Chapter 2

The Economic Approach:

Property Rights,
Externalities, and
Environmental Problems
 Chapter 2 The Economic Approach:
Property Rights, Externalities, and
Environmental Problems

• Introduction
• The Human-Environment Relationship
• Environmental Problems and Economic Efficiency
• Property Rights
• Externalities as a Source of Market Failure
• The Pursuit of Efficiency
• An Efficient Role for Government

2-2 © 2012 Pearson Education, Inc. All rights reserved.

 Introduction

• This chapter introduces the general conceptual

framework used in economics to approach
environmental problems.
• This process involves:
– examining the relationship between human actions and the
environmental consequences of those actions.
– establishing criteria for judging the desirability of such
consequences.
– identifying the nature and severity and potential remedial
action
• The economic point of view is contrasted with
alternative points of view to bring the economic
approach into sharper focus and stimulate deeper and
more critical thinking about all possible approaches.

2-3 © 2012 Pearson Education, Inc. All rights reserved.

 The Human—Environment
Relationship

• In economics, the environment can be viewed as

an asset that provides a variety of services
• It is a source of inputs and energy, which return
to the environment as waste products
• It is a source of goods and services (e.g.
ecosystem goods and services)
– Ecosystems provide us with direct benefits, which include
biodiversity, air, water, carbon sequestration, recreation,
etc.

2-4 © 2012 Pearson Education, Inc. All rights reserved.

 The Human—Environment
Relationship

• The relationship between the environment

and the economic system can be
considered a:
– Closed system (our current system): A system
where there are no inputs and no outputs of energy
and matter from outside the system
• Our planet is an open system with respect to energy
– Open system (maybe in a few decades/centuries): A
system which imports or exports energy or matter

2-5 © 2012 Pearson Education, Inc. All rights reserved.

 FIGURE 2.1 The Economic System and the
Environment

2-6 © 2012 Pearson Education, Inc. All rights reserved.

 The Human—Environment
Relationship
• Treating our planet as a closed system has
important implications:
– The first law of thermodynamics
• Energy and matter can neither be created nor destroyed.
• The mass of materials flowing from the environment (Mf) to the
economy will either accumulate (A) in the economy or return to
the environment as waste (Mw).
• A = 0 è Mf = Mw
– The second law of thermodynamics (entropy law)
• The amount of energy unavailable for work increases.
• Energy is always lost during conversion and the rest, once used,
is no longer available for further work. Also, no conversion from
one form of energy to another is completely efficient.
– Once the stocks of stored energy are gone, the amount of
energy available for useful work will be determined solely
by the flow of renewable energy sources and by the
amount that can be stored

2-7 © 2012 Pearson Education, Inc. All rights reserved.

 The Human—Environment
Relationship

• Two different types of economic analysis can be

applied to increase our understanding of the
relationship between the economy and the
environment
– Positive (Objective) Economics
• Describing what is, what was and what will be
• Is a higher concentration of immigrants associated with
more pollution?
– Normative (Subjective) Economics
• Attempting to answer what ought to be
• What pro-environmental immigration reform should be
adopted?

2-8 © 2012 Pearson Education, Inc. All rights reserved.

2-9 © 2012 Pearson Education, Inc. All rights reserved.
 Environmental Problems and
Economic Efficiency

• The chief normative economic criterion for choosing

among various outcomes occurring at the same point
in time is called static efficiency

– An allocation of resources is said to satisfy the static

efficiency criterion if the economic surplus derived from
those resources is maximized by that allocation.
– Economic surplus is the sum of consumer’s surplus plus
producer’s surplus.
– Consumer surplus (CS) is the value that consumers receive
from an allocation minus what it costs them to obtain it. It is
measured as the area under the demand curve minus the
consumer’s cost (difference between consumer’s WTP and
the price paid).
– CS = (intercept – P*) x Qd x 1/2

2-10 © 2012 Pearson Education, Inc. All rights reserved.

 FIGURE 2.2 The Consumer’s Choice

2-11 © 2012 Pearson Education, Inc. All rights reserved.

 Environmental Problems and
Economic Efficiency

– Producer surplus (PS)

• Producer surplus is the difference between the amount
that a seller receives minus what the seller would be
willing to accept for the good
• Given price P*, the seller maximizes his or her own
producer surplus by choosing to sell Qs units.
• The producer surplus is designated by area B, the area
under the price line that lies over the marginal cost
(supply) curve, bounded from the left by the vertical
axis and the right by the quantity of the good.
• PS = (P* - intercept) x Qs x 1/2

2-12 © 2012 Pearson Education, Inc. All rights reserved.

 FIGURE 2.3 The Producer’s Choice

2-13 © 2012 Pearson Education, Inc. All rights reserved.

 Property Rights

• How resources are used depends on the

property rights governing those resources.
• In economics, property rights refers to a
bundle of entitlements defining the owner’s
rights, privileges, and limitations for use of the
resource.
• Such entitlements and how they affect human
behavior will help understand how
environmental problems arise from
government and market allocations.
2-14 © 2012 Pearson Education, Inc. All rights reserved.
 Property Rights

• Property Rights and Efficient Market Allocations

– Either individuals or the state can capture the property rights.
• Efficient Property Right Structures
– Exclusivity—All the benefits and costs should only accrue
to the owner.
– Transferability—Property rights should be transferred to
others.
– Enforceability—Property rights should be secure from
seizure or encroachment.
• Markets can result in an efficient allocation of
resources not because consumers and producers
are seeking efficiency

2-15 © 2012 Pearson Education, Inc. All rights reserved.

 FIGURE 2.4 Market Equilibrium

= MC

Total variable cost = MC x Q*

Total revenue = P* x Q*

2-16 © 2012 Pearson Education, Inc. All rights reserved.

 Property Rights

• Producer Surplus, Scarcity Rent, and Long-Run

Competitive Equilibrium
– In the short run, producer surplus = profits + fixed
cost.
– In the long run, producer surplus = profits + rent.
• Rent: return on owned scarce inputs
– Under perfect competition, long-run profits equal zero
and producer surplus equals rent.
• Scarcity Rent
– Scarcity rent is the producer surplus that persists in the
long-run competitive equilibrium.
– David Ricardo was first to recognize it. Price of land is
determined by least fertile marginal unit of land
– Price has to be high to create incentive to work less
fertile land à fertile land would reap profits
– Competition cannot affect value since land is limited

2-17 © 2012 Pearson Education, Inc. All rights reserved.

 Externalities as a Source of
Market Failure

• Exclusivity is frequently violated in

practice, resulting in externalities.
– Externalities exist whenever the welfare of
some agent depends not only on his or her
activities, but also on activities under the
control of some other agent.

2-18 © 2012 Pearson Education, Inc. All rights reserved.

 Externalities as a Source of
Market Failure (Example)

• Suppose two firms are located by a river.

• Firm 1 produces steel.
• Firm 2 is located downstream and operates
a resort hotel.
• Firm 1 dumps waste into the river
• Firm 2 uses it for customer water
recreation
• Inefficient allocation of resources arising
from shifting the burden of Firm 1’s waste
to Firm 2.

2-19 © 2012 Pearson Education, Inc. All rights reserved.

 FIGURE 2.5 The Market for
Steel

2-20 © 2012 Pearson Education, Inc. All rights reserved.

 Externalities as a Source of
Market Failure

• Conclusions from Figure 2.5:

• The output of the commodity is too large.
• Too much pollution is produced.
• The prices of products responsible for pollution
are too low.
• As long as the costs are external, no incentives to
search for ways to yield less pollution per unit of
output are introduced by the market.
• Recycling and reuse of the polluting substances
are discouraged due to the cheap external cost.

2-21 © 2012 Pearson Education, Inc. All rights reserved.

 Externalities as a Source of
Market Failure

• Types of Externalities
– External cost (external diseconomy)
• It imposes costs on a third party (e.g. pollution)
– External benefit (external economy)
• It imposes benefits on a third party (e.g. vaccination)
– Pecuniary externalities
• It exists when the external effect comes from altered
prices (e.g. new firm moves into area and drives up
rental price).
• Do not cause market failure since higher prices reflect
land scarcity

2-22 © 2012 Pearson Education, Inc. All rights reserved.

2-23 © 2012 Pearson Education, Inc. All rights reserved.
 Externalities as a Source of
Market Failure

• Private property is not the only way of

defining entitlements to resource use.
Other possibilities include:
– State-property regimes
• Governments own and control property.
• Exist virtually in all countries
• Efficiency and sustainability problems can arise
– Common-property regimes
• Property is jointly owned and managed by a specific
group.
• Successful in Switzerland but no so much in Sri Lanka

2-24 © 2012 Pearson Education, Inc. All rights reserved.

 Externalities as a Source of
Market Failure
• Private property is not
the only way of
defining entitlements
to resource use. Other
possibilities include:
– Res nullius or open
access regimes
• No one owns or exercises
control over the
resources. Susceptible to
national appropriation.
• The Tragedy of the
Commons (Hardin, 1968)
• American bison numbers
went from 25-30 million
in 1806 to 100 by the end
of the century.

2-25 © 2012 Pearson Education, Inc. All rights reserved.

 Externalities as a Source of
Market Failure

• Open-access resources and “tragedy of the

commons”
• “Common-pool” resources are shared
resources characterized by nonexclusivity
and divisibility.
– Nonexclusivity implies that resources can be
exploited by anyone.
– Divisibility means that the capture of part of the
resource by one group subtracts it from the
amount available to the other groups.

2-26 © 2012 Pearson Education, Inc. All rights reserved.

 FIGURE 2.6
Bison
Harvesting

• Property right structures

affect scarcity rent
(economic surplus).
• Difference between TB
and TC or where
MB=MC
• E1 is efficient
• Unrestricted access leads
to inefficient allocation
• No incentive to protect
scarcity rent by
restricting hunting
effort.
• Individuals choose E2

2-27 © 2012 Pearson Education, Inc. All rights reserved.

 Externalities as a Source of
Market Failure

• Open-access resources and “tragedy of the

commons”
– Unrestricted access could cause resource
overexploitation
• No incentive to conserve (unless one can preclude
others from hunting)
– Scarcity rent is dissipated; no one is able to
appropriate rent, so it is lost

2-28 © 2012 Pearson Education, Inc. All rights reserved.

 Public Goods

• Public goods are both consumptively indivisible

and nonexcludable.
– Nonexcludability refers to a circumstance where,
once the resource is provided, even those who fail
to pay for it cannot be excluded from enjoying the
benefits it confers.
– Consumption is said to be indivisible when one
person’s consumption of a good does not diminish
the amount available for others.
– Examples: charming landscape, clean air, clean
water, and biological diversity.
• Biological diversity includes the amount of genetic variation
among individuals within a single species and the number of
species in a community.
– Genetic diversity has also proved to be critical to species survival
– Cross-breeding helps develop superior strains
– Examples: disease-resistant barley, sweet cherries

2-29 © 2012 Pearson Education, Inc. All rights reserved.

 Public Goods

• Species have a value beyond their intrinsic

value because they are interdependent
within ecological communities by providing
balance and stability (e.g. food sources)
• Biodiversity is an important ecosystem
service that is decreasing
• Can the private sector ensure the provision
of an efficient amount of ecosystem
services such as biodiversity?
– The answer is No!

2-30 © 2012 Pearson Education, Inc. All rights reserved.

 FIGURE 2.7 Efficient Provision
of Public Goods (1 of 3)

2-31 © 2012 Pearson Education, Inc. All rights reserved.

 FIGURE 2.7 Efficient Provision
of Public Goods (2 of 3)

2-32 © 2012 Pearson Education, Inc. All rights reserved.

 FIGURE 2.7 Efficient Provision
of Public Goods (3 of 3)

2-33 © 2012 Pearson Education, Inc. All rights reserved.

 FIGURE 2.7
Efficient
Provision
of Public Goods

2-34 © 2012 Pearson Education, Inc. All rights reserved.

 Public Goods

• Efficient level of diversity

• The efficient allocation maximizes economic surplus, which is
represented geometrically by the portion of the area under the
market demand curve that lies above the constant marginal
cost curve. The allocation that maximizes economic surplus is
Q*, the allocation where the demand curve meets the marginal
cost curve.
• Different WTP for A and B requires charging a different price to
each consumer.
• Producers cannot price discriminate especially in the absence
of excludability.
• Consumers have an incentive to understate their preferences
to shift the cost to other consumers.
• Inefficiency arises from the free-rider problem.

2-35 © 2012 Pearson Education, Inc. All rights reserved.

 EXAMPLE 2.3 Public Goods Privately
Provided: The Nature Conservancy

• A free rider is
someone who
derives benefits
from a
commodity
without
contributing to
its supply.

2-36 © 2012 Pearson Education, Inc. All rights reserved.

 Imperfect Market Structures

• Environmental problems also occur when one

of the participants in an exchange of property
rights has inordinate market power.
– Monopoly: when product is sold by a single seller
– Monopolies will supply too little of a good at too high
a price.
– At the monopoly output, marginal benefits are
greater than marginal costs. Net benefits are not
maximized and there is a deadweight loss.
– A cartel is a group of producers who form a collusive
agreement to gain monopoly power (e.g. OPEC).

2-37 © 2012 Pearson Education, Inc. All rights reserved.

 FIGURE 2.8 Monopoly and
Inefficiency

2-38 © 2012 Pearson Education, Inc. All rights reserved.

 DEBATE 2.1 How Should OPEC
Price Its Oil?

2-39 © 2012 Pearson Education, Inc. All rights reserved.

 DEBATE 2.1 How Should OPEC
Price Its Oil? (cont.)

2-40 © 2012 Pearson Education, Inc. All rights reserved.

 Asymmetric Information

• Asymmetric information creates problems

for the market when it results in a decision
maker knowing too little to make an
efficient choice
– Suppose you have a preference for organic food
but did not know what choices were truly
organic
– You would be unwilling to be a higher price and
profits and output of organic farmers would be
inefficiently low
– Organic certification corrects this problem

2-41 © 2012 Pearson Education, Inc. All rights reserved.

 Government Failure

• Political processes can cause environmental

problems
• Special interest groups use the political
process to engage in rent seeking
– Rent seeking is the use of resources in lobbying and
other activities directed at securing protective
legislation (e.g. agricultural producers seeking price
supports and consumer groups seeking subsidies).
– Losers do not rise up to protect their interests
mainly due to voter ignorance
• Information is costly and individual actions are
inconsequential
• Coherent and unified position is unlikely

2-42 © 2012 Pearson Education, Inc. All rights reserved.

 Top Lobbying Spenders, 2016
and 2017 (opensecrets.org)

2-43 © 2012 Pearson Education, Inc. All rights reserved.

 FIGURE 2.9 The Market for Steel
Revisited
A: DWL before subsidy
A+B+C: DWL after subsidy

2-44 © 2012 Pearson Education, Inc. All rights reserved.

 The Pursuit of Efficiency

• Efficiency can be achieved through private

negotiations, judicial remedies, and
regulation.
• The simplest means of restoring efficiency
is through private negotiations
– The number of affected parties must be small

2-45 © 2012 Pearson Education, Inc. All rights reserved.

 FIGURE 2.10 Efficient Output with
Pollution Damage

• If resort offers to pay

steel company C+D, it
would benefit if output
drops from Qm to Q*.
• Refusing offer: PS is
A+B+D
• Accepting offer: PS is
A+B+payment (C+D)
• Accepting makes both
better off by C

2-46 © 2012 Pearson Education, Inc. All rights reserved.

 The Pursuit of Efficiency

• When negotiations are not possible, the court system

may play a role
• The courts can respond to environmental conflicts by
imposing property or liability rules
– The right to add waste products vs. the right to attractive
river
– Entitlement is naturally allocated to the party that can
most easily seize it (i.e. steel company)
– The courts must decide whether to overturn this allocation
• The Coase Theorem
– When negotiation costs are negligible and affected parties
can freely negotiate, the entitlement can be allocated by
the courts to either party and an efficient allocation will
result. Only the distribution of costs and benefits among
the effective parties is changed.

2-47 © 2012 Pearson Education, Inc. All rights reserved.

 The Pursuit of Efficiency

• If the steel company has the (natural) property right,

it is in the resort’s interest to offer a payment that
results in the desired level of output.
• Suppose that the resort has the property right
instead. To pollute, the steel company would have to
offer a payment to the resort.
• In the real world, negotiations are rare and monetary
compensation corresponding to the damage inflicted
could be awarded.
– Problem: after the fact. In other words, the steel company could pay up
while maintaining its inefficient level of output.
• Transaction costs are generally high in the real world.
• Inefficiencies may be better corrected using statutes or
regulations rather than court decisions.

2-48 © 2012 Pearson Education, Inc. All rights reserved.

 The Pursuit of Efficiency (cont.)

• Legislative and Executive Regulation

– Several forms taken including taxes and
regulatory laws tied to potential jail sentences
– Zoning laws for flexibility and reduced
environmental damage (e.g. separating steel
plant from resort)
– Pollution control equipment in vehicles and
plants
– Product labeling (e.g. GMO, organic)
• Can eco-certification make a difference? Organic Costa
Rican coffee

2-49 © 2012 Pearson Education, Inc. All rights reserved.

 An Efficient Role for
Government

• Government intervention is costly

• If transaction costs exceed surplus derived
from correcting inefficiency, then it may be
best to live with the inefficiency
• As societies have evolved the number of
pristine areas has declined, thus increasing
their value beyond the transaction costs of
their protection.
• Can government respond or will rent
seeking prevent efficient political solutions?

2-50 © 2012 Pearson Education, Inc. All rights reserved.

 Exercises

Static efficiency
•Qd = 400 – 20P
•Qs = 16P – 32
Graph these functions, find equilibrium, CS, PS

Externalities
•Demand: MB = P = 100 – 2Q
•Supply: MCp = P = 10 + 0.5Q
•Suppose MCe = 0.5Q
Find private equilibrium, MCs, socially optimal
equilibrium

2-51 © 2012 Pearson Education, Inc. All rights reserved.

 Exercises

Common property
Boats Fish
Caught
/Boat (kg)
1 200
2 190
3 175
4 155
5 130

Find outcomes when fishermen act in their

own interest vs. acting as a group.

2-52 © 2012 Pearson Education, Inc. All rights reserved.

 Exercises

Coase Theorem
Gains to No Factory Factory
Factory with filter with no
filter
Factory $0/day $700/day $800/day
Resort $400/day $250/day $100/day

Analyze the scenarios in which the resort is

given ownership of the river vs. the factory

2-53 © 2012 Pearson Education, Inc. All rights reserved.