ENVIRONMENTAL ECONOM

Kelly de Bruin Umea University

SOCIAL CHOICE : HOW
MUCH ENVIRONMENTAL
PROTECTION?
Chapter 3
Introduction
 2 questions in environmental policy:
 What is the right balance between environmental
protection and use?
 How do we get economic agents to adhere to this
balance?
 The first question is a societal decision, a political
decision
Introduction
 How do you translate all individual preferences
into a societal preference?
 But societies consist of many individuals with
different opinions
 Keep in mind the costs of environmental protection
 The second question is an economic question
 3 examples
Santiago
 Air pollution in Santiago, Chile
 Most pollution comes from diesel busses and
automobiles
 Pollution can be cleaned up at a cost
 If diesel busses are to pay the cost, public transport
will become more expensive
 Wealthier people tend not to take the bus and
probably care more about the environment
Santiago
 What to do? Vote: poor majority wins
 Willingness to pay: rich minority count
California gnatcatcher
 Endangered bird in Southern California
 Gnatcatcher needs land
 Expensive land
 What to do?
 Vote? Who?
Three Gorges dam China
 Nearly completed
 Will create 500 km long reservoir
 Provides electricity
and flood control
 Will destroy ancient cities
and canyons
 Chance of failure
Examples
 Santiago is easiest to solve as all the affected
people reside in Santiago, but distributional issues
 Other examples involve intertemporal issues
 How to you speak for future generations?
Individual preferences
 Often economics is criticised for not caring about
the environment
 Environmental Economic Analysis can lead to
conclusions that environmental protection should
be very low
 Not economics fault, our fault
 Individual preference can be based on different
philosophical ideas, we discuss 4
Biocentrism
 Places value on life
 Intrinsic vs instrumental value
 All life has intrinsic value: animal activists,
 Aldo Leopald: value of ecosystem
Anthropcentrism
 Value of environment is its instrumental value to
humans, i.e. material value
 Often used synonymously with utilitarianism
 Utilitarianism is completely different: just
aggregates all individuals preferences
 I guess they are confused because they are the
same when all individuals are anthropcentric,
which most are unfortunately
Precautionary Principle
 Uncertainty over the future and the effects of
environmental actions
 We need a safe minimum standard
 Minimising regrets
 Rio Declaration:
 ‘Where there are threats of irreversible damage, lack of
full scientific certainty shall not be used as a reason for
postponing cost-effective measures to prevent
environmental degradation’
 Rather be too careful than too bold
Sustainability
 Started from Leopalds idea that we must keep
ecosystems intact
 Many different ideas about what it exactly entails
 Solow: not let future generations be less well off
than us in terms of income per capita
 Brundtland commission : development that meets
the needs of the present without compromising the
ability of future generations to meet their own
needs
Sustainability
 2 key aspects in the debate:
 Natural capital – manmade capital substitution
 Obligations to future generations
 Weak vs strong sustainability
Social choice from individual
values
 Now we need to aggregate individual preferences
into social preferences
The Utility Function
 Assume an economy with N individuals
 These individuals can consume a consumption
good X or an environmental good e (environmental
protection)
 Each individual can consume a different amount of
market goods: i consumes Xi
 All individuals consume the same amount of of
environmental protection (public good)
The Utility Function
 How individuals view benefits of market good and
environmental good are represented by a utility
function Ui
 Ui(Xi,e)
 Societal consumption bundle: a=(Xi,…,Xn,e)
 Individuals substitute X and e
 Different individuals have different utility
functions
Utility functions
The Utility Function
 Environmental protection benefits future
generations
 People today care about future generations based
on 2 ideas:
 Bequest: you care about future generations
 Altruism: you care about people
Voting
 Say we have 2 bundles of goods A and B
 A has more market goods
 B has more environmental goods
 Which do we choose?
 Using a Social welfare function (an aggregate
utility function) we could compare the 2 bundles
 We can also let individuals vote
Pareto criterion
 Unanimity/ Pareto criterion: If all individuals
prefer A (or are indifferent) than pick A
 Technically: start with 2 consumption bundles
 and
 And a group of people
 With utility functions,
 is preferred to for the group as a whole, if
for every individual I,
Pareto Criterion
 And for atleast one
 Z>W

 Y>X

 No matter your

social philosophy
 Not often in real

life
 X and Z?

 B and Z?
Unanimity with side payments
 Now imagine that we can make side payments from
one individual to another
 This can increase the unanimity
 Say 75% of the population prefers
 And 25% prefers
 does not fulfill the Pareto criterion
 Suppose the 75% transfer consumer goods to the
25% if they choose option , then unanimity can
be reached
Unanimity with side payments
 is preferred to for the group as a whole, the
winners can compensate the losers, so that
everyone is better off with
 Transfers can be given by
 Where a positive number is a received amount and
negative a given amount
 Hence
Potential Pareto Improvement
 We can now define what is called potential Pareto
Improvement
 If there exists a vector of transfers from individuals
 , which sums to zero, such that
 is Pareto preferred
to , then it is a potential Pareto improvement
over
Potential Pareto Improvement
 We want to compare
 X and Z
 Anna loses deltaA
 Brew gains deltaB
 Cannot be compared
 But Brew can transfer
 Resource to make up
 For Annas loss
Potential Pareto Improvement
 Can end up in e.g. R
 But this may not always be feasible or desirable
 How much?
 Bribe?
 Kaldor-Hicks compensation principle says that
even if the transfers or not made it is socially
desirable
 Compensation is an issue of equity and can be
decoupled form a social choice
Majority rule
 The main problem with Pareto is that many different
consumption bundles cannot be compared
 Compensation solves this issue a bit, but creates new
bundles, thus we still do not compare the original
bundles
 Majority is most often used in real life: politics etc.
 If the majority prefer A to B, then society prefers A to B
 But it doesn’t measure the level of preferences for A
and B
Supermajorities
 Some rules and laws are based on moral values of
human rights
 These are protected more vigorously than the
choice of president or the passing of a policy
 For example the constitution
 These laws can only be changed by
supermajorities. For example, one needs 75%
majority to change the SA constitution
Voting with more than 2 alternatives

 More complex as people have to rank the alternatives

 Divide into approve and do not approve
 Rank alternatives:
 The choice ranked first by more than half of the voters
wins (termed majority rule)
 The choice ranked first by the largest number of voters
wins (termed plurality rule)
 Borda count, sum the rankings, lowest wins
 Eliminate choice ranked lowest by most, repeat until only
one
Voting with more than 2 alternatives

 Multiple rounds:
 A vs B
 A vs C
 B vs C
 Cycling may occur
 If clear winner in pairwise majority voting:
Condorcet winner
Social Welfare Function
 Social welfare function aggregates individual
utilities into societal utility
 Technically:
 Let W be a function that associates a single number
with each distribution of utilities in society

 If means that
is socially preferred to then is a Bergson-
Samuelson SWF, i.e. a SWF
Social Welfare Function
 This says nothing about whether society prefers
how individuals get their utility, hence we do not
care if someone drinks their utility or plants
flowers for it
 Once we have a SWF, we can draw indifference
curves for society
SWF- indifference curves
 Y Pareto to X
 W(Y)>W(X)
 But also
 W(Z)>W(X)
Examples of SWF
 Benthamite:
 Utilitarian, mostly used. Different peoples utility
can be weighted differently, based on for example
income
 Eqilitarian:
 Total amount but also distribution counts
 Rawlsian:
 Strong as weakest member
Perfect choice mechanism
 There should be a best way, right?
 Arrow set out to identify a Best Choice Mechanism
 He came up with 6 basic requirements:
 1. completeness: compare all options
 2. unanimity: if all prefer a, society prefers a
 3. nondictatorship: no one should get their way, i.e. no one
should have exactly the same preferences as society as a
whole
 4. universality: any possible ranking of individual
preferences is possible
Perfect choice mechanism
 5. Transitivity: if a is preferred to b and b to c, than
a is preferred to c
 6. Independence of irrelevant alternatives: does not
hold e.g. Bush vs Gore
 Arrows impossibility theorem: there is no rule
satisfying all 6 axioms
 No clear perfect solution, yet social decisions need
to be made..
Criticism of the utilitarian
approach
 We assume preferences can be represented in a
utility function but:
 Preferences are not constant: I do not like the
smurfs much anymore, or snus for that matter
 Not all individuals are included in the voting,
future generations
 Preferences are not based on what is right
EFFICIENCY AND
MARKETS
Chapter 4
Introduction
 There is according to EE an optimal level of
pollution
 Once we have this optimal level we must achieve it
as best possible
 Optimal is NOT the same as efficient
 Efficient entails that the least amount of resources
are used to perform a certain task
 Optimal also includes a social goal
Introduction
 If something is optimal it must also be efficient, but
not vice versa
Efficiency
 Efficiency = Pareto optimality
 Typically 2 types: exchange efficiency and
production efficiency
Efficiency
 Competition is considered by some to be a good
thing for 2 disputable reasons:
 1. helps the market economy work smoothly and
adjust to a changing world
 Does not respect historical traditions or preferences
 2. the competitive outcome is best for society
 May be efficient, but not optimal, as there are
market failures, externalities and public goods
Pareto frontier
 Shaded area is Pareto
preferred to X
 Nothing is preferred to

the curve
Pareto Frontier
 The Pareto Frontier consists of all allocations for
which there are no allocations that are Pareto
preferred
 An allocation is Pareto optimal if it lies on the
Pareto frontier and sub optimal if not
 Efficiency = Pareto optimality
Efficiency and competitive markets
 Competitive markets are efficient
 Any Pareto optimum can be achieved with a
competitive market and appropriate income
transfers
 Whereas restrictions in the form of laws and
regulations can be inefficient: waste transfer,
certain emission technologies etc.
Efficiency in exchange
 An economy with 2 people Brewster and Anna
 2 goods: garbage disposal and wine
 Barter economy: they TRADE
Efficiency in exchange
 Concave
 Decreasing

marginal
utility
 Optimal is

where
MRSgd=MRSw
= you would give
1 wine for 1 GD
Edgeworth box
 Shows all possible divisions of the 2 goods
 Map indifference curves of each individual
Edgeworth box
Edgeworth box
Initial endowment
Edgeworth box
Efficiency in exchange
 If indifference curve are tangent then efficient
 When MRSanna=MRSbrewster
 This is also called efficiency in consumption
 Free exchange will lead to Pareto optimality
 Marginal rate of substitution should be the same for
all individuals
Markets and Exchange
 Now we no longer assume barter trade but assume
that goods are traded with prices on a market
 Anna initial endowments are G0 and W0
 She ends up with G* and W*
 Prices of the goods are Pg and Pw
 Anna budget:
 Pg*G0 + Pw*W0 = Pg*G + Pw*W
Budget line
 G= (G0+(Pw/Pg)W0)-(Pw/Pg)*W
 WRONG IN BOOK!
 G and W are related, first term is constant, G and
W are linearly related with slop -Pw/Pg
Edgeworth box #2
Initial endowment
Prices
 We do not know the prices, that is what the
competitive market sets
 But the prices will respect the budget constraints
and hence the budget line will pass through the
initial endowment point and the market equilibrium
point
 Furthermore in the equilibrium the budget line and
indifference curves will be tangent, i.e. the price
reflects the demand for the good
Edgeworth box #2
Efficiency in Production
 We have just looked at dividing existing goods
efficiently among people
 Now we look at dividing scarce production
resources among products to be produced
 Say we have 1 resource: Labour
 And still the same 2 goods wine and garbage
disposal
Efficiency in production
Efficiency in Production
 Profits= Pw*W + Pg*G –C
 C = constant costs of labour
 G=(Profit+C)/Pg-Pw/Pg*W
 The intercept (Profit+C)/Pg of the resource budget
line should be as high as possible (maximising
profits)
 The slope of the line is -Pw/Pg
 It should again intercept the PPF to ensure Pareto
optimality
MRT
 The slope of the curve is referred to as the
Marginal Rate of Transformation between 2 goods
 For efficiency MRTwine=MRTgarbagedisposal
Product mix efficiency
 Only one production input so not covered in book
 MRTL=MRTK=MRSa=MRSb
MRT
 MRT should also be the same for all producers
 This often does not hold when we talk about
pollution
 The equimarginal principle: in controlling
emissions from several polluters, efficiency
requires that the marginal cost of emission control
be the same for all polluters
 This can be achieved through e.g. tradable permits
Kyoto (not so much) Protocol
 1997 in Kyoto, countries tried to form an agreement on
GHG emissions
 Developed countries were expected to reduce there
emissions by around 5-10% of the 1990 levels
 Developing countries were allowed room to develop
 This agreement would lead to 5% less emissions
compared to 1990 globally
 BUT, atleast 55% of the countries and 55% of the
emissions represented through countries needed to
enforce the agreement
Kyoto
 This means that 3 of EU, Japan, US and Russia had to
ratify
 US and Russia didn’t at first
 Why?
 It would cost US a lot
 Russia enjoyed the power I guess
 Finally Russia ratified (2005)
 The EU pushed in the negotiations to be able to pool the
EU emissions and get a EU quota not a countrywise quota
Why?
Efficiency with and without
markets
 We looked at solutions in the terms of prices, where
both the slope of the budget line and of the
resource budget line were the same (-Pw/Pg)
 Then we equated these to the MRS and the MRT
 So without a market and prices we simply can say
that we need to equate MRS and MRT between
commodities
 MRS between consumers
 MRT between producers
Theorems of welfare economics
 First: In a competitive economy, a market
equilibrium is Pareto optimal
 Second: In a competitive economy, any Pareto
optimum can be achieved by market forces,
provided the resources of the economy are
appropriately distributed before the market is
allowed to operate
All good and nice, but…
 Why does the competitive market not solve
environmental or others issues for that matter?
 The competitive market is a theoretical concept
which is imperfect in real life
 There are conditions that need to prevail to be able
to declare a market competitive
 Which hardly ever all hold
Competitive market conditions
 1. complete property rights: well defined transferable
property rights for goods and bads. All costs and
benefits of a good must accrue to the owner only
 2. atomistic participants: Producers and consumers
are so small w.r.t. the total market that they cannot
influence prices, take prices as given
 3. complete information: full knowledge of current
and future prices
 No transaction costs
Supply, demand and efficiency
 Demand curve: shows the quantity demanded by
consumers of a good given a certain price
 Price can be interpreted as a persons marginal
willingness to pay (MWTP)
 If his MWTP was higher than the price he would
buy more, if less, he would buy less
Market equilibrium is Pareto optimal
Consumer and Producer surplus
 We can move from indifference curves to a demand
function: maximise utility given a budget constraint
for many different prices
 We can also do this vice versa
 The willingness to pay (WTP) for a quantity q* for
a consumer Q(p) is equal to the area bounded by
the demand curve, the horizontal axis, the vertical
line q=q* and the vertical axis
Market equilibrium is Pareto optimal
Consumer surplus
 Consumer surplus of q* consumption is the WTP
for q* less the payment for the product
Market equilibrium is Pareto optimal
Supply
 Upward sloping because of increasing costs of
production, scarcity etc
 Producer surplus is the difference between any
revenue received for sale of q* and the costs of
producing those goods C(q*). This is generally
equal to the area bounded by the supply curve,
horizontal line through the price and verticle lines
q=0 and q=q*
Market equilibrium is Pareto optimal
Total surplus
 Total surplus is consumer surplus+ producer
surplus
 Total surplus may not exist, infinite or zero
 Surplus depends on income and prices of other
goods, technically demand and supply curve are
changing every second
 Total surplus is maximised at the market
equilibrium
 Hence is Pareto optimal
Efficient allocation
 There is normally not an one unique efficient
allocation
 However, there is usually one optimal allocation