ECON 463: Environmental and

Resource Economics I

Instructor: Dr. Frank Adusah-Poku

Time slots: Thursdays (2:00pm-3:55pm) @ SCB-SF7.

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 Instructor Details
Name: Dr. Frank Adusah-Poku

Email: fadusahpoku@yahoo.com/fadusah-
poku10@knust.edu.gh

Office: Department of Economics building, KNUST.

Contact hours: Appointment by email.

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 Course Description
• General Introduction to environmental economics
• Analyse the role of nature as a provider of resources for
economic activities
• Impact of economic activities on the quality of the
natural environment
• Apply some economic principles to analyse
environmental issues.

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 Mode of Delivery

Lectures and Discussions

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 Course outline

• The first five chapters of Field and

Field (2018)

• Two Chapters in Harris and Roach

(2015). E.g. Chapters 2 and 3
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 Recommended Text Books

1. Field, B.C. and Field, K. (2018). Environmental

Economics: An Introduction. Irwin/McGraw-Hill,
Boston.
2. Harris, M. J. and Roach, B. (2015). Environmental
and Natural Resource Economics. A Contemporary
Approach, Third Edition, Routledge.

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 Assessment

Activity Weight (%)

Mid-Semester Examination 30
End of semester examination 70

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Introduction

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 What is Economics?

• Study of how and why individuals and groups make

decisions about the use and distribution of valuable
resources.
• Resources: time, money, properties, goods, services.
• Economics is about how society distribute scare
resources.
• Application of economic principles to the study of how
resources are managed.

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 What is environmental economics?

• Environmental Economics: Application of the principles

of economics to the study of how environmental
resources are managed.
• Environmental economics draws from both
microeconomics and macroeconomics.
• Focuses on how and why people make decisions that
have consequences for the natural environment.

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 What is environmental economics?

• First job: to become acquainted with some of the

basic ideas and analytical tools of microeconomics.
• Tools will help us to understand:
• Why the natural environment becomes
degraded?
• What are the consequences of degrading the
natural environment?
• What can be done to reduce this degradation?

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 Positive Vs. Normative

• Positive Vs. Normative economics

• Positive: What is. How the housing market reacts to
changes in interest rates?
• Positive: Involves how things work.
• Normative: What ought to be. A study to determine
what kind of regulation we ought to adopt for a
particular environmental problem?
• Normative: involves more than just knowing how
things work.
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 Economic Vs. Moral approaches
• Economic approach Vs. Moral approach
• Practical difficulties with relying on moral
reawakening as the main approach to combatting
pollution.
• The arrangement of the economic system, within
which people make decisions about how to conduct
their lives (cause of environmental destruction).

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 The importance of incentives
• Problem: How to dispose waste products
• Solution: dispose them in an environmentally friendly
or unfriendly way
• People pollute because it is the cheapest way they
have of solving a problem.
• Decisions taken within a set of economic and social
institutions
• Institutions structure the incentives to make decisions
in one direction or the other.
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 The importance of incentives
• Incentive-type statement: pollution is a result of the
profit motive.
• The only way to reduce environmental pollution
under this is to weaken the strength of the profit
motive.
• How does incentive systems work in an economic
system?

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 Incentives: A household example
• Incentive: something that attracts or repels people
and leads them to modify their behaviour in some
way.
• Economic incentive: payoffs in terms of material
wealth
• Noneconomic incentive: self esteem, the desire to
preserve a beautiful visual environment, the desire to
set good examples for others.

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 Incentives: A household example
• Important to change incentives to achieve
improvements in environmental quality.
• Pay-as-you-throw (PAYT) program in Worcester,
USA.
• Before the program, pay a flat annual fee to have
trash collected
• Problem: no incentive to limit trash production
• How do you get a significant reduction in the
quantity of solid waste handled by the city?
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 Incentives: A household example
• Solution: system that charge people for each bag of
trash
• Response gives people an incentive to search for ways
to reduce the amount of solid waste they produce.
• Recycling, switching to products that have less waste,
etc.
• Impact: large increase in the amount of trash recycled
and a reduction in the total amount of trash.

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 Incentives and Global Warming
• Not all environmental problems are local.
• Traditional air pollution: Regional or national issue
or international or global problem.

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 Incentives and Global Warming
• Global issue: greenhouse effect
• A major focus of environmental economists is to try
to identify the most effective policy approaches to
combat the emissions substances causing the
greenhouse effect.
• 2 main Approaches
• Command and Control policies: laws and
regulations
• Incentive-based policies: emission charges or
taxes and market based trading programs.
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 The Design of Environmental Policy

• EE- major role to play in the design of public policies

for improvement in env’tal quality.
• Environmental programs and policies vary greatly in
their efficiency and effectiveness.
• Pay attention to factors that affect the cost-
effectiveness of environmental regulations.

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 The Design of Environmental Policy
• Pay attention to the way these regulations create
incentives for actions by polluters
• Environmental policies can create perverse
incentives.
• Issues related to the design of environmental policy
are a major part of environmental economics

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 Some key Questions

• What major environmental issues do we face in the 21st

century?
• How can economics help us understand these issues?

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 Economics and the Environment
• Increasing awareness of environmental problems facing
communities, countries and the world.
• In1970, creation of EPA in the United States to respond
to air and water pollution issues.
• In 1972, first international conference on the
environment (the UN conference on the Human
environment) in Stockholm.
• In 1992, the UNCED met in Rio de Janeiro to focus on
major global issues (Earth Summit).
• In 2012, the UN Rio +20 conference on Sustainable
development 24
 Economics and the Environment
• In 2012, the UNEP Global Environmental Outlook report
highlighted the role of increasing population and growing
economies.
• Environmental protection policies are often measured and
sometimes rejected in terms of their economic costs.
• Often policy issues are framed in terms of a conflict between
development and the environment. E.g. the urgency of human
needs and environmental protection (galamsey).
• Does economic development necessarily have a high
environmental price?

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 Economics and the Environment

• Tradeoff? Yes but how should a proper balance be

reached?
• Questions such as these highlight the importance of
environmental economics.

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 Economic growth and the Environment
• The goal of economic and political debate is to identify
growth processes that allow continually rising living
standards
• Economic development and “nature conservation” are
seen as quite distinct and separate problems.
• The 1970s witnessed a shift in perspectives
• Prior to 1970s, the pursuit of economic growth and
development was the mainstay.
• However, it was later recognized that the maintenance
of growth has an important environmental dimension27
 Economic growth and the Environment
• Concern for sustainability began to appear on the
international political agenda
• The common debate was on the interrelationship
between poverty, economic development and the state
of the natural environment.
• The first major challenge to growth as solution to the
world’s problems questioned the sustainability of
growth itself.

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 The Limits to Growth Model
• Chapter 2 of Harris and Roach (2015)
• Presented by a research team from MIT in 1972.
• Addressed the issue of physical limits to economic
growth
• Model captures interrelationship between 5 key
variables.
• Meadows et al. (1972) noted that environmental limits
would cause the collapse of the world economic system
in the middle of the 21st century.
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 The Limits to Growth Model
• Model relied on exponential growth patterns and
feedback effect.
• Feedback effect: when X increases Y which in turn leads
to further increases in X.(capital accum. and growth).
• Results: Exponential growth in population, industrial
output (economic prodn.) and food demand generate
declines in resources and increasing pollution forcing a
reversal of growth by the mid 21st century.
• See Figure 1.
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Figure 1: The Limits to Growth Model, Business-as-Usual Scenario.
(Source: Meadows et al., 2004; Jonathan and Roach, 2017)

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 The Limits to Growth Model
• Using simulations, the study investigated five major
trends of global concern:
(1) accelerating industrialization
(2) rapid population growth
(3) widespread malnutrition
(4) depletion of non-renewable resources, and
(5) a deteriorating environment

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 Limits to Growth Model
• Environmental limits are defined to include:
(1) a limit to the amount of land available to agriculture
(2) a limit to the amount of agricultural output
producible per unit of land in use
(3) a limit to the amounts of non-renewable resources
available for extraction
(4) a limit to the ability of the environment to
assimilate wastes arising in production and consumption
(limit falls as the level of pollution increases)
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 Limits to Growth Model
• Based on these limits, the following conclusions are
drawn:
1.In the basic limits to Growth (LTG) model (i.e. if the
present growth trends in these 5 variables continue
unchanged), the limits to growth on this planet would
be reached within a century. (i.e. resource depletion
and an increase in pollution would lead to a sudden and
uncontrollable reduction in food, industrial output and
population)

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 Limits to Growth Model
2. The LTG also model a “sustainable world” scenario in
1992 where:
• Average family size is 4 (parents with two children)
• Modest limits are put on material production
• Society invests heavily in sustainable technologies
Results
• Human population stabilizing at less than 8 billion.
• Industrial output also stabilizing
• Pollution eventually decreasing
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A Sustainable World Model (1992)

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 Limits to Growth Model
3. If the world’s people decide to strive for this second
outcome rather than the first outcome, the sooner they
begin working to attain it, the greater will be their chances
of success.
• Emphasis on aggressive policies to moderate population
growth, resource consumption and pollution could
avoid the collapse.
• Criticism: (1) flexibility and adaptability of economic
system . (2) overstating the danger of resource
exhaustion
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 Main approach

• Economic valuation approach

• Valuation of a resource in monetary terms
• Put a price on each natural resource and environmental
input to the economy
• Includes estimating a price for inputs not usually
included in market transactions such as clean air and
water.
• Economic techniques can be used to assess the money
value of damages caused by pollution and waste
disposal. 38
 Essential facts of the 21st century

• Population growth
• Rising resource demand
• Increasing energy use
• Dwindling resources
• Pollution

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 Major environmental Problems

1. Pollution
2. Soil degradation
3. Global warming
4. Overpopulation
5. Natural resource depletion
6. Generating unsustainable waste
7. Loss of biodiversity
8. Climate change

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 Role of economics in resolving
environmental challenges
• how to allocate the finite resources of the planet to meet
“the needs of the present, without compromising the
ability of future generations to meet their own needs”.
• Key role in identifying options for efficient natural
resource management
• Crucial for understanding the positive and negative
impact of alternatives and the trade-offs involved.
• Development of economic models to address key
environmental issues such as climate change and
resource use. 41
The economy and the environment

A simple Model

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 Introduction
• Economy: encompasses all activities related to
production, consumption, and trade of goods and
services in an area.
• Elementary economic functions: production and
distribution.
• Production: activities that determine the quantities of
goods and services that are produced and the
technological and managerial means by which this
production is carried out.

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 Introduction
• Distribution: way in which goods and services are
divided(distributed) among the individuals and
groups that make up society
• The final utilization of these good and services is
termed consumption.
• Any economic system exists within, and is
encompassed by, the natural world.
• Economies make use directly of natural asset of all
types.

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 Introduction
• Production and consumption activities also produce
leftover waste products, called “residuals”.
• Depending on how they are handled, these residuals
may lead to pollution or degradation of the natural
environment.
• Study of this residuals flow and its resultant impacts
in the natural world falls under EE.

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Introduction

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A Simple Model

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 A Simple Model
• Economy: producers and consumers.
• Producers converts inputs from the natural
environment into outputs
• Primary inputs: water, petroleum, natural gas, wood
etc.
• Consumers consume the final goods and services
(distribution)
• Production and consumption create residuals
emitted into the air or water or disposed of on land.

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 The Environment as an Asset

Trade off between economic output and environmental quality 49

 How to reduce residuals discharged

• Reduce the quantity of goods and services produced

in the economy.
• Increase recycling
• Reduce residuals from production and consumption
activities

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Analytical Tools

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 What to expect

• Discuss certain basic tools of microeconomics

• Provide an understanding of fundamental concepts
• The application of these tools to environmental
problems
• Benefits and costs

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 Introduction
• Economic and environmental actions create value on
one side and encounter costs on the other side.
• Proceed with simplified models that attempts to
capture the essence of problem.
• Abstract reveals the basic connections and
relationships among the important elements of a
problem.

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 Willingness to pay
• Fundamental notion: individuals have preferences for
goods and services
• Given a choice, they can express one good over
another.
• The value of a good to a person is what the person is
willing to sacrifice for it.
• Barter economy vs. market economy
• Fundamental idea: the value of a good is what the
person is willing to pay. e.g. auction.

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 Willingness to pay
• What determines how much a person is willing to
pay to obtain some good?
• Willingness to pay also reflects ability to pay.

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 Graphical Representation
• Assume you have no candies, How much are you
willing to pay for a candy?
• Assume you possess a candy, how much are you
willing to pay for a second candy?
• Assume you possess two candies, how much would
you be wiling to pay for a third candy?
• The notion of diminishing willingness to pay

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 Willingness to Pay

Quantity WTP ($)

1 3.80
2 2.60
3 1.70
4 1.40
5 0.90
6 0.60

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Graphical Representation (step-shaped)

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Graphical Representation

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 Total Vs. Marginal willingness to pay
• Suppose you are already consuming two candies,
what is the willingness to pay for the third unit?
MWP.
• The height of the rectangles/curve show the MWTP.
• Suppose you are consuming three candies, what is the
total willingness to pay for consuming at a level of
three candies?
• The area under the WTP curve is the TWTP.

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 Demand
• The marginal willingness to pay approach is formally
known as demand curves
• Demand curve shows the quantity of good or services
demanded at any particular price.
• The individual will only consume/demand at a
particular price if the marginal willingness to pay
equals the purchase price.
• Demand more if MWTP>P and vice versa.

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Demand/Marginal WTP curves

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 Demand/MWTP curves
• Curve (b)
• Curves for two different people with different tastes
and preferences
• Curves for the same people but one could be after an
income rise.
• Curves for the same information before and after the
person receives more information

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 Demand/Marginal WTP curves
• Note that demand curves are not uniform but
curvilinear
• At low prices and high rates of consumption, studies
have shown that relatively small increases in price
will lead to substantial reductions in quantity
demanded
• At high prices and low quantity demanded, price
increases have a much smaller effect.

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Demand for water

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Aggregate Demand/WTP

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Aggregate Demand/WTP

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 Benefits
• Do people obtain benefits when the environment is
cleaned up?
• Benefits implies being made better off or their
position is improved
• How do we confer benefits on people?
• How do we know that they value something?
• How much are they willing to pay or willing to
sacrifice?

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 Benefits
• Logic: the benefits that people get from something
are equal to the amount they are willing to pay for it.

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Willingness to pay/benefits

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 Willingness to pay/benefits
• The people with the higher demand curve must place
a greater value on this item and also be willing to pay
more for it.
• The more people value something, the more they are
benefited by having more of that something made
available.

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 Cost
• Goods and services cannot be produced out of thin
air.
• To produce, many types of productive inputs are
required
• Our concept of cost is broader than the monetary
out-of-pocket costs
• Opportunity costs: maximum value of other outputs
we could and would have produced had we not used
the resources to produce the item in question.

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 Cost
• Relevant in any situation in which a decision must be
made about using productive resources for one
purpose rather than another.
• What is the opportunity cost of a particular policy?
• In practice, opportunity costs are measured by the
market value of inputs used up in production.

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 Private and Social costs
• Private costs: costs experienced by the party making
the decisions leading to that action.
• Social costs: all of the costs of the action, no matter
who experiences them.
• Social costs include private costs.
• Consider the action of driving a car.
• Private costs: fuel and oil, maintenance, depreciation,
and even the driving time experienced by the
operator of the car

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 Private and Social costs
• Social costs: include all private costs and also the
costs experienced by people other than the operator
who are exposed to the congestion and air pollution
resulting from the use of car.

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The Concept of Marginal Cost

Quantity MC ($)
1 5
2 7
3 10
4 15
5 22
6 30

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The Concept of Marginal Cost

77
The Concept of Marginal Cost

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 The Concept of Marginal Cost
• The height and shape of the MC could be affected by
several factors.
• Technology
• Price of inputs
• Amount of time a firm has to adjust to changes in
the rate of output.

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 Technology
• Most important factor affecting the shape of the MC is
the technology of the production process.
• Technology: inherent productive capabilities of the
methods and machines being employed
• The quantity of output a firm can get from a given set of
inputs depends on the technical and human capabilities
inherent in these inputs.

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 Technology
• The concept of technology is vitally important in
environmental economics because:
vTechnological change can provide ways to
produce goods and services with fewer
environmental side effects
vTechnology change can also provide better ways
of handling the quantities of production residuals
that remain.

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Technology Improvement

82
 The Equimarginal Principle
• Simple but important economic principle.
• Assume a firm whose operations are divided
between two different plants.
• Each plant produces the same item and hence the
total output is the sum.
• Assume the plants were built at different times and
make use of different technology.
• Plant A (old one) has older technology.

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The Equimarginal Principle

84
 The Equimarginal Principle
• Consider a situation where this two-plant firm
wants to produce a total output. E.g. 100 units.
• How many units should it produce in each plant in
order to produce the 100 units at the least total
cost?
• The total cost of the 100 units can be lowered by
reallocating production.
• What happens to cost when production in plant A is
reduced by one unit?
85
 The Equimarginal Principle
• What happens to cost when production in plant B is
increased by one unit?
• Total costs go down (cost savings) because of
reallocation of production.
• As long as the marginal costs in the two plants differ
from one another, we can continue to reallocate
production.
• The total costs of producing the 100 units in the
two plants will be at a minimum when the marginal
costs of the two plants are equal.
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 The Equimarginal Principle
• Equimarginal principle: happens when the output in
Plant A is 38 units and the output in Plant B is 62
units.
• What is the associated total costs?

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 The Equimarginal Principle
• If you have multiple sources to produce a
given product, and want to minimize the total
cost of producing a given quantity of that
output, distribute production in such a way as
to equalize the marginal costs between the
production sources.

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Marginal Cost and Supply

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Marginal Cost and Supply

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Aggregate (Market) Supply from Individual
Firm Supply Curves

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 Discussion

• Use the logic of willingness to pay to interpret

the statement “I like clean air more than you
do”.

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Markets, Externalities, and Public
Goods

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 What to expect

• The notion of economic efficiency

• Address the question of whether an unregulated
market system can produce results that are socially
efficient.

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 Economic Efficiency

• Criteria for evaluating the performance of an

economic system.
• Allocation of resources that maximises net social
benefits
• Can be applied at different levels: input usage or
output determination
• What quantity ought to be produced? What quantity
is in fact produced?

95
 Economic Efficiency

• Central idea: A balance between the value of what is

produced (WTP) and the value of what is used to
produce it (marginal costs of production).
• Efficient from the standpoint of whom?
• Important to have a concept of efficiency that is
applicable to the economy as a whole.
• How do we identify the rate of output that is socially
efficient?

96
 Economic Efficiency

• Suppose an item is currently being produced at a

particular rate.
• Compare the MWTP for that extra output with the
marginal opportunity costs of the output.
• If the former exceeds the latter, extra output should be
produced; otherwise not.
• The equality of the MWTP and the marginal production
cost is the test for determining if output is at the socially
efficient level.
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Economic Efficiency

98
The Socially Efficient Rate of Output

99
 Markets
• Market system: a system in which the major economic
decisions about how much to produce are made by the
interaction of buyers and sellers.
• Market system will normally produce better economic
results overall than any other system.
• Market: institution in which buyers and sellers of goods
and services carry out mutually agreed-upon exchanges.
• Markets reflects the benefits and costs of economic
activities to those who participate in buying and selling
of goods and services.
100
 Markets
• In a basic economic analysis of markets, demand and
supply curves represent the costs and benefits of a
transaction.
• A supply curve tells us the marginal costs of production
• A demand curve tells us the marginal benefits of
consumption

101
The Market Model

102
Markets and Social Efficiency

103
 Market performance in the presence of
env’tal quality
• Two phenomena to account for: (1) supply side (2)
demand side.
• Supply: External costs (negative externalities)
• Demand: External benefits (positive externalities)
• Property rights

104
 External Costs
• Private costs: labour, raw materials,
machinery, energy, and so on.
• Private costs usually show up in the firm’s
profit-and-loss statement.
• External costs: Firms do not normally take
them into account
• external because they are real costs to some
members of the society
• External costs/third-party costs/spillover
effect. 105
External Costs

106
External Costs and Market Outcomes

107
External Costs and Market Outcomes

108
 External Costs (2)
• See Chapter 3 of Harris and Roach (2015)
• Consider the production and use of automobiles
• Create numerous external costs
(1) air pollution
(2) global warming
(3) automobile oil leaked from vehicles can
pollute rivers and lakes
• The need to assign a monetary value to these costs.

109
External Costs (2)

110
 External costs (2)
• QM is not an economically efficient outcome.
• Compare MSC to MB using a social perspective.
• Produce automobiles only as long as the MB is
greater than MSC.
• Further production past Q* is socially undesirable.
• Market price is too low because it fails to reflect the
true costs of automobiles including external costs.

111
 Internalizing External costs
• What can we do to correct this inefficient market
equilibrium?
• Impose a tax (Pigovian tax) named after Arthur
Pigou
• Also known as “polluter pays principle”.
• Those responsible for pollution pays for the damage
they impose on society.
• Assume that the tax is paid by the automobile
manufacturers.
• What is the proper tax amount?
112
 Internalizing External costs
• Tax on each automobile produced increases the
marginal production costs.
• Shifts the private marginal cost curve.
• A tax exactly equal to the external costs (damage)
associated with each automobile ensures that
MPC=MSC.
• Tax per unit= external damage per unit
• Though the tax was levied on producers, a portion
is passed on to consumers
• The higher price causes consumers to cut back their
purchases. 113
Internalizing External costs

114
 Internalizing External costs
• Argument in favour of government regulation in the
presence of external costs.
• Tax is an efficient policy tool for reaching a more
efficient outcome.
• Should gov’t always impose a tax to counter an
external costs?
• (1) rigorous research to estimate the tax amount
• (2) administrative costs of imposing and collecting
tax.

115
 Internalizing External costs
• Economists generally recommend applying
Pigouvian taxes as an upstream tax.
• Tax imposed at the level of the raw production
inputs.
• How are the tax burden distributed among
producers and buyers?

116
 Open-Access Resources
• One source of external costs.
• Resource or facility that is open to uncontrolled
access by individuals who wish to use the resource.
E.g. ocean fishery, public park, pasture (graze
animals).
• Problems in property rights-definition, distribution,
and/or enforcement.
• There is no way of ensuring that its rate of use is
kept to the level that will maximize its overall value
(Tragedy of the commons).
117
 Open-Access Resource Example 1
• Suppose there are 4 similar firms situated on a lake.
• Firms use the water of the lake in producing their
output and discharge emissions back into lake.
• Each firm must treat the water before use.
• Treatment costs depend on the ambient quality of
the lake.
• Suppose the cost of intake water treatment is
40,000 cedis per year for each firm.

118
 Open-Access Resource Example 1
• Suppose a new firm is contemplating starting
operations on the lake.
• Cost of water treatment for each firm goes up to
60,000 cedis.
• 20,000 cedis of external costs
• Social marginal costs of water supply when the new
firm locates are 140,000 cedis
• Open-access externalities

119
 Open-Access Resource Example 2
Travel times Related to the Number of cars
on the Road
Number of Cars Average Travel Time
between A and B
10 10
20 10
30 10
40 11
50 12
60 14
70 18
80 24

120
 Open-Access Resource Example 2
• Suppose you are considering using this road and there
are already 50 cars using it.
• Suppose you have an alternative route that will take
you 18 minutes.
• Assume you know the state of traffic and the resulting
travel times.
• Does taking the given road lead to savings over the
alternative?
• What will be your individual decision?
• Is that efficient from a society’s standpoint?
• Individual savings Vs. travel costs 121
 Open-Access Resource Example 2
• Net social loss of 96 minutes when you decide to
use the road.
• The advent of GPS.
• The decision process of selecting a driving route,
based on congestion and travel time, has become
more efficient for society.
• The uncontrolled access to the road may inflict
external costs on others in the form of added
congestion and higher travel times.

122
 Open-Access Resource Example 2
• There is always added costs in the use of a common-
property.
• These costs are external to the user
• Internal to the whole group of users.
• When external costs are present, private markets
will not normally produce quantities of output that
are socially efficient.
• Changes in property rights rules, more direct public
intervention, etc.

123
 External Benefits
• Another important source of market failure.
• Benefit that accrues to somebody who is outside, or
external to, the decision about consuming or
producing the good or resource that causes the
externality.
• When the use of an item leads to an external
benefit, the market WTP for that item will
understate the social WTP.

124
 External Benefits Example
• Suppose a quieter lawn mower would provide 50
cedis (maximum WTP) a year of extra benefits to
the user.
• Suppose its use would create 20 cedis of added
benefits to my neighbor because of reduced noise
levels.
• Purchasing decision are made on the basis of
benefits accruing to the buyer.
• Thus, MWP is 50 cedis
• Social marginal benefits is 70 cedis.
125
 External Benefits Example
• Consider a farmer whose land is on the outskirts of
an urban area.
• Farmer’s main concern is the income he can derive
from selling his produce.
• Makes decisions about inputs and outputs according
to their effect on that income.
• Several benefits such as habitat for birds, scenic
values for passers-by.
• External benefits to the farmer but internal benefits
to the society.
126
 External Benefits Example
• Agricultural value of land to the farmer understates
the social WTP to have the land in agriculture.
• Many goods do not involve external benefits. E.g.
examples used for the rudiments of demand and
supply.
• The market demand curve will represent accurately
the aggregate marginal WTP of consumers.
• Does not hold for goods that inherently involves
large-scale external benefits. E.g. public goods.

127
 External Benefits Example
• The free market will fail to maximize social welfare
in the presence of external benefits.
• Consider the case of a good that generates a positive
externality (solar panels)
• Each solar panel installed reduces CO2 emissions
and thus benefits the society.
• Between QM and Q*, MSB > MC and thus optimal
level of solar energy is Q*.

128
External Benefits Example

129
 External Benefits Example
• The most common policy to correct the market
inefficiency in the case of external benefits is a
subsidy.
• A payment to a producer to provide an incentive for
it to produce more of a good or a service.
• A subsidy can be direct, through financial assistance,
or indirect through protective policies.
• A subsidy effectively lowers the cost of producing
solar panels making it cheaper to produce them.
• Net market equilibrium is Q* which is the socially
efficient level of production. 130
External Benefits Example

131
 Property Rights
• Recall on the Pigouvian tax
• Implicit in this type of tax is the idea that society has
a legitimate right to be compensated for any
pollution damages.
• Society has a right to clean air but the polluters do
not have a right to emit.
• Clear cut and appropriate allocation of rights

132
 Property Rights
• A much complicated one
• Suppose a farmer (Kwasi) drains a wetland on his
property to create a field suitable for growing
crops.
• His downstream neighbor (Yaa) complains that her
land will flood and damage her crops.
• Should Kwasi be obliged to pay Yaa the value of any
damages?
• Does Kwasi have the right to do what he wants on
his land?
133
 Property Rights
• Depends on the nature of property rights.
• Does the ownership of the land include a right to
drain wetlands on that land?
• Is this right separate, subject to control by the
community or other property owners?
• Consider two ways the property rights can be
allocated:
• Suppose Kwasi does have the right to drain the
wetland on his land.

134
 Property Rights
• Suppose the net value of crops grown on drained
wetland is 5000 cedis.
• Suppose that Yaa would suffer crop losses of 8000
cedis if the land were drained.
• Yaa could potentially pay Kwasi not to drain it.
• Yaa would be willing to pay Kwasi up to 8000 cedis
to keep the wetland intact.
• Kwasi would be willing to accept any amount higher
than 5000 cedis

135
 Property Rights
• Negotiate an amount between 5000 and 8000 cedis.
• Yaa can purchase the right to say how the wetland
will be used if she is willing to pay any amount
between 5000 and 8000 cedis.
• Result: Wetland would not be drained.
• Second, assign the relevant right to Yaa (passage of
law)
• Will the wetland be drained?

136
 Property Rights
• No
• Yaa would demand at least 8000 cedis to grant
Kwasi the permission to drain the wetlands.
• Regardless of who holds the property rights, the
same outcome is achieved.
• Suppose a particular crop that grows well in
wetlands and could bring Kwasi 12,000 cedis in
profit.
• A deal is now possible (10,000 cedis for the right to
drain)
137
 Property Rights
• This bargaining principle is known as the Coase
theorem (Nobel-prize winning economist)
• States that if property rights are well defined, and
there are no transaction costs, an efficient allocation
of resources will result even if there are
externalities.
• Transaction costs: costs involved in reaching and
implementing an agreement. e.g. costs of obtaining
information, time and effort spent in negotiations.

138
 Property Rights
• The two parties will balance the external costs
against the economic benefits through negotiations
• If external costs exceeds external benefits, then it is
not worth incurring the costs. (e.g. Yaa owns the
right)
• If the economic benefits exceed economic costs,
then it is worth incurring the costs. (e.g. Yaa owns
the right)

139
 Illustration of the Coase Theorem
• Begin with MB and MC of an economic activity that
generates an externality.
• Suppose a factory emits effluent into a river used by
downstream community
• Factory is currently emitting 80 tons of effluent.
• Optimal solution is where MB=MC. (clearly, 80
tons imposes high MC on the community)
• Coase theorem states that this optimal solution can
be achieved by assigning the pollution rights either
to the company or the community.
140
Illustration of the Coase Theorem

141
 Illustration of the Coase Theorem
• Assume the community has the right.
• It will opt for zero pollution
• Total benefits to the company=0
• Total damage to the community=0
• In effect, the community benefits.
• Both parties could benefit from negotiation

142
 Illustration of the Coase Theorem
• Assume the community has the right.
• Company would be willing to pay the community
for the right to emit.
• Successful negotiation will continue as long as MB
exceeds MC.
• Analyse the effects of this optimal outcome using
welfare analysis.
• C= total cost of pollution damage @ 50 tons=
3750

143
 Illustration of the Coase Theorem
• Assume all rights to pollute are sold at a price of
150/ton, then TR (community) from the sale of the
rights is 7500 (B+C).
• Net gain (community)=7500-3750=3750
• Benefits to the company:
• A+B+C=3750+3750+6250=13750
• Pay the community: 7500
• Net gain to the company: 13750-7500=6250
• Total welfare gain: 6250+3750=10000
144
 Illustration of the Coase Theorem
• Assume the company has the right to pollute
• Total benefits to the company at maximum
pollution: (A+B+C+D=16000)
• Total damage to the community:
(C+D+E+F=9600)
• Net social benefits @ 80 tons of pollution, prior to
negotiation would be 6,400.
• Both parties could benefit from negotiation.

145
 Illustration of the Coase Theorem
• Financial benefits @ 50 tons (A+B+C=13750)
• Assume all rights are negotiated for a price of
150/ton, company receives an amount of 4500
from the community.
• Total benefits to the company:
13750+4500=18250 (higher than 16,000)
• Remaining damages of area C by the community:
3750
• Community pays the company: 4500
• Total losses: 4500+3750=8250
146
 Illustration of the Coase Theorem
• 8250 better than its initial losses of 9600
• Total welfare gain: 18250-8250=10000
• Efficient solution is reached regardless of the
assignment of the property right governing
pollution.

147
 Limitations of the Coase Theorem
• Coase theorem: Assign property rights and allow
unregulated markets to address environmental and
resource problems.
• (1) The assumption of zero transaction costs
(several communities OR/AND several factories)
• (2) Free-rider effect (case where the factory has the
right to pollute)
• (3) Holdout effects (case where the communities)
has the right)

148
 Public goods
• Difference between private goods and public goods
• Private goods: goods whose consumption only
affects a single economic agent. e.g. bread
• Public good: 2 key characteristics
1. Non-excludable: people cannot be excluded
from consuming it.
2. Non-rival: one person’s consumption does not
reduce the amount available to other consumers.

149
 Public goods
• Environmental quality is essentially a public good.
• Private markets are likely to undersupply public
goods, relative to efficient levels.

150
 Example
• Consider a small freshwater lake.
• Three homes are located on the shores.
• People use the lake for recreational purposes
• Water quality of the lake has been contaminated by
an old industrial plant that has since closed.
• At present, the lake contains 5 ppm of this
contaminant.
• Homeowners are willing to pay a certain amount to
have the quality improved.

151
Individual and Aggregate Demand for
lowering Lake Pollution.

152
 Example
• As the lake becomes cleaner, the MC of continued
improvement increases.
• At a water quality of 2 ppm, MC= aggregate
MWTP.
• At water quality above 2 ppm, improved water
quality is desirable.

153
Aggregate Willingness to pay for a public good

154
 Aggregate Demand Curves
• Private goods: add together the individual quantities
at each price to get aggregate quantity demanded.
• Public good: Add together the individual MWTP at
each quantity to get the aggregate demand function.
• Note: It is the technical nature of the good that
makes it a public or private good, not whether the
organization providing it is a public or private.

155
 Other Issues
• Can we rely on a competitive market system to get
the contaminant in the lake reduced to that level?
• Suppose a private firm attempts to sell its services to
the three homeowners.
• When a public good is involved, each person may
have an incentive to free ride on the efforts of
others.
• A free rider is a person who pays less for a good
than his or her true marginal WTP.

156
 Other Issues
• The market system cannot be relied on to provide
efficient quantities of public goods.
• Nonmarket institution such as acting together
privately through the homeowners association.
• Opens up the huge topic of public policy for
environmental quality.

157
 Numerical Example
Suppose that a wood mill is situated on the bank of the Oti River in
Ghana. The private marginal cost (MC) of producing wood (in cedis per
ton) is given by the function MC=10+0.5Y, where Y is tons of wood
produced. In addition to this private marginal cost, an external cost,
which is borne by the wider community but not by the polluting firm
itself, is incurred. Each ton of wood produces pollutant flows into the
river which cost the community an amount of 10 cedis. The marginal
benefit (MB) to society of each ton of produced wood in cedis, is given
by MB=30-0.5Y
(a) Find the output that would prevail in the competitive market
(market output).
(b) Find the socially efficient output.
(c) Draw a diagram illustrating the marginal cost (MC), marginal benefit
(MB), marginal external cost (MEC), marginal social cost (MSC),
market output and socially efficient output (MSC). 158
The Economics of Environmental Quality

• Recall: market system, left to itself, is likely to

malfunction when matters of environmental
pollution are involved.
• Policy problem
• Identify the most appropriate level of environmental
quality we ought to try to achieve.
• Effective public policy depends on good information
on how economic and environmental systems
actually work.
159
 Pollution Control
• Different types of environmental pollutants call for
diverse types of public policy.
• One very simple model (A simple trade off)
• Reducing emissions reduces the damages that
people suffer from pollution
• Reducing emissions takes resources that could have
been used in some other way.

160
 Pollution Damages
• All negative impacts that users of the environment
experience as a result of the degradation of the
environment.
• E.g. waterborne diseases, cost of paying more to
treat water, lung cancer, etc.
• Impacts on various elements of the nonhuman
ecosystem. E.g. destruction of habitats of plants and
animals, etc.
• Estimating environmental damages is one of the
primary tasks facing environmental economists.
161
 Damage Functions
• In general, the greater the pollution, the greater the
damages it produces.
• Damage function describes the relationship between
pollution and damage.
• Shows the relationship between the quantity of a
residual and the damage that residual causes.
• Our primary model will make use of marginal
damage functions.

162
 Marginal Damage Functions
• Marginal damage function: shows the change in
damages stemming from a unit change in emissions.
• Areas under marginal damage functions correspond
to total damages.
• Easy to express damage in monetary units. E.g. the
“defensive” expenditure that people make to protect
themselves against pollution.

163
Marginal Damage Functions

164
Marginal Damage Functions

165
 Marginal Damage Functions
• Factors that move damage functions upward are:
1. Differences in population exposed, such as more
people.
2. Different time periods
3. New scientific estimates of increased pollution
impact.

166
 Marginal Damage Functions
• Caveat: The exact amount of damage caused by
different levels of pollution is difficult to measure
with certainty.
• Exacerbated by the fact that much of the damage
can be expected to occur well off in the future.
• The implicit assumption that damage functions are
reversible may not be true for some pollutants. E.g.
greenhouse gases.
• Development in the means of measuring damage
functions with greater accuracy.
167
 Abatement Costs
• Costs of reducing the quantity of residuals being
emitted into the environment.
• The greater the abatement, the greater the cost.
• Abatement costs normally will differ from one
source to another.

168
 Abatement Cost Functions
• Using the concept of the marginal abatement cost
• Marginal abatement cost show the added costs of
achieving a unit decrease in emission level.
• The level of costs encountered when carrying out
any particular task depends on:
oThe technology available to do the task
o Managerial skills that are applied to the job

169
Marginal abatement Cost Functions

170
Anatomy of a Marginal Abatement Cost
Curve

171
Abatement Cost Functions

172
 The Socially efficient level of emissions

• Given that emission is harmful, some would argue

that only a zero level of emission is desirable.
• Zero emissions is generally not economically
efficient.

173
The Socially Efficient Level of Emissions

174
Efficient Level of emissions

175
 Enforcement Costs
• Emission reductions do not happen unless resources
are devoted to enforcement.
• Enforcement costs are mostly public costs.
• Marginal enforcement costs: added costs of
enforcement that it takes to get emissions reduced by
a unit.
• Vertical distance between the marginal cost curves
equals marginal enforcement costs.

176
 Enforcement Costs
• Marginal enforcement costs increase as emissions
decrease.
• The more polluters cut back emissions, the more
costly it is to enforce further cutbacks.
• Lower marginal enforcement costs would move
MAC+E closer to MAC, decreasing the efficient
emission level.

177
Enforcement Costs

178
Example

179