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Functions of Environment, Ayres-Kneese Model, Laws of

Thermodynamics, Club, Common Good

Environment
• It is scarce in nature and has many conflicting alternative usages.
• Economics deals with the problem of choice and how to allocate scarce
resources to the areas of maximum returns.
• But if we rest upon market, then we might get inefficient results, as it would
poorly allocate environmental resources. This is because of presence of
imperfections, externalities, undefined or poorly defined property rights,
which set wrong information and signals incorrect prices.
• Consequent of the incorrect prices, the economic agents such as consumers,
producers, government tend to overexploit environment, as the market prices
fail to capture social cost and social benefits.
• Environment includes all life forms, energy, material resources, the
stratosphere (high atmosphere) and the troposphere (low atmosphere). These
constituent parts of environment interact with each other resulting in changes
in environment (an example is the effect of changes in biosphere on the
composition of atmosphere)
• In Economics, environment is considered as a composite asset that provides
variety of services which supports our life support through-

1) supply of raw materials for consumption and production,

2) absorbs and transforms economic wastes,

3) provides amenities of aesthetic value to society

Circular Flow / Ayres-Kneese’s Material Balance Model- 1969

• It depicts the interlinkage between environment and economy.

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• Economy consists of two sectors- consumption and production and exchange

of GAS takes place between them.
• Environmental services are rendered through 3 interlinked circles which are
contained in E4.
• Production sector extracts energy resources like coal, oil and material
resources like iron ore from the environment, which are then transformed into
GAS for consumption and production purposes. This role of environment is
termed as Supplier of Resources.
• Additionally, there is recycling of resources within the production as well as
consumption sectors. The waste material are created at each stage of
production (say industrial effluents, air pollution, etc.) and consumption
(sewage, litter, etc.). This role of environment is termed as Sink of Receptor
for Waste Products.
• Besides human, environment too creates wastes on itself, like shedding of old
tree leaves, etc. The environment has a capability limit to absorb the waste
and convert them into useful products- termed as Assimilative Capacity or
Carrying Capacity (it is finite and 2nd major function of environment).
• If the waste generation > carrying capacity of environment, then it leads to
pollution, which creates negative externalities and smog.
• This smog effect on nature is related to 3rd service of environment- i.e.
providing aesthetic amenity of spiritual and educational value to society (like
mountain, wild life, sunset, etc.)

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Laws of Thermodynamics

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The inter-linkages in the circular diagram are governed by the physical or natural
laws termed as laws of thermodynamics. It is a branch of science that deals with the
relationships between heat and energy.

First law of thermodynamics (law of conservation of energy or material balance

principle). It states that energy can neither be created nor destroyed, i.e. it can only
be transferred or changed from one form to another. For instance, coal consumption
must be equal to the amount of energy generated + wates in form of gases and solid
due to combustion.
• Two implications of First Law:
✔ As more resources are extracted for the production process, more of waste is
generated. Thus, economic growth which results in increased extraction of
material resources (like coal, water, wind, etc.), for generation of energy, is
also accompanied by increased residual wastes.
✔ There are limits on the degree to which resources can be substituted for each
other in production. The degree of substitutability that can be derived from
the environment is a very important parameter referred to in literature on
economics as the ‘limits to growth’.

Second law of thermodynamics (Entropy [degree of disorder] Law): Entropy

here implies that energy once generated for consumption is unavailable for other
work. Cleaning a untidy room implies that transformation from a state of high
entropy (disorder) to a state of low entropy (order).

• Similarly, production and consumption of energy in a closed system

(environment is a closed system) which are the important inputs of economic

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growth leads to use of material which further lead to flow of energy from low
entropy resource to high entropy resource [order of environment to disorder
of wastes]. It is because of the residual generated and thrown in the economy
• This law also states that no conversion of energy from one form to another is
completely efficient and this conversion process is irreversible. For instance,
CO2 once released in environment leads to no useful substance. Therefore,
entropy creates a physical obstacle.
• Thus, if the earth is a closed system, with a limited stock of low entropy
energy resource (fossil fuel), then the system is unsustainable if the
economic activity degrades the energy resources beyond a point (referred to
as the ‘limit to growth’) where no potential for its further use remains.

But earth is not a closed system, as we get unlimited supply of energy from sun.
Thus, entropy law suggest that the flow of solar energy establishes an upper limit on
the flow of energy that can be sustained. And once the stock of stored energy (fossils)
gets used up, then the rate of economic growth can only be determined by flow of
solar energy.

Public Goods & Private Goods

• Public goods cause market failure due to problem of missing markets.

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• Non-Excludability: Benefits derived from pure public goods cannot be confined

solely to those who have paid for it. Non-payers can enjoy the benefits of

consumption at no cost to them (termed as free-rider problem)

• Non-rival Consumption: Each individual’s enjoyment of good or service does not

diminish others’ enjoyment. MC of supplying a public good to an additional

individual is 0. If a public good is supplied to one, it is available to all.

• Non-rejectable: The collective supply of a pure public goods for all means that it
cannot be rejected by people, say defense
• The main reason why private sector cannot provide public goods is the difficulty in
protecting the property rights.
• Public goods are also known as Collective Consumption Goods

Public Goods & Private Goods

• A quasi-public good is a near public good, as it possess some of the features of
public good, like:
• Semi Non-Rival: Till a point, more people using a part, beach, open wi-fi donot
reduce the space/speed available for/to others. But as no. of users increases, the
speed reduces, space become crowded.

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• Semi Non-Excludable: Although possible but is difficult to exclude non-paying

consumers like fencing the park, charging entrance fees to the beech, putting
accessing fees to wi-fi.
• Private Goods: Refer to all those GAS consumed by private individuals to satisfy
their wants.
• These goods can be provided in competitive market
Features
• Excludable: The suppliers of private good can very exclude those who either can’t
or unwilling to pay.
• Rivalry in Consumption: One’s consumption reduces the amount available to others.
• Revealed Preference: People reveal their preference effective demand and market
price. The revealed preferences are the signals for the producers to produce goods
that the individuals want.

Club goods
Club goods, sometimes referred to as artificially scarce goods, are often excludable and
non-rivalrous public goods. This means that the item is available for the public to benefit
from, and it can keep its value no matter how many people consume it. However, the item
is excludable because it allows consumers to bar other people from gaining its benefits if
they don't pay for it. These items are artificially scarce because there is a financial gain in
making them exclusive rather than the possibility of them running out. Examples of club
goods include items like: Toll roads, Private parks, Cinemas
Common-pool resource goods
A common-pool resource good is an item that's created as part of a resource system. This
item can be natural or man-made. These goods are typically public, but they can become a
private or excludable good. These goods differ from public goods because they have high
consumption rates, which can impact their value. Some examples of common-pool
resource goods include: Fishing grounds, Irrigation systems, Coal mines, Timber fields
Free goods:

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Free goods are those goods that exist in such plenty that you can have as much of them as
you like without any payment, e.g., air, sunshine, etc. They are free gifts of nature. Man
has not made them nor has man to pay for them to get them.

Tragedy of Commons-Garrett Hardin, 1968

[Freedom in the Commons brings Tragedy to all]
• It is a tendency for any good which is rival and non-excludable to be overused and
undermaintained.
• As common resources are not owned, so it is difficult to prevent anyone from
consuming these goods.
• People have the incentive to gather or consume more of common resource before
the others.
• Common resources like wildelife can be subjected to the tragedy of the commons.
• The resources must be carefully maintained to remain useful, but there is a little
incentive for the users to invest in maintenance.
• ToC can be regarded as type of externality where any investment in maintenance by
an individual user provides an external benefit to others.
• As per Hardin, environmental problems are caused by overuse of common property
resources. All people have equal rights to use these resources, as they are public
goods:
• No ownership of common property say sees, mountains
• Non-exclusion, not possible to exclude others from using common property, indeed
expensive to stop others.
• Rival
Solutions to the tragedy of the commons
• Social customs
• Government regulations
• Tradeable allowances
• Joint ownership is needed to control overuse

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• Membership and fees should be paid to reduce usage

• Restrict number of users/members
• Fines and penalties for over-using the commons

• In 1968, Garrett Hardin postulated that humans were doomed to suboptimal

outcomes, due to the tragedy of the commons. Individuals behaving rationally
would lead to overconsumption and thus, collectively suboptimal outcomes. He, and
many who came after, argued that the solutions to this tragedy were either
privatization of a resource, or alternatively government control and top-down
regulation.
• But decades of research have demonstrated that local communities have
demonstrated the capacity to avoid this “tragedy” through the formation of
institutions that are collectively designed, monitored, and enforced. In Elinor
Ostrom’s seminal book “Governing the Commons” she argues that by forming
institutions that follow 8 principles can allow communities to avoid the tragedy of
the commons and collectively self govern collective (or “common pool”) resources.
Elinor Ostrom 2009 Nobel Laurette
Principles to Avoid Tragedy of the Commons

1. Boundaries of users and resource are clear

2. Congruence between benefits and costs

3. Users had procedures for making own rules

4. Regular monitoring of users & resource conditions

5. Graduated sanctions

6. Conflict resolution mechanisms

7. Minimal recognition of rights by government

8. Nested enterprises
Subsequent research has demonstrated that by improving trust through face-to-face
communication, users of a resource are more likely to be able to devise rules and creative

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solutions that help sustain a local resource. This research has become the basis for
extensions such as collaborative resource management, conceptions of complex socio-
ecological systems and their management, and the principles of resilience and robustness.

Externality
• Presence of externalities prevents achievement of Pareto optimality even under PC.
• It happens when the decision-makers does not bear all of the cost or reap all the
gains from their actions.
Types of Externalities
• Negative Externality/External Cost/External Diseconomy- Pollution by a firm
during production
• Tragedy of the Commons: Over-fishing in open sea by one leads to lesser
output by other fishing companies
• Positive Externality/Beneficial Externality /External Economy- I am gardening
in front of my home benefits others.
• Network Externality- One buying smart phones for video calling, would encourage
others too buy smart phones.
• Pecuniary Externalities- These don’t affect consumption or production but affect
prices (eg- property dealer)
• Technological Externalities- They affect consumption & production costs (eg-
coal)

1. The free-market fails when there is no allocative efficiency such that the marginal
benefit of the activity does not equal its marginal cost. The market fails to attain
private efficiency when marginal private benefit (MPB or commonly denoted as
MB when it is understood to mean marginal private benefit) does not equal marginal
private cost (MPC or just MC). The market also fails to achieve social efficiency
when there is a discrepancy between marginal social benefit (MSB) and marginal
social cost (MSC).

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2. Private costs are direct costs incurred when an individual consumes a product, and
also when a product is produced. Examples: (i) The cost of production of new bird
flu vaccine. (ii) The costs (monetary, time, best alternative given up, etc.) of buying
an ice cream.

3. Private benefits are benefits received directly by the consumers or the producers of
a product. Examples: (i) The revenue from selling a new bird flu vaccine for the
producer. (ii) The satisfaction of eating a chocolate ice cream.

4. An externality (spill-over) is costs or benefits to third parties who are not directly
involved in the consumption or the production of a good.

a. Negative externality when costs are imposed on third parties. Examples: (i)
Air pollution due to car exhaust. (ii) Visual pollution due to an ugly air
polluting factory. (ii) Second hand tobacco smoke to non smokers.

b. Positive externality when benefits spilt-over to third parties due to

consumption or production of a good. Examples: When a lot of people are
immunized against COVID19 then there will be a lower outbreak of the disease
and an individual who have yet to be immunized will also benefit from the
situation.

5. Social costs are the total costs incurred by the society when a good is consumed or
produced. Social costs can be defined as private costs plus costs to third
parties (i.e. private costs + total negative externalities).

6. Social benefits is the total benefits accrued to the society from an economic activity.
Social benefits can be defined as private benefits plus benefits to third
parties (i.e. private benefits + total positive externalities).

In order to decide whether or not social efficiency is achieved (i.e. highest possible social
benefits given the constraint of costs), we need to consider how marginal social benefits
compared to marginal social costs. So, CBA is also called marginal cost-benefit analysis.

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Marginal cost is the additional cost of consuming or producing one more unit of a good.
Costs incurred by private individuals and society are called marginal private costs (MPC)
and marginal social costs (MSC) respectively. Marginal cost slopes upward because of
diminishing marginal returns. Marginal social benefits (MSB) and marginal private
benefits (MPB) slopes downwards like a demand curve.

Marginal benefit is the additional benefit from consuming or producing one more unit of
a good. Benefits accrued to private individuals and society are called marginal private
benefits (MPB) and marginal social benefits (MSB) respectively. The marginal benefit
curve is downward sloping because of the principle of diminishing marginal utility in the
consumption of a good.
When MSB > MPB then we have positive externality
and when MSC > MPC then we have negative externality

Refer to the class-recording or live session to understand this concept and based on the
knowledge and understanding gained, fill-in the below table.

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DO IT ON YOUR OWN

Coase Theorem has been covered in Microeconomics, so it has not been covered in
Public Economics notes.

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