Chapter III (SE)

Lecture Note, Natural resource and Environmental Economics Chapter Three
CHAPTER III
EFFICIENCY, PROPERTY RIGHT, MARKET FAILURES & THE ENVIRONMENT
3.1 Efficiency
The Definition of Efficiency in welfare economics owes much to the economist-Vilifiredo Pareto
therefore an efficient local State is often known as Pareto Optimality
Definition of Pareto optimality:
“A situation is efficient or Pareto optimal if it is impossible to make one person better-off
except by making some one else worse-off”.
Stated differently, Pareto efficiency is a situation in which it is impossible for an individual to
gain with out another individual incurring a loss.
But if an economy is inefficient, it is possible to make at least one person better off at no cost to
any one else. Such a change is called Pareto Improvement or a Pareto Superior Move.
i. The natural environment is a complex system of resource stock, which provides a variety
of valuable service flows to society.
ii. Environmental resources are available in limited quantity.
Economic efficiency is classified in to two:

a. Static efficiency: concerned with allocation of resource in specific point of time (ignores
time factor).
b. Dynamic efficiency: concerned with allocation of resource over a period of time.
A. Static Economic Efficiency and Optimality

In a two person, two good and two input economy, the following three conditions have to be
fulfilled for static efficiency: efficiency in consumption, efficiency in production and product
mix efficiency,
9 Tow person: (A,B) UA = (XA, YA); X=(KX,LX)
9 Two goods: (X,Y) UB = (XB, YB); X=(KY,LY)
9 Two input: (L,K)
Arba Minch University 1 ©tefedha, 2006.

1) Efficiency in consumption
The efficient consumption requires that all individuals place the same relative value on all
products (value being assed at the marginal).
A B
⎛Ux ⎞ ⎛ ⎞
⎜ ⎟ = ⎜Ux ⎟ Where Ux = Marginal Utility from commodity X.
⎜U ⎟ ⎜U ⎟
⎝ y ⎠ ⎝ y⎠
D If they are not in equilibrium, there is a condition for exchange.
Graphically:
Exchange efficiency is described by the tangency between two indifference curves in Edge
Worth–Bawley Box
X
O2
Contract Curve
D
4 Y
Y C
B
IV
3
2
III
A
1 II
I
O2
X
Note: Exchange efficiency occurs the contract curve.

- Movement from Z to A or Z to B is Pareto improvement. But mort from A to B(or B to C
or C to D)is not improvement.
2) Efficiency in production
Efficient production requires that the marginal rate of substitution between factors be the same in
all industries.
X Y
⎛ MPL ⎞ ⎛ MPL ⎞
⎜⎜ ⎟⎟ = ⎜⎜ ⎟⎟
⎝ MPK ⎠ ⎝ MPK ⎠
X
MRTS LK = MRTS LK
y

Graphically, production efficiency is described by the tangency between two isoquants (in the
Edgeworth-Bawley box)
L
OY
Efficiency Locus
D
4 K
K C
B
IV
3 Not that production efficiency occurs on
2 the efficiency locus like at points
III A,B,C,&D
A
1 II
OX
L
3) Product-mix efficiency
Product-mix efficiency requires that the subjective Value of X in terms of Y should be equal to
its marginal cost.
UX MPKY
=
Uy MPKX
MRSXY = MRTYX
The Social Welfare Function and Optimality

There are numerable efficient configurations of the economy, depending among others, in the
initial destitution of resources. However, efficiency does not constitute asocial optimum. To
obtain social optimum, we need a utility frontier of the economy known as grand utility frontier,
and the social welfare function.
• To obtain grand utility frontier (GUF), we take each feasible output mix from the
transformation curve, and construct its utility frontier. This gives a family of utility frontier.
The overall utility frontier. This gives a family of utility frontier. The overall utility frontier
is then the outer envelop of all these frontiers

Grand Utility frontier of

Utility frontier
for (X0,Y0) Pareto Optimality
UB
Utility frontier
for (X1,Y1)
Utility frontier
for (X2,Y2)
UA
• The social welfare function is given as:

W= (UA, UB)
(This is the function, which relates the welfare of the socially to utility level of individuals in the
society)
This gives rise to what is sometimes called the isowelfare curve.
UB
W= (UA, UB) with a slope of

∂w
∂U A = wU A
∂w wU B
∂U B
W2(UA, UB)
W1(UA, UB)
W0(UA, UB)
UA

• To obtain the Social Optimum (or constrained “Bliss Point”), we use the social welfare
function to pick the preferred utility mix. At the optimum, the slope of the isowelfare
curve is equal to the slope of the grand utility frontier.
U XB wU A
i.e. =
U XA wU B
UB
Isowelfare function
Constrained Bliss-Point
SICIII
SICII Grand Utility frontier
SICI
UA
This is the fourth optimality condition. It is the condition for social justice (It is an optimality
condition, but not Pareto optimality condition. The Pareto optimality conditions are the former
three).
B. Inter temporal (Dynamic) Economic efficiency and optimality

In static efficiency, we do not talk about time. Here time is considered
UG1 Inter temporal Utility Possibility

Frontier (IUPF)
SICIII
SICII
SICI
UG2
G1 G2
Inter temporal social welfare fun = W = W (U , U )

Rawlins and utilitarian social welfare function

♣ Rawlins Social Welfare function
Rawls argued that if one wants to maximize welfare fun of a society, it must maximize this fun
W= min (UG1, UG2). They argued that SWF depends on the minimum of UG1 and UG2
E.g. W= min (10, 15) the value of this fun is 10 b/c it is the minimum. It doesn’t matter what
happens to 15 as long as 15 doesn’t go down below 10. We should care for the least well of in
society. It focuses more on the issue of equity.
In this case, the decision is made by the current generation, but they took future generation in to
account. In order to arrive at fair decision, you need to put every body behind a veil of Ignorance.
Here they do not know to which generation they belong and hence less likely to bias to their
generation.
♣ Utilitarian Social Welfare fun (USWF)

W= φ1UG1 + φ2UG2
To determine inter temporal welfare you have to add the weighted current generation utility and
weighted (discounted) future generation utility.
1
It r is a discount rate, φ1=1 and φ2 =
1+ r
Efficiency in a market economy

Does the market system results in efficiency? Yes, but under several assumptions.
Conditions required for a market system to efficiently allocate resources.

Static and dynamic efficiencies as Net benefit Maximization.

Static efficiency: Allocation of resource is said to be efficient in a specific period of time if net
benefit is maximized from the use of the resources.
Net Benefit = total benefit – total cost

NB = TB - TC
Efficiency = Max NB
dNB dTB dTC
= − = 0 , because at maximum of NB, the derivative is zero.
dQ dQ dQ
MB-MC=0
MB=MC
Dynamic efficiency: maximization of net benefit over time. (Since many of the decision made
now affect the value of assets for the future generation, we should take the future generation in to
account while taking some actions.)
When optimizing over time, we introduce discounting because there is a time value of money.
NB1 NB2 NBt
NB0 + + + ,,,, + where NB0 is maximum NB of current period.
(1 + r ) 1
(1 + r ) 2
(1 + r ) t
Note that the issue of discounting and intergenerational equity will come up with the discussion
of dynamic efficiency.
-------------------------------------------------------------------------------------------------------------
The chief normative economic criterion for choosing among various allocations occurring at the
same point in a time is called static efficiency or merely efficiency.
♣ An allocation of resource is said to satisfy the static efficiency criterion if net benefit from the
use of those resources in maximized by that allocation. i.e., B>C or B/C >1 for both B&C
positive.
So far so good, but how does we measure benefits and cost?
In economics the system of measurement is anthropocentric, which simply manse human
centered. All benefits and costs are valued interims of their effects on humanity.
9 Benefits can be desired from the demand curve (for the good or service provided by the
action). Demand curves maeasure the amount of a particular good people would be willing
to purchase at various prices.

For each quantity purchased, the corresponding point on the market dd curve represents the
amount of money some person is willing to pay for the last unit of the good. The total willing to
pay for some quantity of this good - say, 3 units – is the sum of the willingness to pay for each
of the three units. Hence, the total willingness to pay is the area under the continuous market
demand curve to the left of the allocation in question.
Total willingness Sum of WTP for the The area of the

E.g. = 1st, 2nd, & 3rd unit =
to pay for 3 units shaded region below
Note that total willingness to pay is the concept we shall use to define total benefits. Thus, total
benefits are equal to the area under the market demand curve from the origin to the allocation of
interest.
9 Measuring total costs on the same set of axes involves logic similar to measuring total
benefits. It is important to stress that environmental services have costs even though they are
produced without any human inputs
Note that all costs should be measured as opportunity costs.
For environmental services, their opportunity cost is the net benefit forgone b/c the resources
providing the service can no longer be used in the next most beneficial use. Resources are not
free if they can be put in alternative resources.

In graphing costs, we shall use the marginal opportunity cost curve to correspond to the marginal
willingness – to – pay function used previously to graph benefits. The marginal opportunity cost
curve defines the additional cost of producing the last unit. In purely completive markets, the
marginal opportunity cost curve is identical to the supply curve
Total cost is simply the sum of the marginal cost. The total cost of producing 3 units is equal to
the cost of producing the first unit plus the cost of producing the second units plus the cost of
producing the third unit. As with total willingness to pay, the geometric representation of the
sum of the individual elements of a continuous marginal cost curve is the area under the marginal
cost curve.
Since net benefit is defined as the excess of benefits over costs, it follows that net benefit is equal
to that portion of the area under the demand curve w/c lies above the supply curve.
Having defined the measurements of costs & benefits, we can now make an inference as to
whether a certain allocation is efficient so not. An allocation is said to be efficient if it maximizes
the net benefit. One implication of the above analysis is what we shall call the first equimarginal
principle.
First Equimarginal Principle (the “Efficiency Equimarginal Principle”)
‘Net benefits are maximized when the marginal benefit from an allocation equal the marginal
costs’
This criterion helps to minimize wasted resources, but is it fair? The ethical basis for this
criterion is derived from a concept called praetor optimality,….

Dynamic efficiency:
The static efficiency criterion is very useful for comparing resource allocations when time is not
an important factor. Yet many of the decisions made now have consequences, which persist well
in to the future. Time is a factor exhaustible energy resources, once used, are gone. Biological
renewable resources (such as fisheries or forests) can be over harvested, learning smaller and
possibly weaker populations for future generations. Persistent pollutants can accumulate over
time. How can we make choices when the benefits and costs may occur at different points in
time?
Incorporating time in to the analysis requires an extension of the concepts we have already
developed. This extension provides a way for thinking not only about the magnitude of benefits
and costs, but also about timing. In order to incorporate timing, the decision rule must provide a
way to compare the net benefit received in one period with the net benefit received in another.
The concept that allows this comparison is called present value.
Recall that the net present value of a one - time net benefit received n years from now is
Bn
NPV [Bn] =
(1 + r ) n
And, the net present value of a stream of net benefits {Bo,…, Bn} received over a period of n
years is computed as
n
Bi
NPV [Bo, ---,Bn] = ∑ (1 + r )
i =0
i
Where r is the appropriate interest rate and Bo is the amount of net benefits
received immediately. The process of calculating the present value is called
discounting, and the rate r is referred to as the discount rate.
The traditional criterion used to find an optimal allocation when time is involved is called
dynamic efficiency, a generalization of the static efficiency concept already developed. In this
generalization, the present value criterion provides a way for comparing the net benefits received
in one period with the net benefits received in another.

An allocation of resources across n time period satisfies the dynamic efficiency criterion if it
maximizes the present value of net benefits that could be received from all the possible ways
allocating those resources over n – periods.
The simple mathematics of Dynamic Efficiency

Assume that the demand curve for a delectable resource is linear and stable over time. Thus the
inverse demand curve in year t can be written as
pt = a − bqt ---------------------------------------------------------------1
The total benefits from extracting an amount qt in year t are then the integral of this function (the
area under the inverse demand curve).
qt
(Total Benefits)t = ∫ (a − bq)dq ------------------------------------------------------- 2

o
b 2
= aq t − q t ------------------------------------------------------- 3
2
Further assume that the marginal cost of extracting the resource is a constant C and therefore the
total cost of extracting any amount qt in year t can be given by
(Total Cost)t = cqt --------------------------------------------------- 4
If the total available amount of this resource is Q, then the dynamic allocation of a resource over
n years is the one which satisfies the maximization problem:
b
aqi − qi2 − cqi
n
⎡ n
⎤
Max
q
∑
i =1
2
(1 + r ) i −1
+ λ ⎢
⎣
Q − ∑
i =1
qi ⎥ --------------------------------5
⎦
Assuming that Q is less than would normally be demanded, the dynamic efficient allocation must
satisfy.
a − bqi − c
− λ = 0 ---------------------------------------------------------- 6
(1 + r ) i −1
n
Q − ∑ qi = 0 ---------------------------------------------------------------- 7
i =1
An implication is that (P – MC) increases over time at rate r.

Illustration:
Let the inverse demand function for the delectable resource is P = 8-0.4q and the marginal cost of
supplying it is $2.
a) If 20 units are to be allocated between two periods, in a dynamic efficient allocation how
much would be allocated to the first period and how much to the second period when the
discount rate is 0.10?
Solution: Using equation 6, we obtain the following
8 − 0.4q1 − 2 − λ = 0 ------------------------------------------------------------------ 8
8 − 0.4q1 − 2
− λ = 0 ----------------------------------------------------------------- 9
1.1
q1 + q 2 = 20 -------------------------------------------------------------------------- 10
From equation 8,9, and 10, we obtain
Q1 = 10.238
Q2 = 9.762
λ = $1.095
Note that equation (8) states that a dynamic efficient allocation the PV of the marginal net
benefit in period 1 (8-0.4q1 -2) has to equal λ. Equation 2 states the PV of the marginal net
benefit in period 2 should also equal λ. There fore, they must equal each other.
b) What would the efficient price be in the two periods?
P= 8 – 0.4q
P1= 8 – 0.4q1and P2= 8 – 0.4q2
P1= 8 – 0.4(10.238) and P2= 8 – 0.4(9.762)
P1 = 3.9 and P2 = 4.1
c) What would the marginal user cost be in each period?
The value of λ obtained from equations 8 & 9 is the present value of marginal user cost.
That value is λ=1.905.
Note that equation (8) states that price in the first period (8-0.4q1) should be equal to the sum of
marginal extraction cost ($2) and marginal user cost ($1.905). Multiplying (9) by (1+r), it
become clear that price in the second period (8-0.4q2) is equal to the marginal extraction cost
($2) plus the higher marginal user cost [λ (1+ r) =(1.905) (1.10)= $2.905] in period 2.

d) Check that PV-MNB1 = PV-MNB2

6 − 0.4q 2
6 − 0.4q1 =
1+ r
6 − 0.4(9.762)
6 − 0.4(10.238) =
1 .1
1.905 = 1.905 = λ
9 What does the marginal user cost measures? Marginal user cost measure the opportunity cost
of producing an extra unit of the resource against the future generation. MUC = PVMNB =λ.
9 In a perfect competitive market, p = MC, but for dilatable resources, P>MC why? This is
because every unit of the resource produced and used in one period is a loss to the other
period and this loss is referred to as the marginal user cost. Hence the marginal cost is not
only the extraction cost but also the opportunity cost (MUC).
Traditionally, at optimum levels,
MC = MB
MC = total MC ⇒ the total socially accepted MC
Social accepted MC includes, Private MC + MUC
Private MC = MEC
MCT=MEC + MUC
Thus, at equilibrium,
MB = MCT
MB = MEC + MUC
We know that P = MB
MB1 = 8-0.4q1 MB2 = 8-0.4q2
= 8-0.4(10.238) = 8-0.4(9.762)
= 3.905 = 4.095
Check that MCT = MB
MEC + MUC = MB
Period I: MEC1 + MUC1 = MB1 Period II: MEC2 + MUC2 = MB2
2+1.905 = 3.905 2+2.095 = 4.095
3.905 = 3.905. 4.095 = 4.095.
Static efficiency is achieved!!

Therefore, the price here is not only the private price but also social price; that is why it is above
the (private) MC.
P
P, C MCT
MUC
MEC
Q Time
As resource gets scarce, P increases
As time goes, the unavailability of
resource increases=>P increases
Note: the gap between p & MC is
the MUC which involves the value
of depletion of resources to the next
generation.
MUC = P - MC
3.2 Market Failures

Definition:

3.3 Environmental externalities
The assumption of the perfect competitive market is that all benefits form sale of product and
cost of production fully reflected in its demand and supply of the product. When all benefits and
cost are considered the intersection of MSB&MSC leads to maximum benefits.
An externality exists whenever the welfare of some agent, either a firm or a house hold, depends
not only on his or her activities but also on activities under the control of some other agent.
Or it accrues whenever the activity (or consumption & production decisions) of one agent affect
the utility of another agent in unintended way, and when no compensation is made by the
producer of the external effect to the affected party (i.e. when the effect of the causer is not
reflected in the market transaction).
E. g. Consider the case of steal factory &the resort hotel (both using the same river).
In analyzing externality, we have to distinguish between social & prorate values
Distinction between private and social values

Private costs: cost that are borne to under take an activity by the economic agent undertaking the
activity
Social costs: cost that are borne to undertake an activity by the economic agent undertaking the
activity plus costs imposed on all other economic agents.
Social costs = private costs + external cost
Social costs ≥ private costs
Private benefit: benefit obtained form the realization of an activity by the economic agent
undertaking the activity.
Social benefits: benefits obtained form the realization of an activity by the economics’ agent
undertaking the activity plus benefits obtained by all other economic agents.
Social benefits = Private benefits +Social benefits
Social benefits ≥ private benefits
Types of Externalities:
1. Negative Externality [External diseconomy]

9 It is cost of resources not reflected in the price of the product.

9 It causes additional cost to the other members of society that consumers and
producers of good will not take into account.
9 It leads to an excess of social cost [SC] over private cost [pc]. A steel manufacturing
firm for instance produces both the steel & pollution. Here, the society consider both
the cost of pollution & the cost of producing the steel
⇒ Private cost = cost of producing the steel
Social cost = cost of producing the steel & cost of pollution
SC = PC + EC
Hence, social marginal cost function (Mcs) includes both of these cost as well.
Eg -emission of smoke form factory
-anise of aim plane, etc
2. Positive Externality (external Diseconomies)
• It is a benefit not reflected in prices
• It causes additional benefit to other member of the society that consumer or producer
of the good & will not take into account.
• It results in excess of social benefit over private benefit.
i.e MSB > MPB by MEB
e.g. – Vaccination - plainest certain infections disuse
- Education - Directly benefit the individual
- Spillover effects to society
- Discovery of HIV /Aids vaccine
- Bees keeper benefit fruits producers & vice-versa .
3. Pecuniary Externality [Pseudo externality]
• It occurs when one individuals activity level affects the financial circumstance of
other, but which need not produce a miser allocation of resources in a world of pure
competitions
E.g. suppose that a new firm moves in to an area and drives up the rental price of
land. That increase creates a negative effect on all those paying rent and therefore
is an external diseconomy.
• This pecuniary diseconomy, however, doesn’t cause a market failure because the
resulting higher sent are reflecting the scarcity of land.
E.g. increase shoe demand→increase price of leather→affect the welfare of leather

4. Unidirectional Externality
• occur when externalities are in one directional, or uni-directional.
A→B
5. Reciprocal Externalities
• Occur when externalities are reciprocal, bi-lateral or bi-directional
A↔B
i.e., In the case of negative externalities, each of the agents damages all the other agents
through its actions.
E.g. Acid rain in Europe !
6. Technological Externalities
• Prevail when at least one of the variables in the production or utility fun of an agent
falls under the control of an external economic agent, this is a cause of market failure
E.g. U1=U1(X1,Y1) and U2=U2(X2,Y2,Y1)
Here comes externality. In the absence of externality, Y1 doesn’t appear in U2
Externalities and Economic Efficiency

Here, we are going to analyze the impact of externality on the market system and demonstrate the
condition for efficacy. Recall that, in the presence of externalities social cost are different form
private costs and /or social benefit are different form private benefit
=> MSC≠MPC and /or MSB≠M$B
Hence, in the existence of externalities the traditional condition of MC=MB has to be revised so
as to incorporate the external costs & benefit.
9 When there are external benefits
In the case an unregulated market system would under produce (desired) quantity of a given
good.
⇒ Qs>Qm, where Qs = social optimum
Qm = Private (market) optimum

MSC (=MPC)
Ps
Pm
MSB (=D2)
MPB (=D1)
Qm Qs Education
MPB= marginal private benefit

MSB = marginal social benefit
MSB = marginal External benefit
Qm = out put produced by the market system
Qs = socially optimum out put level
Social optimum occurs when MSB= MSC
Private optimum occurs when MPB = MPc
Alternative method of depicting positive externality
a = social inefficiency or dead

weight loss due to the
externality.
Concussion: when there are positive externalities not enough of the activity is undertaken by the
market system

9 when there are external casts:

In this case an unregulated market system would over produce the [undesired ] quantity of a give
good.
⇒Qs < Qm
MPC = marginal private cost

MSC = marginal social cost
MEC = marginal external cost
Alternative method of depicting a negative externality

Summery of the impact of externalities on the market system.
Negative externality Positive externality

Quantity produced Too much Too little
Cost / Benefits Costs greater than socially Benefits lees than socially optimal
optimal
Stimulus to innovation Little incentive to reduce social Little incentive to expend social
costs benefits
3.4 Property Right
Definition: property right refers to a bundle of entitlements defining the owner’s right, privileges
and limitations for use of the resource. This property right can be vested either with individuals
as in capitalist economy, or with the state, as in centrally planned socialist economy
Note that the manner in which produces and consumers use environmental resource depends on
the property right governing those resources.
Four main characteristics of an efficient property rights structure in a well functioning market
economy include
1. Universality: all resources are privately owned and all entitlement –etnas completely
specified
2. Exclusivity: all benefits and costs accrued as a result of owning and only to the owner,
either directly or indirectly by sale to other
3. Transferability: all property right should be transferable form one owner to another in a
voluntary exchange
4. Enforceability: Property rights should be secure form involuntary seizure or encroachment
by other
An owner of a resource with a well defined property right has a powerful incentive to use that
resource efficiently because a decline in the value of that resource are presents personal loss
transferability (exchangeability of property rights) facilitates efficiency, the price level which
producers & consumers maximize their face will adjust until surplus and market clears.

Is this allocation efficient? According to our definition of static efficiency it is clear that the
answer is yes ! the net benefits is maximized by the market allocation and it is equal to the sum
of the consumer and producer surplus.
Other property Rights Regimes

Private property is not the only possible way of defining entitlements to resource use other
possibilities include
a. State property regimes: where the gov’t owns &controls the property. With varying degrees
state property regimes exist in virtually all countries of the world e.g. parks &forests
Here the efficiency & sustainability problem can also when the seventies of bureaucrats who
implement and /or make the rules for resource use diverge form collective interests
b. Common property regimes :are those resources jointly owned and managed by a specified
group of co-owners rather than private entitlement to use such resources may be formal
(protected by specific legal rule ) or informal (protected by tradition or custom ) efficiency &
sustainability of use depends on these rules (unsuccessful experience is more common )
e.g. Grazing land in rural area
c. Res nullius Regimes : are those resources in which no one owns or exercises control over
the resource. The main focus of this section can be exploited on a ‘first-come-first-served’
basis, because no individual or group has the legal power to restrict its access.
Every body’s property is no body property.
Get it while the getting is good.
Note that open access resource hare given rise to what has became known as the “tragedy
of the commons”
Distinguish b/n common pool resources and public goods.
Common pool resources are characterized by non exclusivity and divisibility.
E.g. A large lake like Lake Tana with unlimited no of fishermen who have access to it.
3.5 Public Goods

Public goods are goods that either will not be supplied by the market or if supplied, will not be
supplied in sufficient quantity. E.g. clean air, clean water, biological diversity, national defense,
police , public clock, street light, etc

Major characteristics of pure public good

1. Non rival in consumption (=> indivisibility )
2. Non exclusive in consumption (=> non excludability )
Consumption is said to be indivisible when one person’s consumption of a good does not
diminish the amount available for other (or does not reduce the supply available for others)
This implies that it costs noting for additional individual to enjoy the benefits of the public
good. => the marginal cost of producing public good to additional consumer is zero. Hence,
according to the efficiency rule p should be zero. Thus it is inefficient to put positive price
on public goods.
E.g. let’s take defense:
70 million people = costs x br
60 million +1 person =?
=> cost x !!
=> Admitting one user does not increase the of defence because mc=0
Non excludability: refers to circumstance where ,once the resource is provide , even those
who fail to pay for if cannot be excluded form enjoying the benefit if confers.
It is not possible or at least very costly to exclude or to protect non payers from getting
benefit from these type of goods.
⇒ Can we rely on the private sector to produce the efficient amount of public goods such as
biological diversity ? Unfortunately the answer is no! Why? Consider the following case.
In the following figure, individual demand curves for preserving biodiversity have been
presented for two consumers A&B. The market demand curve is represented by the vertical
summation of two individual – demand curves. A vertical summation is necessary because
every one can simulate onerously consume the same amount of biological diversity we are
therefore able to determine the market demand by finding the sum of the amounts of money
they would be willing to pay for that level of diversity.
What is the efficient level of diversity? => The amount that maximize net benefit (= area
under the market demand cure that lies above MC)

Cost of
Diversity
Person A Q* is the allocation that maximizes net

A
benefit because it is the allocation were
O
the demand curve crosses the Marginal
cost cure.
Note: Both consumers consume this
B Person B
amount. At this level of availability, the
marginal net benefit to person B is OB, to
O person A is OA, and the sum of this
(OA+OB) is society marginal cost come.
MC
OB
OA
⇒ Would a private market supply this amount? No! The efficient market equilibrium for a
public good requires different price for each consumer. In the case. If A is charged Pa
(=OA) and B is charged Pb (=OB), than both consumer will be satisfied with the efficient
allocation.
⇒ Further more, the revenue collected will be sufficient to finance the supply of the public
good (because PbQ* + PaQ* = MC.Q* ). Thus although an efficient pricing system exists,
it is very difficult to implement.
The efficient pricing system requires changing a different price to each consumer font in the
absence of excludability; consumer may not choose to reveal the strength of their preface for this
commodity. Therefore, the producer could not possibly know what price to charge. Inefficiency
results because each person is able to become a free rider on the other’s contribution.
⇒ A free rider is someone who driver the benefits form a commodity without contributing to its
supply.

Because of the consumption indivisibility a non excludability property of public good, consumer
receive the benefits of any diversity purchased by other people. When this happens, if tends to
diminish incentive to contribute, and the contribution are not sufficiently large to finance the
efficient amount of the public good; it would be under supplied.
Summery: the fundamental problem associated with public good are
1. Free rider problem: individual want to consume freely
2. Pricing problem: efficiency in public good requires different pricing for different
individual which is difficult to implement.
3. Information problem: the problem of revealing the demand for public goods.
Correcting Market Failure

The major problem in environmental economics are public good & externalities But is there any
solution to these problems. Basically two solutions are proposed.
a. Redefining Property Right

One reason for inefficiency is improper definition of property right. Hence, we need to assign
exclusive property right to the individuals. The individual will get a fee for the use of resource.
The fee should be equal to the MC (= SMC) of using the resource. However, it should be noted
that most common property resources are vast are vast (or large) and single ownership may not
be practical. Therefore, government regulation or ownership may not be particle. Therefore,
government regulation or ownership may be needed.
When assigning property right is not possible a government or community can invest on resource
maintenance or it can restrict harvesting. e.g. by giving quotas, issuing license or imposing taxes.
b. Internalizing Externalities
When there is an externality, for firm which causes the externality, the profit maximization
conditions are not the same as the Pareto efficiency conditions. Therefore, the society must find a
way of inducing their firm to accounting for the externality. Internalizing externalities may be
defined as the process by which an externality is absorbed by the market system. This can be
done by:
¾ private transaction
¾ government instruments

Conditions required for internalizing externalities by private transactions

¾ there must be technically feasible gains form internalizing externalities
¾ there must be net gains form internalizing the externalities
⇒ transactions cost must be less than gains form internalizing externalities
¾ there must be well defined property right
⇒ there should be no institutional barriers in internalizing
But the conditions are hardly achieved!
Government instrument
There are two main types of government instruments for internalizing externalities, namely
a. Regulatory instruments
E.g. air and water quality standards, permits and licenses, land water controls.
They are also called command-and-control measures.
b. Economic instruments
E.g. Pigovian subsidies and taxes, tradable pollution rights, etc.
They are also called the market based instruments
What other policies generate efficiency? One clever method is known as Merging.
The computation of the effectiveness of the method is obtained by merging the two firms and
maximizing the joint profit πj, where πj=π1+π2.
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Lecture Note, Natural resource and Environmental Economics Chapter Three

Economic efficiency is classified in to two:

A. Static Economic Efficiency and Optimality

Arba Minch University 1 ©tefedha, 2006.

Note: Exchange efficiency occurs the contract curve.

Arba Minch University 2 ©tefedha, 2006.

The Social Welfare Function and Optimality

Arba Minch University 3 ©tefedha, 2006.

Grand Utility frontier of

• The social welfare function is given as:

W= (UA, UB) with a slope of

Arba Minch University 4 ©tefedha, 2006.

B. Inter temporal (Dynamic) Economic efficiency and optimality

UG1 Inter temporal Utility Possibility

Arba Minch University 5 ©tefedha, 2006.

Rawlins and utilitarian social welfare function

♣ Utilitarian Social Welfare fun (USWF)

Efficiency in a market economy

Arba Minch University 6 ©tefedha, 2006.

Static and dynamic efficiencies as Net benefit Maximization.

Net Benefit = total benefit – total cost

Arba Minch University 7 ©tefedha, 2006.

Total willingness Sum of WTP for the The area of the

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Arba Minch University 10 ©tefedha, 2006.

The simple mathematics of Dynamic Efficiency

(Total Benefits)t = ∫ (a − bq)dq ------------------------------------------------------- 2

An implication is that (P – MC) increases over time at rate r.

Arba Minch University 11 ©tefedha, 2006.

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d) Check that PV-MNB1 = PV-MNB2

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3.2 Market Failures

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3.3 Environmental externalities

In analyzing externality, we have to distinguish between social & prorate values

Distinction between private and social values

1. Negative Externality [External diseconomy]

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Externalities and Economic Efficiency

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MPB= marginal private benefit

Alternative method of depicting positive externality

a = social inefficiency or dead

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9 when there are external casts:

MPC = marginal private cost

Alternative method of depicting a negative externality

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Summery of the impact of externalities on the market system.

Negative externality Positive externality

3.4 Property Right

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Other property Rights Regimes

3.5 Public Goods

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Major characteristics of pure public good

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Person A Q* is the allocation that maximizes net

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