CHAPTER 4:

THE ECONOMIC OF
ENVIRONMENTAL QUALITY

Dr. Nguyen Thi Thanh

Huyen
I. Pollution as market failure
Without the control of the third party, if
the market works as the rule of invisible
hand, pollution causes market failure.
Reason: The rule of competitive market is
violated due to pollution. It distorted the
traditional market’s activities.
Pollution from an economic perspective
If market good is defined as
environmental quality then this
environmental good/bad is a public
good/common property good.
If market good is a normal economic
good and there is external cost/benefit
arised during the production, then
pollution is externality.
II. Environmental quality as
Environmental Goods

What is 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
Essential factors for Environmental
quality to be Environmental Good

There are needs to the environmental

quality.
There are markets for Environmental
goods.
There is no agreed definition of “environmental
goods”, but is generally agreed that such goods
generally fall into one of two categories A or B:
A) The first category includes raw and
manufactured industrial goods used
to provide an environmental service
such as wastewater treatment, solid
waste management, and air pollution
control.
These goods, which include a wide
variety of industrial products such as
valves, pumps and compressors, can
be specifically employed for
environmental purposes.
B) The second category of
environmental goods includes
both industrial and consumer
goods whose production, end-use
and/or disposal have reduced
negative, or potentially positive,
environmental impacts relative a
substitute good providing similar
function and utility.
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
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
III. 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 my ability to do so),
d 2) A public good is also non-
excludable in consumption (e.g.
we cannot be prevented from
seeing the view or breathing the
air).
 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 it isn’t there for other people to
consume.
 Deriving Aggregate Demand for Public
Good

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
Consider Two Goods with Identical Aggregate Demand:
• The first good is a private good, (i.e., Chicken Sandwiches)
• The second good is a public good, (i.e., Water Quality at Mono
Lake)
 Private Good: Notice that the
market price is an efficient
mechanism.
 The equilibrium price of a chicken sandwich
is P=MC, so that each chicken sandwich
costs $P. Consumers compete for the
consumption of sandwiches, and, at a price
of $P, will self-select socially optimal
quantities.
Consumer 1eats Q1* sandwiches, consumer
2 eats Q2* sandwiches and Q1* + Q2* =
Q*,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.
 Relate to the case of the private good. The social
optimal solution would be to provide Q* and then
charge each consumer a unit price equal to the
individuals’ marginal value at Q*, or, P1* and P2*.
As in the case of private goods, the high demand
individual will pay a larger amount than the
individual with a lower willingness to pay for the
good).
=>It is impossible
IV. 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:
 Production Cost: labor, capital and fish swimming
around in water.
 Cost to get the fish: The capital and labor.
 If the fish stock is owned, the fisherman will have to
pay the owner for each fish harvested. => The
fisherman pay all the opportunity costs of all of
reducing the stock and opportunity cost to get the
fish out of the dock.
Common property:
 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.
V. Environmental impacts as economic
“externalities”
Definition
Externalities refers to situations
when the effect of production or
consumption of goods and services
imposes costs or 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.
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.
Economic consequence of an externality

Positive externality
Social benefits=private benefits + External benefit
And external benefit >0
Therefore Social benefits > Private benefits

Negative externality

Social costs =private costs + External cost

And external costs > 0
Therefore Social costs > Private costs
Both negative and positive externalities exist

Externality Beneficial Harmful

Originating In
Production Honey Fossil fuel
Activity production combustion
Atmospheric
Externality Pollination for pollution
fruit growing
Consumption Vaccination of High stereo
Activity one person volume in
Reduced risk of apartment
Externality infection for rest Noise pollution
of population
The efficiency loss due to a positive
externality
The efficiency loss due to negative
externality
Case 1: One firm
The efficiency loss due to negative
externality
Case 2: An Industry
Exercise 1
A factory producing chemical fertilisers
(MNPB=4-0,5q) is polluting the nearby
river, causing environmental damage:
MEC=1,5q.

a. How much will the factory produce to

maximise its profit, and how much profit will it
then have?
b. If the goverment decides to regulate the
company using a tax, how high should the tax
rate be, how much tax will the company be
paying,and how much profit will it then have?

Exercise 2
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.

 How many boxes of honey bees were there in the bee
farm to maximize bee farm’s profit and how much was
the price?
 How many boxes and at what price of honey bees should
be good for the social net benefit?
 Draw the graph