Q* is the aggregate efficient level.
The shaded regions show the total payment by each individual.
 PUBLIC GOOD: THE MARKET PRICE IS NO LONGER AN
EFFICIENT MECHANISM, BECAUSE THE STOCK OF A PUBLIC
GOOD IS NEVER “CONSUMED AWAY”

The equilibrium price of

water quality cannot be
P=MC, because then
Consumer 1 would not pay
for any water quality
improvements, Consumer
2 would pay for only Q2,
and, since Q2 < Q*, the
efficient level of water
quality would not be met.
 III. ENVIRONMENTAL GOODS AS
COMMON-PROPERTY GOODS

• Common-property goods are owned by everyone,

meaning property rights are not controlled by
anyone in particular.

• Goods characterized by rival consumption and the

inability to exclude nonpayers.
 EXAMPLES

• A common-property fishery,
• A common property oil field,
• A common-property wilderness area,
• A common-property air space,
• A common- property aquifer,
• A common-property rain forest.
 COMMON PROPERTY GOOD CAUSES MARKET TO FAIL

Commercial fisherman harvests caught fish to sell

Private property Common property

• Production Cost: labor, • The commercial
capital and fish swimming fisherman will not
around in water. take into account
• Cost to get the fish: The the opportunity cost
capital and labor. to society of
• If the fish stock is owned, the reducing the stock
fisherman will have to pay because he or she
the owner for each fish will not have to pay
harvested. => The fisherman this cost.
pay all the opportunity costs • That is, when an
of all of reducing the stock input is free, people
and opportunity cost to get will overuse it.
the fish out of the dock.
 TRAGEDY OF THE
COMMONS
• Commonly-owned resources tend to
be over-exploited Garrett Hardin
• Conflict between self-interest and the common
good
 IV. ENVIRONMENTAL IMPACTS AS
ECONOMIC “EXTERNALITIES”
Definition
• Externalities refers to situations when the effect of
production or consumption of goods and services
imposes costs / benefits on others which are not
reflected in the prices charged for the goods and
services being provided. (OECD)

• Externalities arise when property rights cannot be

clearly assigned.
 EXTERNALITY

• Externalities are classified as:

Ø︎Consumption to consumption ︎
ØConsumption to production ︎
ØProduction to consumption
ØProduction to production
 NEGATIVE EXTERNALITY

Production imposes costs on others which are not

reflected in the prices

E.g: Chemicals dumped by an industrial plant into a

lake may kill fish and plant life and affect the
livelihood of fishermen and farmers nearby
 POSITIVE EXTERNALITY

Production imposes benefits on others which are not

reflected in the prices

E.g. Construction of a road

Construction of a road which opens a new area for

housing, commercial development, tourism, etc.
EXTERNAL COSTS FROM GASOLINE
CONSUMPTION
Both negative and positive externalities exist

Externality Beneficial Harmful

Originating In

Production Activity Honey production Fossil fuel combustion

Externality Pollination for fruit Atmospheric pollution

growing

Consumption Vaccination of one person High stereo volume in

Activity apartment
Reduced risk of infection
Externality for rest of population Noise pollution
 ECONOMIC CONSEQUENCE OF AN
EXTERNALITY

Positive externality Negative externality

• Social benefits=private • Social costs =private
benefits + External benefit costs + External cost
• External benefit >0 • External costs > 0
Therefore
Therefore,
• Social costs > Private
• Social benefits > Private costs
benefits
THE EFFICIENCY LOSS DUE TO A
POSITIVE EXTERNALITY

MPC:Marginal
Private Cost
MSC:Marginal
Social Cost
MPB:Marginal
Private Benefit
MSB: Marginal
Social Benefit
MEB: Marginal
External Benefit

MSB=MPB+MEB
 THE EFFICIENCY LOSS DUE TO A
POSITIVE EXTERNALITY
• Private/Firm equilibrium is defined where MPB = MPC,
at point B
-> The equilibrium price for firm is Pm and equilibrium
quantity is Q.
• Social equilibrium is defined where MSB=MSC , at
point E .
->The social equilibrium price is Ps and equilibrium
quantity is Qs.
• Q < Qsà When there is a positive externality, the
market tends to produce less than society’s desire.
• Deadweight loss is ABE
 THE EFFICIENCY LOSS DUE TO
NEGATIVE EXTERNALITY
EXAMPLE: A PAPER MILL

• Production residuals cause harm to downstream users

• What will the social marginal cost curve look like?
o Social MC = private MC + external MC (MSC=MPC+MEC)
o What does this imply about relationship between Qs and Q?
MARKET FAILURE

MSB MSC=

MEC

Qs Q
 THE EFFICIENCY LOSS DUE TO
NEGATIVE EXTERNALITY
Case 1: One firm

MR

Qs Q
The efficiency loss due to negative
externality
Case 2: An Industry
 THE EFFICIENCY LOSS DUE TO
NEGATIVE EXTERNALITY

• The producer's optimal level is at MPB=MPC (point

B) , with the price at Pm and output Q'.
• An efficient social allocation of resources is
achieved at MSC =MSB (point E), with output Qs
and price Ps.
• Q’> Qs àWhen there is a negative externality, the
market tends to produce more than society’s
desire.
• Deadweight loss is ABE
 EXTERNALITY

• When environmental values are concerned, there

are likely to be very substantial differences between
market values and social values.
• Market failures cause the divergence.
 EXERCISE 1

• A honey bee farm produced honey. The honey was sold in

the market $2 per kg and 10kg honey was collected from
each box.
• Next to the bee farm, there was a blue berry farm. The bees
flew into the blue berry farm and each box could pollinate for
one hectare of the blue berry. However the bees did not
enough to pollinate all the plants so that the blue berry farm’s
owner hired people to hand pollinate with the cost of $10 per
hectare.
• The marginal cost of bee farmer is MPC= 10+2Q
a)How many boxes of honey bees were there in the bee farm to
maximize bee farm’s profit and how much was the price?
b)How many boxes and at what price of honey bees should be
good for the social net benefit?
c)Draw the graph
 EXERCISE 2

MPB= 90- Q
MEB=45-0.5Q (equibrium quantity of firm )
MPC=5+Q
1. Calculate TSC (QM)
(Total Social Cost at equibrium quantity of firm)
2. Calculate NSB (QM)
(Net social Benefit at QM)
3. Calculate TSC (QS)
(Total social cost at equibrium quantity of society)
4. Calculate NSB(QS)
(Net social Benefit at QS)
5. What will be the dead weight loss?
6. Draw the graph