Slide 5.1
Chapter 5
The economics of the environment
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Slide 5.2
• Natural resources
• Amenity services
• Waste products.
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Slide 5.3
Economy
Environment
Benefit from the
natural environment
Flow of waste
Households
(consumers)
Amenity
services
Goods and
services
Factor
services
Waste
Natural
resources
Firms
(producers)
Flow of resources
Relationship between the economy and the environment. The environment is linked to the economy in terms
of providing natural resources and amenities as well as acting as a dumping ground for waste products
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Sustainable economic welfare(1)
• Essentially, any increase in the GNP figure is
adjusted to reflect the following impacts
which are often associated with rising GNP:
• 1- Monies spent correcting environmental
damage (i.e. defensive expenditures);
• 2- Decline in the stock of natural resources (
i.e. environmental depreciation);
• 3-Pollution damage ( i.e. monetary value of
any environmental damage not corrected).
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Sustainable economic welfare(2)
• By failing to take these environmental
impacts into account, the conventional
GNP figure does not give an accurate
indication of sustainable economic
welfare, i.e. the flow of goods and services
that an economy can generate without
reducing its future production capacity.
• Suppose we consider the expenditure
method of calculating GNP.
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Sustainable economic welfare(3)
• It could be argued that some of the growth in
GNP is due to expenditures undertaken to
offset the impact of environment damage.
• For example, some double-glazing may be
undertaken to reduce noise levels from
increased traffic flow, and does not therefore
reflect an increase in economic wellbeing,
merely an attempt to retain the status quo.
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Sustainable economic welfare(4)
• Such defensive expenditures should be
subtracted from the GNP figure.
• So too should be expenditures associated
with a decline in the stock of natural
resources.
• For , monetary value of minerals extracted
from rock is included in GNP, but nothing
is subtracted to reflect the loss of unique
mineral deposits.
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Sustainable economic welfare(5)
• Environmental depreciation of this kind
should be subtracted from the
conventional GNP figure.
• Finally, some expenditures are incurred to
overcome pollution damage which has not
been corrected; e.g. extra cost of bottled
water when purchased because tap water
is of poor quality ( and sometimes it is
dangerous to drink).
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Sustainable economic
welfare(6)
• Additional expenditures of this kind should
also be subtracted from the GNP figure, as
should the monetary valuation of any
environmental damage which has not been
corrected.
• We are then left with an Index of Sustainable
Economic Welfare (ISEW) which subtracts
rather more from GNP than the usual
depreciation of physical capital.
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Sustainable economic welfare(7)
• ISEW= GNP - depreciation of physical capital
- defensive expenditures
-depreciation of environmental capital
- monetary value of residual pollution
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Sustainable economic welfare(8)
• The effect of such adjustments is quite
important.
• The UK GNP per capita(unadjusted) has grown
by around 2.0% in real terms as an annual
average growth rate since 1950.
• However, the adjustment outlined above for
each year over the period gives an ISEW per
head for the UK which corresponds to a mere
0.5% average annual growth in real ISEW over
the period.
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Exercise
• Calculate ISEW if you know that the GNP
= 10 billion , depreciation of physical
capital= 2 billion ,defensive expenditures =
1 billion, depreciation of environmental
capital = .5 billion and monetary value of
residual pollution = .3 billion
• ISEW= 10-2-1-.5-.3= 6.2 billion.
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Slide 5.13
• Marginal net private benefit (MNPB) : the extra net
benefit, i.e. profit, received by the firm in
producing one more unit
• Marginal external cost (MEC): the extra damage
to society as a result of producing one more unit
• The optimum level of pollution is achieved at a
scale of activity where MNPB = MEC
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Slide 10.14
MEC
Costs and
benefits
MNPB
0
Qs
Scale of economic activity
An optimum level of pollution exists where MNPB equals MEC with the firm producing Qs. If a firm produces
an amount below Qs the benefits the firm derives in terms of profit is greater than the cost on society in
terms of MEC, thus output should be expanded. If the firm is producing an output above Qs then the cost to
society is greater than the benefits the firm is deriving and so output should be reduced . The scale of
activity
Qs is
termed
the social
optimum
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Wall:
Economics
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Slide 5.15
• Mostafa has a monopolist firm and his
functions are as follows:
• P= 100-0.25Q
• MR=100-0.5Q
• MC=5
• MEC= 0.25Q
Where P is the price, Q is the output, MR is the
marginal Revenue, MC is the marginal Cost and
MEC is the Marginal External Cost.
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Slide 5.16
• 1. If the government does nothing, how
much does Mostafa produce to maximize
his profit?
• MR=MC
• 100-0.5Q=5
• Q=190
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Slide 5.17
• 2. What is the marginal Social cost (MSC) of
Mostafa’s profit maximized level of output?
• MSC=MC+MEC
• MC+MEC
• =5+ 0.25*190= 52.5
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Slide 5.18
• 3- What price do consumers pay for each
unit of Mostafa’s output?
• P= 100-0.25Q
• = 100- 0.25* 190= 52.5
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Slide 5.19
• 4. Is this level of production optimal? Why?
• Yes it is optimal as price= MSC
• 5.Should the government take a pollution
fees? Why?
• No as the production level is optimal.
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Slide 5.20
• Bargaining and negotiation
• Environmental taxes
• Tradable permits
• Environmental standards
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Slide 5.21
• Coase theorem
• Bargaining yields social optimum solution
• Income distribution from that solution
depends upon whether property rights are
assigned to ‘polluters’ or to ‘victims’
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Slide 5.22
MEC
Costs and
benefits
MNPB
A
D
B
0
C
Qs
Q1
Scale of economic activity
An optimum level of pollution exists where MNPB equals MEC with the firm producing Qs. If a firm produces
an amount below Qs the benefits the firm derives in terms of profit is greater than the cost on society in
terms of MEC, thus output should be expanded. If the firm is producing an output above Qs then the cost to
society is greater than the benefits the firm is deriving and so output should be reduced . The scale of
activity
Qs is
termed
the social
optimum
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Wall:
Economics
for Business
and Management 3rd edition
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Slide 5.23
• Property rights to polluter (i.e. firm)
– Negotiated solution possible at social optimum output
Qs
– Victim will be willing to offer up to C + D to avoid the
‘damage’ of Q1 solution
– Polluter will require at least C for restricting output
from Q1 to Qs
– Income distribution: Polluter receives profit of A + B;
Victim suffers ‘damage’ of B and pays at least C to
polluter
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Slide 5.24
• Property rights to victim
• Negotiated solution possible at social optimum output Qs
• Polluter will have to pay compensation of C + D to victim if
output is raised from Qs to Q1
• Polluter will only receive C in profit if output raised from Qs to
Q1
• Polluter will therefore have a ‘self interest’ in producing no
more than Qs
• Income distribution: Polluter receives profit of A and pays B
Griffithsto
andvictim
Wall: Economics for Business and Management 3rd edition
© Pearson Education Limited 2011
Slide 5.25
• See payoff matrix in utils, with each individual
having option to negotiate or free-ride!
• Left side of each box (in italics) is A’s outcomes;
right side is B’s outcomes
• Free-ride: seems attractive option to A and B
individually – yields 90 utils (dominant strategy);
but only 50 if both free-ride
• Negotiation: better with 80,80 outcome
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Slide 5.26
Individual B
Negotiate
Free-ride
Negotiate
80
80
10
90
Free-ride
90
10
50
50
Individual A
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Slide 5.27
• Pigouvian tax: a tax on the producer of an
externality which is exactly equal to the marginal
external cost imposed
• Polluter pay principle: environmental taxes are
consistent with this widely accepted principle,
under which the polluter pays the cost of any
damage he/she imposes on the environment
• Environmental taxes internalise the externality
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Slide 5.28
MEC
Costs and
benefits
MNPB
MNPB − t
t
0
Qs
Scale of economic activity
If an environmental tax of t were to be introduced, the effect would be to shift the MNPB curve downwards
by the amount of the tax and to the left. If the tax is set correctly it will achieve an optimal level of economic
activity, Qs
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Slide 5.29
• Limit pollution: total number of permits issued limit
environmental damage
• Market-based: polluters can buy or sell permits at
an agreed price
• Efficient mechanism: firms which can reduce
pollution at a cost below the market value of the
permit have the incentive to do so, and sell
permits; and vice versa
• Allocation of permits: various mechanisms, e.g.
‘grandfathering’
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Slide 5.30
• It is politically easier to get companies to agree on
a pollution-control policy that begins by distributing
a valuable new property right
• The emission allowance will have a market value
as long as the number of allowances created is
limited
• They are cost effective
• Companies have flexibility in that they can achieve
their emission reduction levels based on their own
strategy
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Slide 5.31
• How are permits initially allocated?
• Should the permits be allocated free or auctioned?
• The emission allowance will only have a market value as
long as the number of allowances created is limited
• Permits give the owner of a permit the right to pollute. In
other words a permit to emit pollutants
• The permits can act as a barrier to entry into the sector
• Administrative costs
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Slide 5.32
• Salma firm and Habiba firm emit
pollution in their production
processes.
• The government has established a
standard for the pollution levels of
Salma and Habiba firms of 25000
units of pollution.
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Slide 5.33
• To ensure this level of pollution is
achieved efficiently, the government
sells permits to the firm that entitle
them to emit a unit of pollution.
• Salma firm has the following demand
function for pollution emission
𝑃
permits:𝐷(𝑆) = 15000 −
5
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Slide 5.34
• Habiba firm has the following
demand function for pollution
emission permits: 𝐷(𝐻) = 13000 −
2𝑃
5
• 1. What is the equilibrium price of
pollution permits?
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Slide 5.35
• Equilibrium in the permit market
requires:
• 25000=D(S) + D(H)
•
3𝑃
25000=280005
• P=5000
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Slide 5.36
• 2. If the government makes the standard more stringent
and allows only 15000 units of pollution, what happens
to the equilibrium price of pollution permits?
• If the government sells only 15000 pollution permits,
permit market equilibrium requires:
• 15000=D(S) + D(H)
•
3𝑃
15000=280005
• P=21666.67.
• Reducing the pollution standard by 40% resulted in the
price of pollution permits rising by 333.33%.
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Exercise(6)
• Now assume that we have the same
demand functions for Salma and Habiba
Firms and the government has established
a standard for the pollution levels for both
of these firms = 25000 units of pollution.
To ensure this level of pollution, the
government has allocated 15000 pollution
permits to Salma Firm and 10000 pollution
permits to Habiba Firm.
Griffiths and Wall: Economics for Business and Management 3rd edition
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Exercise(7)
• The question is :
• Is the government’s allocation of pollution
permits efficient?
• If the government allowed the firms to trade
permits, would the firms be motivated to
trade?
• If so, what would be the efficient level of
trading?
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Exercise(8)
•
•
•
•
•
•
For Salma Firm
D(S)=15000-P/5
P/5=15000- D(S)
P=75000-5D(S)
If the permits is = 15000
P= 75000-5 (15000)= 0 so the price for Salma
Firm is = ZERO
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Exercise(9)
•
•
•
•
•
•
•
For Habiba Firm
D(H)=13000-2P/5
2P/5=13000- D(H)
P=32500-5/2D(H)
If the permits is = 10000
P= 32500- 5/2 (10000)= 7500
Since the price or marginal benefit of polluting is
much higher to Habiba Firm, the current
allocation of pollution permits is not optimal.
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Exercise(10)
• Habiba Firm is willing to pay 7500 for a permit at the
government allocation while the price of a permit to
Salma Firm is ZERO. Thus , there is a trade opportunity.
If the government allowed the firms to trade the permits,
the optimal allocation sets:
• P ( D(S))= P (D(H))
• P ( D(S))= P ( D(H)=32500-5/2(25000-D(S))
• 75000-5D(S)= 32500-5/2(25000-D(S))
• D(S) =14000
• So the efficient level of Salma Firm is = 14000 and for
Habiba Firm is = 11000
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Exercise(11)
• The price of a permit for Salma Firm if it uses 14000
permits is 5000. (As P=75000-5D(S) so P= 750005(14000)= 5000)
• Habiba Firm is willing to pay 5000 per permit to purchase
1000 permits from Salam Firm.
• Both firms are better off and society has achieved the
efficient allocation of pollution permits.
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Slide 5.43
• Minimum standards set
• Non-market based mechanism for pollution
control
• Regulators must monitor the situation and be
able to sanction breaches in standards
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Slide 5.44
St2
Costs of
benefits
St1
MEC
MNPB
X
Pen2
Pen1
Penalty
Y
0
QA
Qs QB
Scale of economic activity
The setting of a standard such as St1 will achieve the optimum level of economic activity and therefore
pollution, provided that the penalty is set at Pen2
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Slide 5.45
• The marginal social costs and abatement
costs of a certain type of air pollution for a
factory are given as:
• MSC=-1121+22.5Q
• MCA= 879-17.5Q
• Where Q=units of pollution per day, MSC
and MCA are measured in dollars.
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Slide 5.46
• The factory is located in a small town that is
currently setting community standards. You
have been hired to perform the analysis
requested below.
• 1. if the community wished to set a pollution
standard for the factory, what daily level of
pollution should be allowed?
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Slide 5.47
• To determine the optimal level of pollution,
we equate MSC to MCA
• -1121+22.5Q=879-17.5Q
• -2000=-40Q
• Q=50
• 50 units of pollution is optimal.
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Slide 5.48
• 2. as an alternative, some members of the
town council favour an emissions tax for the
factory. If a tax is implemented, at what level
should the tax be set?
• To determine tax, examine MSC or MCA at
optimal level.
• MCA=879-17.5(50)
• MCA=4
• Set tax=MCA=MSC=4
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