CHAPTER THREE

EFICIENCY, PROPERTY RIGHTS,

MARKET FAILURES AND
THE ENVIRONMENT
3.1. Efficiency and resource allocation
*Environmental Economics places considerable
importance on economic efficiency (or just efficiency) in
resource allocation.
* Environmental resources are available in limited
quantities, and this is evidently true for non-renewable
stock resources, such as mineral deposits and fossil fuels.
* And for renewable resources, it remains true that there
are limits to the quantities that can be harvested in any
period of time. Furthermore, if harvesting is persistently
above sustainable levels, the possibility of the stock
irreversibly collapsing to zero arises.
* An allocation of resources describes what goods are produced,
which combinations of inputs are used in producing those goods,
and how the outputs are distributed.
* Generally, allocation of resources can be viewed in two different
ways: Static Allocation which is an allocation at some point in
time and inter-temporal (dynamic) allocation which is resource
allocation over time.
Static allocation of resources
An allocation of resources is said to be efficient if it is not possible
to make one or more persons better off without making at least
one other person worse off.
Or, an allocation is inefficient if it is possible to improve someone's
position without worsening the position of anyone else. A gain by
one or more persons without anyone else suffering is known as a
Pareto improvement.
* Consider an economy consisting of two persons (A& B), two
goods (X&Y) produced and production of each good uses two
inputs capital and labor (K&L) each of which is available in
fixed quantities. For analytical purpose let's assume that:
1. There are no externalities in either consumption or production.
This means that consumption or production by any person do not
have uncompensated effects upon others.
2. X & Y are private (not public) goods.
Let the total utility generated by each individual after consuming
both commodities is given by
UA= f (XA, YA), UB=f (XB, YB)
And let the production function associated with product after using
the two inputs available in fixed quantity is given by
X=f (KX, LX) , Y=f (KY, LY)
Then resource is said to be allocated efficiently if
1. There is efficiency in consumption.
 If there is efficiency in consumption then marginal rate of
substitution between x and y will be the same for both A and B.
 If there is inefficiency in consumption then two consumers can
exchange commodities at the margin in such a way that at least
one of them gain with out affecting the other.
2. There is efficiency in production
 It requires that the ratio of the marginal product of each input
be identical in the production of both goods.
 If this condition is not satisfied, the allocation must be
inefficient as it would be possible for producers to exchange
some K for some L so that the total production of at least one
good can increase with out affecting the output level of the other
from the same total volume of inputs.
3. Product mix efficiency
* This requires that the ratios of the marginal utilities of both goods
are the same for each consumer and this is equal to the ratios of the
marginal products of each input for both goods.
(Note : refer to your class notes and detailed discussions from
your test book.)
*For an economy with given quantities of available
resources, production functions and utility functions,
there will be many efficient allocations of resources.
The criterion of efficiency in allocation does not
identify a particular allocation.
*Let us assume we have a vertical line representing
utility level generated by the second consumer “B”,
and horizontal axis representing utility level generated
by the first consumer “A”.
*If all resources in the economy are used to produce
product X and Y according to the test and preferences
of consumer A, then all final products of the economy
will be consumed by A. at this point utility by A will
be maximized while B generates zero. And the reverse
is true for consumer B.
* Joining UBmax on the vertical axis and UAmax on the
horizontal axis , we will get a utility possibility set, and all
points at and below this curve will represent all possible
combination of UA and UB that are possible with the
available level of resource, given production technology
(function) and consumption function in the economy.
UB

UBmax utility possibility frontier

UAmax UA
* All points along the UPF represent combinations of UA
and UB that can result in allocative efficiency. And
resource allocation that can result in points outside of the
UPF may result in higher utility for either or both of
individuals. But due to resource constraint, these points
will be unattainable.
* On the other hand points inside the UPF are attainable,
but inefficient. And we can check the possibility of
pareto improvement if further resource reallocation are to
be made from this point.
* Consider the graph from the next immediate slide, and
check if resource reallocation that can cause movement
from point “J” to “K” to “L”, “M” , “P” and “T” can
result in pareto improvement.
* UPF
UB
UBmax K L
M
J P
T

UAmax UA
* Remember for there to be pareto improvement, the resource
reallocation must make at least one of the economic agent better off
with out affecting the utility of others.
*The utility possibility frontier is the locus of all
possible combinations of UA and UB that correspond
to efficiency in allocation. How?
*Among these infinite numbers of allocative efficiency
points, which one will be best from the societies point
of view?
Social welfare function and optimality
*For a two person economy, we will have a social
welfare function like
W = W(UA, UB)
*Here we need to assume that SWF is a non
decreasing function of UA and UB.
* Thus, we can say, social welfare function is of the same
nature as a utility function. And as we can depict utility
function using indifference curves, we can depict social
welfare functions using social welfare indifference
curves.
* Along the social welfare indifferent curve, we will have
different combinations of UA and UB that give the same
level of social welfare.
* Which combinations of UA and UB can maximize the
social welfare given the available resource, production
and consumption functions?
* Here we will need social optimal point that is efficient
and can also maximize the social welfare.
*We have different combinations of UA and UB
represented by utility possibility frontier, that are
attainable and achieve allocative efficiency for given
production and consumption function and available
resource.
*And we have different combinations of UA and UB
that give the same level of social welfare represented
by social welfare indifference curve.
*Thus, the unique combination of UA and UB, that
maximizes the social welfare for given level of
resource, production technology and consumption
function will be determined where the slope of UPF
and SWIC are equal, or the two curves are tangent.
Graphically,
UB

UBmax A
E

URB R B SWIC

URA UAmax UA

* Among points “A”, “E” and “B”, point “A” and “B”can
achieve allocative efficiency but they are not optimal.
* Pointsalong the utility possibility frontier that are not
tangent to the social welfare function are efficient but
not optimal. And they will be on the lower SWIC
compared to the one that is tangent to the UPF.
* Thus, for a given point to be socially optimal point first
it must fulfill the criteria of allocative efficiency.
* While allocative efficiency is a necessary condition for
optimality, it is not generally true that moving from an
allocation that is not efficient to one that is efficient
must represent a welfare improvement. How?
* For example check if the resource reallocation from
point R to A, point R to E, and from point A to E can
result in welfare improvement.
 Allocation in market economy
* Welfare economics theory points to a set of circumstances such
that a system of free markets would sustain an efficient
allocation of resources.
* The assumptions include
1. Markets exist for all goods and services produced and
consumed.
2. All markets are perfectly competitive.
3. All transactors have perfect information.
4. Private property rights are fully assigned in all resources and
commodities.
5. No externalities exist.
6. All goods and services are private goods. That is, there are no
public goods.
7. All utility and production functions are well behaved.
 Partial equilibrium analysis of market efficiency
Let us assume the economy produces product “X”.
*What must be the efficient amount of “X” to be
produced by the given economy?
*Thus, the partial approach will only be concerned
about the production and consumption of product
“X” while ignoring the rest of the economy.
*It begins by identifying the benefits and costs to
society of using resources to make product X.
*Then, defining net benefit as total benefit minus
total cost, and efficient output level of X would be
the one that maximizes net benefit.
*For various levels of production of X, we will have related
total benefits and costs as represented by the curves below.
*Benefits and costs are measured in monetary values.
* Given that we call an outcome that maximizes net benefits
‘efficient’, we will find a point where the distance between
the two curves is maximized, or the level of X production
that maximizes net benefit.
* It is a measure, in money units, of the efficiency gain that
would come about from producing X* compared with a
situation in which no or zero X was produced.
* Graphically,
TB, TC
TB(X)

TC(X*),TB(X*) d TC(X)

X*
* Initially when the economy increases its production of “X”, the
associated net benefit will increase and it will reach maximum at X*. If
production of “X” increases after this level, net benefit will decrease.
Thus, the economy will be at optimal at X* where net benefit is
maximized.
* We can represent it graphically using a net benefit curve.
NB

NB(X*)

X* X

* And if we use the marginal approach we will reach to the same

conclusion.
* We can derive the marginal benefit and cost functions just from
the first derivative of the cost and benefit functions with respect
to X.
* And given the cost and benefit functions that give us the cost
and benefits graphs as represented above, we will have
marginal benefit and cost functions which will result in some
how straight marginal benefit and cost curves.
* Thus the level of X that maximizes the net benefit will be the
level where the marginal benefit and marginal cost are equal.
What will happen if the level of X production is below or
above X*?
MB, MC

MB
E

MC
X*
* The area beneath a marginal function over some range gives
the value of the change in the total function for a move over
that range.
* The area below the marginal benefit curve between zero and
x* will give the total benefit of producing X* amount. And
the area below the marginal cost curve between zero and x*
will give the total cost associated with producing x* amount.
* The difference between these two areas will give us the net
benefit of producing X* amount.
* Graphically,
MB MC
TB TC

0 X* 0 X*
MC, MB
NB MB

MC=MB E

MC
0 X* X
* This marginal benefit curve as it can represent consumers
willingness to pay for additional units of X, it will represent
the market demand for X, and since we are operating under
perfectly competitive market where producers produce when
their marginal cost is equal with the market price, the
marginal cost curve will represent the market supply curve.
* Thus, the equilibrium market price will be determined where
the market demand and market supply curves cross each other.
* Put another way, all consumers face a common market price
PX, and each will adjust their consumption until their marginal
utility (in money units) is equal to that price. Each firm faces
that same fixed market price, and adjusts its output so that its
marginal cost of production equals that price. So we have:
P = MBx*= MCx*
Graphically,
P consumer surplus
g’ S, MC
Px E

h’ D, MB
0 x1 X* X
producer surplus
Consumer surplus and producer surplus
* After the price is set and all X products demanded are sold at
that price. So, the individual who would have been willing to
pay 0g′ for a single X product is actually getting it for PX.
Similarly, the individual who would have been willing to pay
just a little less than 0g′ actually pays PX. And so on, until we
get to the individual whose WTP is PX, and who also actually
pays PX.
* All individuals whose WTP is greater than PX are getting a
surplus which is the excess of their WTP over PX.
* Consumers’ surplus is the total of these individual surpluses,
the area between the demand curve and the price line over
0X*.
* Thus, we can conclude, consumers’ surplus is the difference
between total willingness to pay and total actual expenditure.
Producer surplus
* The first unit of X costs 0h′ to produce, but sells in the
market for PX, so there is a surplus of h′PX. The surplus on
the production of each further “X” is given by the vertical
distance from the price line to the supply curve. The sum of
all these vertical distances is total producers’ surplus.
 Property Right
*The manner in which producers and consumers use
environmental resources depends on the property rights
governing those resources.
* In economics, property right refers to a bundle of
entitlements defining the owner’s rights, privileges,
and limitations for use of the resource.
* By examining such entitlements and how they affect
human behavior, we will better understand how
environmental problems arise from government and
market allocations.
 Efficient Property Right Structures
* The structure of property rights that could produce efficient
allocations in a well functioning market economy will have
the following characteristics.
1. Exclusivity
All benefits and costs accrued as a result of owning and using
the resources should accrue to the owner, and only to the
owner, either directly or indirectly by sale to others.
2. Transferability
All property rights should be transferable from one owner to
another in a voluntary exchange.
3. Enforceability
Property rights should be secure from involuntary seizure or
encroachment by others.
*An owner of a resource with a well-defined property
right (one exhibiting these three characteristics) has a
powerful incentive to use that resource efficiently
because a decline in the value of that resource
represents a personal loss.
*For example, a farmers who own the land have an
incentive to fertilize and irrigate it because the
resulting increased production raises his/her income.
Similarly, they have an incentive to rotate crops when
that raises the productivity of their land.
*When well-defined property rights are exchanged, as
in a market economy, this exchange facilitates
efficiency. How?
*Efficiency is not achieved because consumers and
producers are seeking efficiency.
*In a system with well-defined property rights and
competitive markets in which to sell those rights,
producers try to maximize their surplus and consumers
try to maximize their surplus.
*The price system, then, induces those self-interested
parties to make choices that are efficient from the
point of view of society as a whole.
*Itchannels the energy motivated by self-interest into
socially productive paths.
 Property Right Regimes
* Private property right regime
Involves property owned and managed by an individual agent.
* State property regime
Exist not only in former communist countries, but also to varying
degrees in virtually all countries of the world. Parks and forests,
for example, are frequently owned and managed by the
government.
Problems with both efficiency and sustainability can arise in
state-property regimes when the incentives of bureaucrats, who
implement and/or make the rules for resource use, diverge from
collective interests. What is the status of national parks in
Ethiopia?
* Common property
These are those shared resources that are managed in common
rather than privately.
* Entitlements to use common-property resources may
be formal, protected by specific legal rules, or they
may be informal, protected by tradition or custom.
* Common property regimes exhibit varying degrees of
efficiency and sustainability, depending on the rules
that emerge from collective decision making. How?
Consider the two examples from the text book
(Allocation of grazing land in Switzerland and Fishing
in small fishing village in Sri Lanka).
*If properly managed and implemented efficiency and
sustainability can be achieved like the case of goods
under private property regime.
*Res nullius property resources or open access
resources
The main focus of such regimes can be exploited on a
first-come, first-served basis because no individual or
group has the legal power to restrict access.
And they have given rise to what has become known
popularly as the “tragedy of the commons.”
*Common Pool resources are characterized by non
exclusivity and divisibility.
*Non Exclusivity implies that they can be exploited by
anyone while divisibility means the capture of part of
the resource by one group subtracts it from the amount
available to the other group.
 Market Failure
Public goods
* One of the assumptions for pure market system to
support an efficient allocation is for there to be no
public goods.
* Some of the services that the natural environment
provides to economic activity have the characteristics
of public goods, and cannot be handled properly by a
pure market system of economic organization.
*There are two characteristics of goods and services
that are relevant to identify a given good as public or
private good. And these criteria's show the presence of
not only polar cases but also intermediate cases in
between.
*These are rivalry and excludability.
* Rivalry which is also called
divisibility refers to whether
one agent’s consumption is at the expense of another’s
consumption.
* Excludability refers to whether agents can be prevented
from consuming.
* Pure private goods exhibit both rivalry and excludability.
* Pure public goods exhibit neither rivalry nor
excludability.
* Open-access natural resources exhibit rivalry but not
excludability.
* Congestible resources exhibit excludability but not, up to
the point at which congestion sets in, rivalry.
 Excludable Not excludable
Rivalry Pure private goods Open access goods
(Ordinary goods and (Ocean fishery)
services)
Not rivalry Congestible goods Pure public goods
(services (Air, Sunshine)
provided by a
wilderness area in
private park, cinemas,
private parks,
satellite television )

• Public good can exist naturally or they can be produced

and supplied by a firm or the government.
• Examples of public goods include street light,
lighthouse, public firework, clean air and other
environmental resources.
 The free rider problem
* Public goods provide a very important example of market
failure, in which market-like behavior of individual gain-
seeking does not produce efficient results.
* The production of public goods results in positive
externalities which are not remunerated.
* If private organizations don't reap all the benefits of a public
good which they have produced, their incentives to produce it
voluntarily might be insufficient.
* Consumers can take advantage of public goods without
contributing sufficiently to their creation. This is called the
free rider problem, or occasionally, the "easy rider
problem" (because consumer's contributions will be small
but non-zero).
Possible Solutions to the Free- Rider Problem
1. Assurance contracts
An assurance contract is a contract in which participants make
a binding pledge to contribute to building a public good,
contingent on a quorum of a predetermined size being reached.
Otherwise the good is not provided and any monetary
contributions are refunded. A dominant assurance contract is a
variation in which an entrepreneur creates the contract and
refunds the initial pledge plus an additional sum of money if
the quorum is not reached. The entrepreneur profits by
collecting a fee if the quorum is reached and the good is
provided.
In game-theoretic terms this makes pledging to build the public
good a dominant strategy: the best move is to pledge to the
contract regardless of the actions of others.
Coasian solution
*The coasian solution, named for the economist Ronald
Coase, proposes a mechanism by which potential
beneficiaries of a public good band together and pool
their resources based on their willingness to pay to
create the public good.
* Coase (1960) argued that if the transaction costs
between potential beneficiaries of a public good are
sufficiently low, and it is therefore easy for
beneficiaries to find each other and pool their money
based on the public good's value to them, then an
adequate level of public goods production can occur
even under competitive free market conditions.
* In some ways, the formation of governments and
government-like communities, such as homeowners
associations can be thought of as applied instances of
practicing the coasian solution by creating institutions to
reduce the transaction costs.
Government provision
Impose taxation to fund the production of public goods. This
does not actually solve the theoretical problem because good
government is itself a public good.
Thus it is difficult to ensure the government has an incentive
to provide the optimum amount even if it were possible for
the government to determine precisely what amount would be
optimum. These issues are studied by public choice theory
and public finance
 Externalities
* Exclusivity is one of the chief characteristics of an efficient
property rights structure. This characteristic is frequently
violated in practice. One broad class of violations occurs
when an agent making a decision does not bear all of the
consequences of his or her action.
* Suppose two firms are located by a river. The first
produces steel, while the second, somewhat downstream,
operates a resort hotel. Both use the river, though in
different ways. The steel firm uses it as a receptacle for its
waste, while the second uses it to attract customers seeking
recreation.
* If
these two facilities have different owners, an efficient
use of the water is not likely. Why?
*An externality exists whenever the welfare of some
agent, either a firm or household, depends not only on
his/her activities, but also on activities under the
control of some other agent (s).
*For Instance, steel production inevitably involves
producing pollution as well as steel. The demand for
steel will be depicted by the demand curve D, and the
private marginal cost of producing the steel (exclusive
of pollution control and damage) is depicted as MCP.
Because society considers both the cost of pollution
and the cost of producing the steel, the social marginal
cost function (MCS) includes both of these costs as
well.
* As a result,
A. The output of the commodity is too large.
B. Too much pollution is produced.
C. 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.
D. Recycling and reuse of the polluting substances
are discouraged since release into the
environment is so inefficiently cheap.
* Externalities occur due to the deviation of private and social
benefits and costs.
A. Negative externality
Many negative externalities are related to the environmental
consequences of production and use. Example
* Water pollution by industries that adds poisons to the water.
* Anthropogenic climate change attributed by greenhouse gas
emissions from burning oil, gas, and coal.
* The harvesting by one fishing company in the ocean
depletes the stock of available fish for the other companies
and overfishing may be the result.
B. Positive externality
Examples of positive externalities (beneficial externality,
external benefit, external economy, or Merit goods) include:
* A beekeeper keeps the bees for their honey. A side effect or
externality associated with his activity is the pollination of
surrounding crops by the bees.
* Knowledge spillover of inventions and information - once an
invention (or most other forms of practical information) is
discovered or made more easily accessible, others benefit by
exploiting the invention or information.
* Education creates a positive externality because more
educated people are less likely to engage in violent crime,
which makes everyone in the community, even people who
are not well educated, better off.
 Externality and economic inefficiency
* Positive externality with consumption
In this case social marginal benefit will be greater than private
marginal benefit associated with the consumption. The
examples include vaccination and education.
P
PMC = SMC

SMB
PMB X
X1 X2
* The economy will produce ‘X1’ amount where private
marginal benefit and private marginal cost are equal.
But the society will desire ‘X2’ where social marginal
benefit and cost are equal. Thus, with the presence of
positive externality with consumption, products will be
under supplied, and the society will face a welfare loss
which is also called a dead weight loss. In this case the
dead weight loss will be the area below social marginal
benefit curve above private marginal benefit curve
between x1 and x2.
* Positive externality with production
Here production activity in a given firm affects the
production cost of other firms positively. As a result,
following the production activity, the social marginal cost
associated with the production will be less than the private
marginal cost. Example, consider a software developer firm
P
PMC
SMC

PMB=SMB
Dead weight loss

X1 X2
* Here what the society will desire x2 amount of the product
to be produced where the social marginal benefit and cost
curves are equal. But, what the economy actually produce
is where the private marginal benefit and cost curves are
equal. As a result, the product will be under supplied, and
the society will face a welfare loss.
Negative externality with production
* Here production activity with in given firm affects the
production cost of other firms negatively. As a result,
following the production activity, the social marginal cost
associated with the production will be greater than the
private marginal cost. For example consider any firm
which discharges pollutants to the environment.
* Negative externality
P SMC

PMC

PMB = SMB

X2 X1 X
* What the society desire is for less of these products to be
produced. But the economy will produce where private
marginal cost is equal with private marginal benefit. The
society will face a welfare loss as represented by the dead
weight loss represented above.
 Negative externality with consumption
Here a consumption by an economic agent affects the utility
of other agents in the economy negatively. For example
consider smoking cigar or opening loud music.
P
PMC = SMC
Dead weight loss

PMB
SMB
X2 X1
* The desired level of output is x2 but the economy produces and
supply x1 amount. The product is being over supplied and the society
losses some welfare as a dead weight loss.