Environmental Economics

by

Jrgen E. Blank

1
1 ECONOMICS AND THE ENVIRONMENT .............................................. 5
1.1 ECONOMY ENVIRONMENT INTERDEPENDENCE ...................................... 5
1.1.1 Introduction ...................................................................................... 5
1.1.2 Classification of natural resource systems ....................................... 5
1.2 THE ECONOMY AND THE ENVIRONMENT ................................................. 7
1.3 LIMITS TO GROWTH................................................................................... 9
1.4 STATIC LIFETIME AND RESERVES VERSUS RESOURCES ........................... 11
REFERENCES ....................................................................................................... 13
2 CONCEPTS OF SUSTAINABILITY......................................................... 14
2.1.1 Introduction .................................................................................... 14
2.1.2 Concepts and management rule...................................................... 16
2.1.3 Production with non-renewable natural resources ........................ 20
2.1.4 Use of renewable natural resources ............................................... 23
2.1.5 Ecological Economics .................................................................... 26
2.1.6 Evolutionary Economics ................................................................. 27
2.1.7 Indicators........................................................................................ 27
2.1.8 Institutions ...................................................................................... 34
REFERENCES ....................................................................................................... 37
3 WELFARE AND THE ENVIRONMENT ................................................. 38
3.1 INTRODUCTION ....................................................................................... 38
3.2 EFFICIENCY AND OPTIMALITY ................................................................ 39
3.2.1 Maximizing social welfare .............................................................. 41
3.2.2 Market economy and efficiency ...................................................... 42
3.3 INCOMPLETE MARKETS .......................................................................... 44
3.4 THE COMMONS AND PUBLIC GOODS ....................................................... 45
3.5 EXTERNALITIES....................................................................................... 48
3.6 COASE-THEOREM.................................................................................... 49
REFERENCES ....................................................................................................... 55
4 ENVIRONMENTAL POLICY INSTRUMENTS: TARGETS................ 56
4.1 INTRODUCTION ....................................................................................... 56
4.2 FLOW VERSUS STOCK POLLUTANTS ........................................................ 56
4.3 OPTIMAL POLLUTION LEVEL ................................................................... 57
4.3.1 Optimal flow-pollution level ........................................................... 58
4.3.2 Optimal stock-pollution level.......................................................... 62
REFERENCES ....................................................................................................... 68
5 ENVIRONMENTAL POLICY INSTRUMENTS: INSTRUMENTS...... 69
5.1 INTRODUCTION ....................................................................................... 69
5.2 EVALUATIVE CRITERIA ........................................................................... 70
5.3 THE TRADITIONAL APPROACH: COMMAND AND CONTROL (CAC)
REGULATIONS ..................................................................................................... 74
5.4 PRICE RATIONING: CHARGES AND TAXES ............................................... 79
5.4.1 The Pigovian taxes.......................................................................... 83
5.4.2 Pricing and Standards Approach by Baumol and Oates ................ 86
5.5 QUANTITY RATIONING: MARKETABLE (TRANSFERABLE) EMISSION
PERMITS .............................................................................................................. 88
5.6 ENVIRONMENTAL LIABILITY LAW ......................................................... 93

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 REFERENCES ........................................................................................................98
6 INTERNATIONAL ENVIRONMENTAL PROBLEMS ..........................99
6.1 INTRODUCTION ........................................................................................99
6.2 CO-OPERATION VERSUS NON-COOPERATION ..........................................99
6.3 INTERNATIONAL AGREEMENTS IN CLIMATE GAS REDUCTION ...............102
6.3.1 The greenhouse gas problem.........................................................102
6.3.2 Impacts of different kinds of policy instruments............................103
6.3.3 Taxes .............................................................................................106
6.3.4 Tradable Permits...........................................................................107
6.3.5 Joint Implementation.....................................................................108
6.3.6 Participation in an international agreement to mitigate greenhouse
gases-emissions .............................................................................................108
6.3.7 Need for future research activities ................................................111
REFERENCES ......................................................................................................112
7 COST BENEFIT ANALYSIS ....................................................................113
7.1 INTRODUCTION ......................................................................................113
7.2 METHODS OF COSTS-BENEFITS ANALYSIS .............................................114
7.3 THE PROBLEM OF DISCOUNTING ...........................................................117
7.4 STAGES OF A COST-BENEFIT-ANALYSIS.................................................119
REFERENCES ......................................................................................................120
8 THE ECONOMICS OF THE CO2-PROBLEM......................................121
8.1 INTRODUCTION ......................................................................................121
8.2 SPECIFICITY OF CO2 AS AN ENVIRONMENTAL PROBLEM ......................122
8.3 SPECIFICITY OF CO2 AS A RESOURCE PROBLEM ...................................123
8.4 RESOURCE PRICING WITH AN ENVIRONMENTAL CONSTRAINT ..............125
REFERENCES ......................................................................................................128
9 VALUING THE ENVIRONMENT...........................................................129
9.1 INTRODUCTION ......................................................................................129
9.2 REVEALED PREFERENCE METHODS .......................................................130
9.2.1 Travel cost method ........................................................................130
9.2.2 Hedonic Pricing ............................................................................131
9.3 STATED PREFERENCE METHODS ............................................................133
9.3.1 Conjoint Analysis and Choice Modelling......................................133
9.3.2 Contingent valuation .....................................................................134
REFERENCES ......................................................................................................139
10 BIODIVERSITY .....................................................................................140
10.1 INTRODUCTION ......................................................................................140
10.2 VALUING BIODIVERSITY ........................................................................142
10.3 POLICY RESPONSE AND INTERNATIONAL INSTITUTIONS TO PRESERVE
BIODIVERSITY ....................................................................................................143
REFERENCES ......................................................................................................146
11 BIOLOGICAL RESOURCES ...............................................................147
11.1 INTRODUCTION ......................................................................................147
11.2 ECONOMIC MODELLING OF MARINE LIVING RESOURCES ......................148
11.2.1 The Schaefer-Gordon Model .........................................................148
11.3 THE DYNAMIC EXTENSION OF THE GORDON-SCHAEFER MODEL ..........151
11.4 THE BEVERTON-HOLT MODEL ..............................................................152

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 11.4.1 Multi-Species Approaches ............................................................ 154
11.5 FISHERIES MANAGEMENT MODELS ...................................................... 155
11.6 REGULATORS BEHAVIOUR ................................................................... 156
11.7 INDIVIDUAL TRANSFERABLE QUOTAS (ITQ) ....................................... 156
11.8 IS AQUACULTURE AN ALTERNATIVE? ................................................... 158
11.9 CONCLUSION ......................................................................................... 159
REFERENCES ..................................................................................................... 160
12 GLOSSARY ............................................................................................ 161

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1 Economics and the Environment

Learning objectives
In this chapter you will
learn to classify natural resource systems
learn how economic activities will affects the natural environment by
pollution
learn how environmental damages will affect economic activities and set
limits to economic growth
distinguish between resources and reserves
why static lifetime is not a measure for the availability of natural resources

1.1 Economy environment interdependence

1.1.1 Introduction

Environmental Economics can be defined as the application of the economic theory

to environmental issues. Environmental economics can be seen as a part of the
Environmental and natural resource economics which can be defined as the
application of the principles of economics to the study of how environmental and
natural resources are developed and managed. This allows to distinct between
natural resource and the environment or environmental resources.
Natural resources resources provided by nature that can be divided into
increasingly smaller units and allocated at the margin. Natural resources serve as
inputs to the economic system
Environmental resources resources provided by nature that are indivisible.
Environmental resources are affected by the system through the flow of residuals
(e.g. pollution) to the environment.

1.1.2 Classification of natural resource systems

There are several criteria for classifying natural resource systems. Resource
systems could be distinguished by their physical attributes or according to their
time for regeneration. A classification along the physical attributes could be done
by environmental resources, biological resources, energy resources and non-energy
resources, minerals. According to the time of regeneration, natural resources can be
distinguished in reproducible, renewable and non-renewable resources. A non-

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renewable resources have a time of regeneration that is beyond economic meaning.
For example, oil, natural gas and coal needs some hundred thousand years to be
replaced. Reproducible resources have a time of regeneration less than one year,
and their regeneration process is mainly controlled by mankind. Between this two
positions are the renewable resources. Their regeneration time is more than one
year and up to 100-200 years. They are growing without human activities.
Examples of natural resources are assigned to these classification categories in Tab
1. Note that there is some flexibility, for example forests are classified as
renewable resources, but their regeneration is influenced by human activities such
as afforestation, selective cutting etc.

environmental biological energy non-energy

resources resources resources resources.
minerals
noise agricultural solar energy salt
products
reproducible non- hydro (from
permanent plantation rivers)
(< 1 year)
air and water management
ethanol
pollution
groundwater trees, forests firewood
permanently fish geothermal
renewable water and energy
game
(1-200 years) soil
hydro (from
contaminatio whales
water
n
reservoirs)
ozone layer endangered fossil fuels mineral (iron
non-
animals and (oil, gas ore, copper,
renewable groundwater
plants coal) etc)
reservoirs
(> 2000 years)
uranium humus
Tab 1 Classification of resource systems I

Depending on the circumstances, natural resources can be used directly, by taking

the resource out of a stock (water) or from a flow (solar energy, geothermic
power), or the natural resource can be used only by taking it out of a stock (energy
resources, metals) or a flow (biomass). Typically stock resources can be
distinguished whether they are recyclable or not. This is represented in Tab 2:

Stock reduction Direct use

non-recyclable recyclable
Stock
resource energy metals non-metallic
resources resources, soil
biomass solar energy,
Flow resource geothermic
power
Tab 2 Classification of resource systems by mode of supply and mode of use

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1.2 The Economy and the Environment

The economy and the environment are interlinked. The economy represents all
economic activities done by firms as their role of producers and household in their
role as suppliers of labour and consumers. A simple economy can be described by
these two agents. Firms decide how much they will produce by using inputs in the
production process like labour (L) and capital (K), whereas capital means man-
made capital like machines, buildings etc. By using these inputs and a given
production technology , given by the production function F ( K , L ) the output Y is
determined. but further, the firms can produce two types of output, consumption
goods, labelled by C and investment goods, labelled by I, Y = F ( K , L ) = C + I .
Typically, it is assumed that households want to maximize their utility. For a
moment, lets assume that utility is simply a function of consumption, that the
more is the better. Utility is measured per household (or per capita). Now we have
some interesting effects, a growing population causes a reduced utility per
household, if production is constant. But a growing population results in a higher
work force, hence, a higher input of labour increase the production possibility, and
consumption can be increased. Furthermore, producing investment goods I, results
in a reduction in consumption goods C. But investment results in an increase in the
economies capital stock K, and hence the production input K becomes larger,
which allows for higher production later. A society can decide, whether it will
consume a given level, or reduce consumption today and invest in capital stock for
higher consumption possibilities tomorrow. The answer for the optimal
consumption path is the so called "Golden Rule" of capital accumulation by
Edmond S. Phelps (1961). Obviously, if a society could choose a savings rate that
maximized its own consumption, it would save nothing and consume everything.
But that would leave future generations in a lurch as no capital would have been
built to enhance future output and consumption. If, conversely, the current
generation saved so much that future generations would in fact be better off than
the current, then we are also violating "Golden Rule" as we are not doing unto
ourselves what we have done for posterity. The condition is that the collectively-
chosen or policy-imposed savings (i.e. investment) propensity is such that future
generations can enjoy the same level of consumption per capita as the initial one.
Based on Frank P. Ramseys (1928) determination of the "optimal rate of savings"
in a simple economy by using the fiction of a grand "social planner". This simple
economy can be found on the top of Abb. 1
Obviously, capital and labour are not the only essential inputs in the production
process. Raw materials, energy are essential inputs to. As seen in the previous
chapter, we have stock resources as inputs, like fossil fuels (coal, oil, natural gas),
uranium, metals (minerals and metals like: copper, iron ore, bauxite, etc.),
symbolized by the letter R. A further production input are produced by so called
backstop-technologies. A backstop technology is a technology that is available in
vast quantities at the backstop price and backstop price is constant (constant
marginal production costs), since the backstop technology is not exhaustible, e.g.:
solar energy. The natural resource substitute is labelled by Z. Renewable resource
like timber, fish are also a production input, symbolized by N. The problems how
to allocate these natural resources over time, and what is the optimal extraction or
harvesting rate is the topic of resource economics. These inputs are often
transformed in the production process into outputs which the consumer demand:
wood into paper, oil into gasoline, fish into fish fingers.

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Abb. 1 Environmental and natural resources and the economy

Besides the desired production of goods and services, unwanted by-products are
produce, too. If they are not economically valuable: Pollution or waste. For
instance, carbon and sulphur from electricity generation by coal power plants. But
pollution and waste also results from consumption activities, garbage and
disposals, like cans, waste paper. Waste may be solid, water- or airborne.
Therefore, the environment is used as a waste sink. Environment represents all
natural resources, renewable and non-renewable, the ecosystem (flora and fauna),
the oceans and the atmosphere. The natural environment has some limited
assimilative capacity to absorb and transform pollution and waste into harmless
substances, that is the natural regeneration rate. Environmental damages occur

8
when emissions exceed the natural regeneration rate, and produce undesirable
impacts on the environmental quality and on the renewable resource system.
Sulphur causes acid rain, which damage forests and hence the timber quantity and
quality. Environmental damages can reduced by investing in environmental capital.
To reduce sulphur emissions a combustion gas desulphurisation plant had to be set
aside the coal power plant. But for some inputs to the natural environment, there is
no natural process available to transform them into harmless, or at least less
harmful, substances. These pollutants are cumulating in the environment. Examples
of cumulative pollutants are heavy metals like lead, cadmium or mercury, and
chemical products like DDT or PCBs. In case where the cumulative pollutants are
accumulated in biological resources, like fish or game, this process is called
bioaccumulation. For cumulative pollutants the stock in a given period is described
by:
t
Stc = Pt dt
0

Whereas for degradable pollutants the stock at a given time depends for short term
pollutants on current flow Pt less the amount of pollution removed by the natural
degredation Dt .:

Std = Pt Dt for short term pollutants

t t
or Std = Pt dt Dt dt for durable, but not cumulative pollutants.
0 0

The environment, respectively the environmental quality E, provides households

directly with amenity from enjoying the scenic beauty of a landscape, from hiking
in the forest or fishing on the river. Hence, households, people, derive utility not
only from consumption but also from the environmental quality. Therefore the
households utility function includes the environmental quality and consumption:
U = F (C, E ) .

And finally, the natural environment provides the economic system with so called
life-support services, that is, the climate regulation, the water cycle, the
atmospheric composition, the photosynthesis cycle. Without these function, life on
Earth would be impossible.
Another aspect of the economic-environmental system is the co called process of
co-evolution. The economic subsystem changes over time due to the changing of
the environmental subsystem: Climate changes influences the production of
agricultural products. On the other side, economic activities, like the burning of
fossil fuels results in higher carbon emissions and hence results in climate change.

1.3 Limits to growth

In 1972 a report published by the Club of Rome called The Limits to Growth
challenged the common view, that economic growth is essential and necessary for
the well-being of mankind. The book reports a study using a computer model to
simulate the future development of the world system.

9
 In the abstract to the study, the following conclusions are given :
1. If the present growth trends in world population, industrialization,
pollution, food production, and resource depletion continue unchanged, the
limits to growth on this planet will be reached sometime within the next
one hundred years. The most probable result will be a rather sudden and
uncontrollable decline in both population and industrial capacity.
2. It is possible to alter these growth trends and to establish a condition of
ecological and economic stability that is sustainable far into the future. The
state of global equilibrium could be designed so that the basic material
needs of each person on earth are satisfied and each person has an equal
opportunity to realize his individual human potential.
(Meadows et. al., 1972)

Within the public, the report was interpreted as an actual forecast for the future.
The main message from this report, was that the worlds will run out of natural
exhaustible resources. It was not recognized, that this was only a certain scenario,
even based on existing, but changeable, trends.
As an example for petroleum the following reserve lifetime are given:
- Static Index: 31 years
- Static Index with 5 Times Known Reserves: 155
- Average Projected Annual Growth Rate (%): 3.9
- Exponential Index: 20 years
- Exponential Index with 5 Times Known Reserves: 50
Static lifetime is interpreted as the number of year, how long an stock of proven
reserves can be extracted by actual demand.
Coincidently, in 1973 the first oil price crisis raised, with quadrupling the oil price
from 3 to 11 US$. This strengthen the fear of running out of essential natural
resources and hence, the end of economic growth.
A main focus within the report was on the population growth. Population growth
was seen as the main danger to the environment, but recognizing feedback effects,
damage environment will set restriction on population growth, but also on
economic growth.
However this report was the beginning of the economic theory of exhaustible
natural resources. Economists like Robert Solow, gave more optimistic answers to
the predictions done by the Club of Rome report. In his influential paper
Intergenerational Equity and Exhaustible Resources (1974) Solow regards a
system as sustainable if the legacy left for the next generation is of equal value to
that inherited by the present generation, even if some of its endowment of natural
resources is consumed. It assumes that man-made capital can be substituted for any
natural resources consumed by the present generation. That is, a society can
survive even if a natural resource is exhaustible. Another reason, why the message
of the Club of Rome was misleading will be shown in the next section.

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1.4 Static lifetime and reserves versus resources

As mentioned in the previous section, static lifetime indicates the years a stock of
proven reserves will last, given actual demand. Tab 3 shows the static lifetime of
some natural resource as mentioned by the Club of Rom in 1972 and by the
Association of Cities and Regions for Recycling and Sustainable Resource
Management (ACR+) in 1999.

Natural Resource Club of Rome 1972 ACR+ 1999

Coal 230 216
Crude Oil 31 44
Natural Gas 38 64
Aluminium 100 202
Copper 36 28
Iron 240 132
Lead 26 21
Nickel 150 41
Silver 16 17
Tin 17 37
Zinc 23 25
Tab 3 Static lifetime of natural resources comparing 1972 and 1999

The reason why the static lifetime is not useful to indicate the lifetime of an
exhaustible resource can be shown by the so called McKelvey diagram, named
after Vincent E. McKelvey, former director of the U.S. Geological Survey.
In the format of a McKelvey diagram, this logic defines the vertical axis (degree of
economic feasibility). The horizontal axis (degree of geologic assurance) contains
identified and undiscovered components. Reserves are resources which are
accessible by technical devices and whose exploitation is economical sensible.
Resources are the natural occurrence of all physically available material in the
earth Out of the total amount of resources only a small part can be used by the
technology available today. Taken together, the measured, indicated, and inferred
occurrences are often referred to as proved reserves or reserves. In short, reserves
are those occurrences that are identified, measured, and at the same time known to
be technically and economically recoverable
If resource prices are increasing, marginal resources become economic and hence
resources will be turned into reserves. Furthermore, increasing resource prices
gives incentives for more activities in exploration for finding new discovered
resource, turning resources into reserves again.
Hence, static lifetime is not an appropriate measure for the availability of natural
resources.

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 Identifies Resources Undiscovered Resources
proven Inferred Hypothetical Spekulative
Measured Indicated

Increasing feasibility of economic recovery

Economic
Marginal Reserves

Marginal reserves
Subeconomic

Submarginal

Resources

Increasing certainty

Abb. 2 McKelvey Diagram

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References

Boulding, Kenneth (1966): The economics of the coming spaceship earth, in H.

Jarrett (ed.), Environmental quality in a Growing Economy. Baltimore.
Meadows, Donella H., Dennis L. Meadows, Jrgen Randers, and William W.
Behrens III. (1972): The Limits to Growth. New York: Universe Books
Phelps, Edmund S. (1961): "The Golden Rule of Accumulation: A Fable for
Growthmen," American Economic Review Vol. 51 (September 1961); reprinted in
A.K. Sen, ed., Readings in Economic Growth Theory (Penguin, 1969).
Ramsey, Frank.P. (1928) "A Mathematical Theory of Saving", Economic Journal,
Vol. 38, p.543-59.
Solow, R. M. 1974A. The economics of resources or the resources of economics,
American Economic Review, vol. 64, no. 2
Solow, R. M. 1974B. Intergenerational equity and exhaustible resources, Review
of Economic Studies, (Symposium)

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2 Concepts of Sustainability

Learning objectives
In this chapter you will
learn the concept of sustainable development
learn to interpret the sustainability management rules
learn the concepts of managing non-renewable and renewable resources
learn the concepts of ecological economics and evolutionary economics
learn about indicators to measure sustainability
get an overview over institutions dealing with sustainable development

2.1.1 Introduction

Sustainability or Sustainable Development stands for the protection of life and

production possibilities in the sense of a global and permanent maintenance of the
environment as well as for the development and stabilization of the economic
system and social behaviour. The originator of the term sustainability was the
German agriculturist Georg Ludwig Hartig, who claimed in his book on forestry,
published 1795, that a sustainable forestry policy should be in such a way, that the
next generations should have as much benefits from the use out of a forest as the
now living generation1. The term of sustainability became popular by the so called
Brundtland Report Our Common Future, editetd by the World Commission for
Environment and Development, WCED, 1987, headed by the former Norwegian
Prime minister Gro Harlem Brundtlant. Sustainability is defined as Sustainable
development is development that meets the needs of the present without
compromising the ability of future generations to meet their own needs. Economic
growth is seen as a key concept for the economic welfare of the less developed
countries. The UN-Conference for Environment and Development (UNCED) held
1992 in Rio de Janeiro, known as the Earth Summit, adopted the term
Sustainable Development to widen the more quantitative approach towards more
qualitative aspects of sustainability in its Agenda 21. Agenda 21 is a programme of
the United Nations related to sustainable development. and signed by 179 Heads of
State and Government It is a comprehensive plan of action to be taken globally,
nationally and locally by organisations of the UN, governments, and major groups
in every area in which humans impact on the environment. The number 21 refers to
the 21st century. In the Agenda 21 three dimensions of sustainable development

1
Hartig, Georg Ludwig (1795): Anweisung zur Taxation der Forsten, Gieen.

14
are defined: Social, economic and environmental dimensions. In figure 2 the
dimensions of sustainability are shown as overlapping circles.

Environmental Sustainability Economic Sustainability

Maintainance of the environmental Maintainance and development
system and the natural capital of the man-made capital stock
Natural resource and environ- Economic growth,
mental protection;ensure competition,
biodiversity, risik- and
stability, efficiency
emission rationing

Social Sustainability
Maintenance of the social
capital stock
education, security, health,
human rights, social justice

Abb. 3 Dimensions of sustainable development

Environmental Sustainability
The aim of the environmental Sustainability is to maintain the environmental
system. The environmental system can be seen as the life support system for all
terrestrial activities: it compromises all gifts of nature: renewable and non-
renewable natural resources, clean air and water, etc. Furthermore the
environmental system acts as a deposit for man-made pollution. Economists refer
to this as natural capital (Kn).
Economic Sustainability
The aim of economic sustainability is to maintain the man-made capital stock (Km).
The man-made capital stock is build up by the excess of production over
consumption. The creation of physical capital (machinery, infrastructure, etc.)
represents production not intended for direct consumption. Rather, the creation and
accumulation of capital is intended to increase the level of productivity of a nation
and thus allow for an increase in the production of goods and services at future
date. Some new created physical capital, i.e. investment) is only for replacing the
decline in ability of assets to produce output (replace broken machines , normal
deterioration). Only net investment, i.e. gross investment minus physical
depreciation, results in a higher man-made capital stock.
Social Sustainability
In addition to environmental and economic sustainability the claim for social
sustainability requires the maintenance of the social capital stock(Ks). But the

15
conceivability, what one should understand under the term of social sustainability
is very vague. Often economists reduce social capital to human capital, that is all
the skills and knowledge embodied within people. Training and education expand
the human capital stock, while loosing skills the human capital can also depreciate.
A broader definition of social sustainability is given by additional principles that
might be achieved, like equity, diversity; interconnectedness, health, human
settlements, quality of life, or a democratic political system. This comprise
judgements about social and cultural norms of societies. Due to the problem of
manageability, social sustainability will be neglected within the environmental
discussion about sustainable development.
Sustainable development can be understood as development and growth strategy
which integrates economic and social sustainability considering the
intragenerational and intergenerational justice. Several approaches to
operationalising the concept of sustainable development have been set up.

2.1.2 Concepts and management rule

A common starting point of different approaches to operationalising sustainable

development lies in the finding of management rules, controlling the use of
renewable and non-renewable natural resources and as well as all functions of the
eco-system providing to the economic system. As already seen, such functions are
the function of the environment as a deposit for emissions, and last but not least in
the impact on human well-being. The latter means the influence on the utility of a
certain lovely landscape compare to an industrial and polluted area. Regarding
the terms of man-made capital and natural capital, the discussion whether natural
capital (Kn) can be substituted by made-made capital (Km) and vice versa, gives the
range for two extreme positions: weak versus strong sustainability. Note, that
strong and weak doesnt mean more ort less sustainability, the difference lies
in the substitution possibilities of both kinds of capital.
Weak sustainability
The proponents of the concept of weak sustainability are more optimistic in that
way, that there is a substitute for nearly an service provided by the natural capital.
Assume a person gets its utility by going swimming in a near by lake. Due to water
pollution, swimming will be dangerous. The proponents of the concept of weak
sustainability argues, that a reduction in lake water quality can be substituted by a
new build open air bath. For discussion: Can a lovely landscape be substituted by
watching TV or a reduction in cod by investing in fish trawler?
Figure 3 illustrates so called indifference curves, that is, curves along which
satisfaction or utility is constant. The utility is on a given indifference curve always
the same for all combinations of man-made and natural capital. For example, the
society is indifferent between the combination of K m1 and K n2 or the combination
of K m2 and K n1 . Both yield the same level of utility ( U2 ). A reduction in natural
capital can be compensated by more man-made capital.

16
Abb. 4 Indifference curves and weak sustainability

The safe minimum standard approach

Whereas the concept of weak sustainability regards natural and man made capital
as perfect substitutes, the safe minimum standard (SMS) approach requires that
each component of the natural capital stock should not be reduced below a critical
level as long as the social cots are unacceptable large. The reason is twofold: First,
degradation of natural capital below a certain level may result in extinction of a
specie, which might have potential useful resources not known yet. Second, there is
an ignorance of current society about the needs and preferences of future
generations. The SMS approach is identified mostly with Bishop (1978) and
originates from decision making under uncertainty. A stricter version of the SMS
approach is called the critical natural capital approach, were no consideration is
given to the costs of falling below the critical level. The SMS approach is
illustrated in Abb. 5.

Hk

critical level Hn

17
Abb. 5 Safe minimum standard approach

Strong sustainability
Less optimistic are the proponents of strong sustainability. intergenerational equity
demands that the stock of both capital are independent of each other. Especially the
natural capital stock must be maintained and the total natural capital stock should
not be allowed to fall. Natural and man-made capital are complementary to each
other, for example, fish trawler are senseless without fish stocks. Another argument
is, that nature has its own rights in nature. An even stronger version claims for
maintaining individually subsets of natural capital to be non declining.
Economically, the version of strong sustainability can be described by a fixed-
proportions (or Leontief production) function as described in figure 4. Thus, the
utility is given by minimum value of the two capital stocks: U = min ( H k , H n ) .
Natural capital and man made capital are complements instead of substitutes.

Hk
U3
U2
U1

C
Hk2 B U3
1
H A U2
k
U1

H1n Hn2 Hn

Abb. 6 Indifference curves and strong sustainability

Daly (1990) identified conditions under which a concept of strong sustainability

could be followed. He developed three operational principles or management
rules under which constant natural capital stock could be maintained. These rules
are as follows:
Rule No. 1:
For a renewable resource, the sustainable rate of use can be no greater than the
rate of regeneration.
This rule has a long tradition in fisheries economics, although not in fisheries
policy. As it will be shown in chapter 2.1.4 this rule allows for infinitely many
solutions, because the level of the stock size at which the resource can be harvested
is not determined by this management rule. Further, interaction among different

18
species of a renewable resource are ignored, i.e. even a sustainable harvest of
herring might result in a irreversible decline if cod, because cod wont found
enough herring and starve.
Rule No. 2:
For a non-renewable resource, the sustainable rate of use can be no greater than
the rate at which a renewable resource can be substituted for it. This is in turn
subject to the constraint above on the rate at which the renewable resources can be
used.
Non-renewable resources (oil, gas, iron ore, copper) should be used in such a way,
that only one part of the resource should be used for consumption but another part
has to be used for investment in renewable substitutes (biomass and solar energy
for fossil fuels like oil and gas). The investment stream must be sufficient high, that
when the non-renewable resource will be exhausted, a renewable substitute has
been built up to deliver the same amount of consumption as the non-renewable
resource did before exhaustion. The problem is to find the optimal extraction rate
and to determine the shares of investment and consumption over time. this requires
perfect foresight economic key factors such as economic growth rate, technical
progress and the size of the non-renewable resource stock.
Rule No. 3:
For pollution absorption capacity, the sustainable rate of use (that is, the rate of
emissions of pollution) can be no greater than the rate at which that pollution can
be processed or absorbed by the environment.
Daly gives no rule for cumulative pollution, like heavy metals as mercury. But it
can be easily concluded, that they should be set to zero. Since the absorptive
capacity is difficult to determine, society has to determine so called critical loads
for solid pollutants and critical levels for aerially pollutants.
Originally Daly gives a fourth rule: Put on controls on the macroeconomic scale.
Whereas a given scale (the product of population times per capita resource use)
constitutes a given throughput of resources and thus a given load on the
environment. According to Daly economic activities are beyond their optimal
scale, therefore the matter-energy throughput of the economy is to high and it
should be at a scale at which the remaining ecosystem (the environment) can
continue to function and renew itself year after year (Daly, Townsend 1993, p.267).
Herman E. Daly
Herman E. Daly (born 1938), an american economist, is
currently Professor at the University of Maryland, School
of Public Affairs. From 1988 to 1994 he was Senior
Economist in the Environment Department of the World
Bank He holds a B.A. from Rice University and a Ph.D.
from Vanderbilt University. He has served on the boards
of directors of numerous environmental organizations,
and is co-founder and associate editor of the journal
Ecological Economics.
His interest in economic development, population,
Photo: University of
resources, and environment has resulted in over a
Maryland
hundred articles in professional journals and anthologies,
as well as numerous books, including:

19
Toward a Steady-State Economy (1973); Steady-State Economics (1977; 1991);
Valuing the Earth (1993); Beyond Growth (1996) ; and Ecological Economics and the
Ecology of Economics (1999).

The concepts and management rules of sustainability neglect the economic growth
aspect of sustainability. Therefore, in addition to the management rules there is
need for economic optimization behaviour. Only this allows to determine the long
run economic growth path and hence the use of the natural capital. One instrument
to analyze the long run economic growth path of an economy is the neoclassical
growth theory.

2.1.3 Production with non-renewable natural resources

Based on the pioneering work by Robert M. Solow (1956), Trevor Swan (1956),
the neoclassical growth theory stated that the long-run rate of growth is
exogenously determined and that an economy will always converge towards a
steady state rate of growth, which depends only on the rate of technological
progress and the rate of labour force growth. Since economic growth has no value
on its own, utility of a society is therefore function of (per-capita) consumption,
whereas utility increase with increasing consumption, but with diminishing
marginal utility. The utility maximizing behaviour can be described by the so
called Golden Rule savings rate, that is the rate of savings which maximizes steady
state growth consumption in the Solow-Swan growth model. However, the Solow-
Swan model did not take into account the role of non-renewable resources as
essential input into the production process. The report to the Club of Rome
published in 1972 under the title The Limits to Growth stated a more pessimistic
view on the future availability of non-renewable resources and hence on the
economic system. Whilst the book did not predict what precisely would happen, it
stated that if the world's consumption patterns and population growth continued at
the same high rates of the time, the earth would reach its limits within a century.
However, this results in an incorporation of essential non-renewable resources in
the neoclassical growth model (see Solow 1974a, b).
In his seminal paper Intergenerational equity and the investing of rents from
exhaustible resources John Hartwick (1977) set out a rule for ensuring a non-
declining consumption path over time in case a non-renewable resource is an
essential input in the production process. Such a consumption path requires that the
Hotelling rent, that is the difference between price (i.e. marginal revenue) and
marginal costs of extraction (see box 1), must be invested in man-made capital.
The natural capital stock is declining whereas the man-made capital stock is
increasing in such a way that total capital stock will be held constant. Alternatively
if human capital is recognised, investment in human capital stock (education,
training) has the same effect. This rule is called the Hartwick rule. To achieve a
non-declining consumption path depends on the substitutionability of the inputs in
the production process. Especially in the case of energy resources the elasticity of
substitution is less than one, in this case, a constant consumption path is not
reachable.
However, following the Hartwick rule is only possible when following the concept
of weak sustainability. In case the concept of weak sustainability focuses only on a

20
non-declining consumption regarding intergenerational justice, than sustainability
is nothing else than following the Hartwick rule. The objective of a constant
consumption level for all generations can be attributed to John Rawls A. Theory of
Justice (1971). Rawls challenges the traditional utilitarian approach, where welfare
is the sum of the stream of individual discounted utilities. If we did not know in
advance where we would end up in the society, Rawls posits that a just social
contract should be one that anyone would agree upon. Originally Rawls did not
mentioned the intergenerational justice, but the idea is, that a person would not
know in which generation she would be born. It might be an affluent society or a
poor and hungry society. Therefore the individual lives behind a veil of ignorance.
Since no one knows to which generation he or she will belong, the question [of
choice] is viewed from the standpoint of each (Rawls, 1971, p.287). From the so-
called original position of equal ignorance, individuals are induced to choose
consumption programs that maximize the welfare of the least well-off generation.
The conclusion in a Rawlsian sense is that regardless in which generation an
individual would be born, she should receive the same utilities. The aim of society
is to maximize that level of utility, that can be sustained over all generations.
Mathematically the Rawlsian objective function is as follows:

Formel (1) max U ( Ct ) = max min Ct

Ct , Rt

The society has to choose that level of consumption C, that is the minimum for any
generation t. This minimum consumption level should be maximized. The system
can be controlled by the consumption for generation t and the amount of non-
renewable resource R used by generation t.
The utilitarian approach regard welfare as the sum of individual utilities, and in an
intertemporal case, future utility as a function of consumption will be discounted
by the time preference rate .
Mathematically the utilitarian objective function is as follows:

Formel (2) max U ( Ct ) e t dt
Ct , Rt
0

If the non-renewable resource is essential input in the production process, two

restrictions must be taken into account, whether following an utilitarian or a
Rawlsian approach: First, the change in man-made capital stock K tm by generation
(or more common: time) t due to investment I.:

dK tm
Formel (3) K m = I t = F ( K tm , Rt ) Ct
dt
Whereas investment It is production Yt minus consumption Ct :
I t = Yt Ct = F ( K , Rt ) Ct
t
m

Second, the change in the resource stock done by generation (or at time) t,
dSt
St due to the resource extracted by generation (or at time) t:
dt

dSt
Formel (4) St = Rt
dt

21
Initial endowment of capital stock K 0m and non-renewable resource stock S0 are
given, Ct and Rt are non-negative.

Assuming further a Cobb-Douglas function given by: Yt = F ( K tm , Rt ) = K tm Rt

with + = 1 and < .

After solving the two optimization problems, the optimal consumption path can be
derived. In figure 1.5 the Rawlsian consumption path CtRawls and possible optimal
1
utilitarian consumption paths are drawn. The utilitarian consumption path Ctutil is
characterized by a low endowment of initial capital stock, whereas the
2
consumption path Ctutil is derived from a high endowment of initial capital stock,
i.e. K < K . Note that in figure 1.5 the Rawlsian consumption path CtRawls has the
1
0
2
0

initial capital stock of K 01 .

In case of a relatively low initial capital stock and given a utilitarian objective it is
optimal to build up capital stock for higher consumption in the future. In the long
1
run consumption will decline and approaching zero. This is the Ctutil paths in
figure 1.5. In case of a relatively high endowment of initial capital stock, it might
be optimal not to invest in the capital stock and hence, consumption will decline
2
steadily, illustrated by path Ctutil . The Rawlsian consumption paths CtRawls results
in a constant and sustained consumption level. The consumption level depends on
the initial endowments. Societies with a high endowment of man-made capital will
stay on a higher consumption level than a society with a low endowment.
Therefore, the intragenerational justice aspect is neglected. Industrialized countries
will have higher sustainable consumption compared to developing countries. For
the latter there is no development, since development, measured in increasing
consumption, violates the Rawlsian criteria. This might explain why Rawls did not
apply his concept of justice for problems of intergenerational justice.

Ct

1
Cutil
t

CRawls
t

2
Cutil
t

t
Abb. 7 Utilitarian and Rawlsian consumption paths

22
Box 1
The Hotelling Rule or optimal rates of depletion for non-renewable resources

Hotelling addressed the question: what is the rate of depletion of the stock of a non-
renewable resource in a perfect cometitive market? The answer he offered related
the returns which could be realised for such a resource to the returns which might be
realised from any other asset, such as financial investments on the stock exchange.
Assume, that a non-renewable resource, say oil, can be extracted costlessly, the
total resource stock is known and owned by individual resource owners. The
resource stock must be extracted within two periods, today t = 0 and tomorrow t = 1 .
Market demand is given and identical in the two periods.
Assume further todays oil price is given by p ( t = 0 ) = p0 .
If a resource owner would sell one barrel of oil today, he will receive a market price of
p0 . Investing the revenue in fixed-interest securities with an interest rat of r , he
would receive p0 (1 + r ) tomorrow. Hence, the resource owner is indifferent whether
he will sell the barrel of oil today at a price of p0 or whether he will sell the barrel of
oil tomorrow at a price of p0 (1 + r ) : p1 = p0 (1 + r ) .

Now assume that the increase in price is larger than r , i.e. p1 > p0 (1 + r ) . The
resource owner will sell his barrel oil tomorrow. But, if all other resource owners
behave in the same way, todays oil price will increase due to the decreasing market
supply. Hence, some resource owners will switch from selling the barrel of oil
tomorrow to today. This results in a declining price p1 and a rising price p0 . This
lasts as along as the price path p1 = p0 (1 + r ) is reached. The same arguments held

for p1 < p0 (1 + r ) .

Hence the arbitrage condition p1 = p0 (1 + r ) is the unique equilibrium price path.

p1 p0
The price of a non-renewable resource must rise with the interest rate: p0
=r.
When there is a cost of extraction, the arbitrage condition is no longer that the price
rise at the rate of interest but that net price (the resource rent or Hotelling rent)
defined as the difference between the market price of the resource and marginal
extraction costs must increase at a rate equal to the rate of interest. This can be
shown to be socially optimal.

2.1.4 Use of renewable natural resources

Renewable resources are characterized by a change in stock over time due to a

regeneration function and without human exertion. Renewable resources are fish

23
stocks, forest, game and other wildlife. Agriculture and Aquaculture are not count
as renewable resources. But the environment can be interpreted as a renewable
resource in its function as a sink for anthropocentric pollution, with a self
purification (i.e. regeneration) function. The concept of a sustainable use of
renewable resources has an obvious solution along the management rule No 1 and
3.: the sustainable rate of use can be no greater than the rate of regeneration. and
the sustainable rate of use (that is, the rate of emissions of pollution) can be no
greater than the rate at which that pollution can be processed or absorbed by the
environment.
The concept of sustainable yield was identified by the fishery scientist Milnar B.
Schaefer in the 1950s. He stated that the addition to the fisheries biomass in each
period as a function of the size of the fish stock in that period. This results in a
logistic growth equation, described by:

dX t
Formel (5) X t = F ( X t , t ) = aX t bX t2
dt
The parameter a and b can be interpreted as environmental conditions. The variable
X t describes the stock level at time t, and X t describes the change of the stock as
a function of time t and the stock level X t .
The Schaefer curve is illustrated in figure 7. For simplicity the time subscript t will
be omitted where possible. The simplest version of the Schaefer curve can be
described by the following features:
a A minimum critical biomass (zero in figure 1.7). If the stock falls to this
level, growth will fall to zero, the species become extinct.
b An environmental carrying capacity K, that is the maximum size of the fish
stock. Without use (fishing) the stock is expected to maintain equilibrium at
this level therefore it is the ecological equilibrium. Beyond the carrying
capacity there is a shortage of food supply, too many predators, or any other
restrictions on the habitat, the stock is declining. The stability of this
equilibrium is illustrated by the arrows in figure 1.7.
c A maximum sustainable yield (MSY) population. At this stock size,
population growth is maximized. Fishers could harvest the MSY) in each
period and the stock size would be unaffected. This is the largest harvest that
would be compatible with a stable stock size.
d Besides MSY any yield ( Y < MSY ) can be harvested at two different stock
levels.

24
 
X t

MSY

F(X)

0 XMSY K Xt
Abb. 8 The Schaefer curve

Any yield can be harvested sustainable as long as it correspond to the regeneration

function. This implies different stock levels. The maximum sustainable yield
(MSY) normally is not economically efficient.1 The concept of sustainable use of a
renewable resource as in the Schaefer model, works only for one species systems
and within a given and constant environment. Typically species have to live in a
complex predator-prey-system. The environment will be effected by natural
activities (earthquakes, volcanic eruption, large fires) and at least by man-made
activities. These activities will lead to changes in the regeneration function,
particularly in changes of the parameters a and b in equation Formel (5). Due to
this complexity within the ecological system, it is nearly impossible to derive a
simple management rule. Furthermore, the ecological system can be characterized
by non-linearities and stochastic behaviour. The precaution motive becomes more
relevant. Resource stocks and the absorption capacity of the environment and the
should be used at a lower rate as suggested by the traditional theory for renewable
resources.
Even, if from todays point of view there are no economic or use values of a
natural resource, it might be possible that there will be potential for future use.
These potential benefits, which might occur in the future should be recognised
already today. This component is called option value, first introduced by Weisbrod
(1964) in the context of the closure of a national park. An option value is the value
of the option to make use of a resource in the future. Therefore, the management
rules are not sufficient to run a sustainable system. Especially the exponents of the
ecological economics postulate more restrictions on the use of natural resources.

1
The interested reader is referred to the Gordon-Schaefer-Model, explained in standard
textbooks on resource economics. See, for example, Hanley (1997),

25
2.1.5 Ecological Economics

The concept of ecological economics follows the ideal of sustainable development,

regarding the complexity between man and nature and emphasizing the bounds set
by the ecological system for human activities. Whereas the term of environmental
economics follows the traditional branch of economic theory, meaning following a
concept of maximizing social welfare.
Ecological economics emerges in the 1980s as natural scientists, most of them
ecologists, and economists came together to overcome the gap between the natural
science and economics, especially the neoclassical way of thinking. The idea goes
already back to a paper written by Kenneth Boulding in 1966, The economics of
the coming Spaceship Earth.

Kenneth E. Boulding
Photo: University of Colorado
Kenneth E. Boulding was born in Liverpool,
England, on January 18, 1910, and died in
Boulder, Colorado, on March 18, 1993. In 1937,
graduated from Oxford University. Boulding
came to the United States in 1932 and became a
U.S. citizen in 1948. He has held teaching
appointments at the University of Edinburgh,
Colgate University, Fisk University, Iowa State
College at Ames (where he wrote his famous
1944 paper on liquidity preference and the
University of Michigan and the International
Christian University in Japan (from whence
arose his first work on "evolutionary" economics
(1970)) - before finally settling at the University of
Colorado at Boulder in 1967, where he was
Distinguished Professor Emeritus at their
Institute of Behavioral Science.

The ecological economist demand , that the ecological and social aspects should be
recognized as limits to the economic development. The proponents of ecological
economist, like Daly, call for the concept of strong sustainability as discussed in
chapter 2.1.2. Each capital stock (man made, capital, natural capital and social
capital) are not substitutes against each other all kinds of capital are
complementary. Ecological economist argues in support of a constant natural-
capital rule. It notes that natural capital has already grown scarce and will
probably become the limiting factor for economic production. From todays
viewpoint, the natural capital stock is already overused. Hence, a declining
economic growth path is necessary for sustainable development. Furthermore,
since the economic wealth unequally distributed among nations, a redistribution
from the developed world to the developing countries is crucial. The developed
societies should invest in natural capital instead of investing in man-made capital.
Besides the three management rules discussed above, Daly derived a fourth
management rule:

26
Scale of economic activity, measured by the product of population and per-capita
resource consumption in a given region, should result in a non declining natural
capital stock.
According to Ecological economics, there is a limit to the scale of the economy,
which is set by the need to sustain the carrying capacity of the ecosystems and
resources of the earth.

2.1.6 Evolutionary Economics

Whereas the neo-classical economic theory is in the search for stable equilibrium
paths of sustainable development, the proponents of the evolutionary economics
reject this approach. The ecological system can be characterized by unpredictable,
non-linear behaviour. The same would be true for the economic system. An
equilibrium approach, as used by neo-classical economist, is not applicable to the
economy. Regarding sustainable development, evolutionist economist are
combining the evolutionary ecological ant the evolutionary economical system,
called co-evolution. In contrast to neo-classical economics, which its equilibrium
approach and in case of deviation from the equilibrium the economic system tends
always towards the equilibrium, evolutionary economics can be characterized by
contingency, accumulation and irreversibility. An evolutionary approach has to
take into account jumps, uncertainties, non-linear ties and chaotic behaviour along
dynamic paths. A projection of future development in respect of the ecological,
social, and economical system is not possible. The evolutionary approach allows
for an explanation of historical processes, but is unable to predict future
development. Hence, it is not predictable whether the society follows a sustainable
path or not. There is only one simple managing rule, make sure that there is
sufficient diversity in the ecological system (biodiversity), the social and
economical system. Society must have a variety of options to react to future
environmental changes, whether they are natural or man-made. Similar to the
biology of evolution, the greater the variety the greater the change to fit to
changing environment.
Besides his contribution to ecological economics, Kenneth Boulding was one of the
advocates of the evolutionary methods in social science, put forward most
completely in his Ecodynamics (1978) and Evolutionary Economics (1981).

2.1.7 Indicators

Already the Brundlandt report asked for indicators, which allow to measure
sustainable development. The claim for indicators for sustainable development was
established in the so called Agenda 21.
The Agenda 21 is a comprehensive plan of action to be taken globally, nationally
and locally by organizations of the United Nations System, Governments, and
Major Groups in every area in which human impacts on the environment.
Agenda 21, the Rio Declaration on Environment and Development, and the
Statement of principles for the Sustainable Management of Forests were adopted
by more than 178 Governments at the United Nations Conference on Environment
and Development (UNCED) held in Rio de Janerio, Brazil, 3 to 14 June 1992.

27
The Commission on Sustainable Development (CSD) was created in December
1992 to ensure effective follow-up of UNCED, to monitor and report on
implementation of the agreements at the local, national, regional and international
levels.
The early indicator work under CSD organized the chapters of Agenda 21 under
the four primary dimensions of sustainable developmentsocial, economic,
environmental, and institutional. Within these categories, indicators were classified
according to their:
driving force,
state, and
response characteristics.
The term driving force represents human activities, processes, and patterns that
impact on sustainable development either positively or negatively. State indicators
provide a reading on the condition of sustainable development. Response indicators
represent societal actions aimed at moving towards sustainable development. Tab 4
illustrates the essence of this DSR framework.
SD Dimension Chapter of Driving Force State Response
Agend 21 Indicators Indicators Indicators
Social
Economic
Environmental
Institutional
Tab 4 DSR Framework for Sustainable Development Indicators

This kind framework is also known as PSR (pressure-state-response) framework,

using the term pressure instead of the more general term driving force. The PSR
framework is developed and used by the OECD
The PSR framework is based on a concept of causality: Human activities exert
pressures on the environment and change its quality and the quantity of natural
resources, the state . Society responds to these changes through environmental,
general economic and sectoral policies (the societal response). The latter form a
feedback loop to pressures through human activities.In a wider sense, these steps
form part of an environmental (policy) cycle which includes problem sensitivity,
policy formulation, monitoring and policy evaluation.

28
Soure: OECD, 1993
Abb. 9 Pressure - State - Response Framework

The United Nations Commission on Sustainable Development (CSD) had a work

programme on indicators of sustainable development in 1995. The framework
employed in the CSD work programme to guide the selection of sustainable
development indicators has evolved from a driving force-state-response approach
to one focusing on themes and sub-themes of sustainable development.
A final framework of 15 themes and 38 sub-themes has been developed to guide
national indicator development beyond the year 2001. It covers issues generally
common to all regions and countries of the world. The framework, together with
the core set of sustainable development indicators, is summarized in Abb. 10.

SOCIAL

Theme Sub-theme Indicator

Percent of Population Living below

Poverty Line
Poverty (3)
Gini Index of Income Inequality
Equity
Unemployment Rate
Gender Equality Ratio of Average Female Wage to
(24) Male Wage
Health (6) Nutritional Status Nutritional Status of Children
Mortality Rate Under 5 Years Old
Mortality
Life Expectancy at Birth
Percent of Population with Adequate
Sanitation
Sewage Disposal Facilities

29
 Population with Access to Safe
Drinking Water
Drinking Water
Percent of Population with Access to
Primary Health Care Facilities
Healthcare Delivery Immunization Against Infectious
Childhood Diseases
Contraceptive Prevalence Rate
Children Reaching Grade 5 of
Primary Education
Education Level
Education (36) Adult Secondary Education
Achievement Level
Literacy Adult Literacy Rate
Housing (7) Living Conditions Floor Area per Person
Number of Recorded Crimes per
Security Crime (36, 24)
100,000 Population
Population Growth Rate
Population (5) Population Change Population of Urban Formal and
Informal Settlements
ENVIRONMENTAL

Theme Sub-theme Indicator

Climate Change Emissions of Greenhouse Gases

Ozone Layer Consumption of Ozone Depleting
Atmosphere
Depletion Substances
(9)
Ambient Concentration of Air
Air Quality
Pollutants in Urban Areas
Arable and Permanent Crop Land Area
Agriculture (14) Use of Fertilizers
Use of Agricultural Pesticides
Forest Area as a Percent of Land Area
Land (10) Forests (11)
Wood Harvesting Intensity
Desertification (12) Land Affected by Desertification
Area of Urban Formal and Informal
Urbanization (7)
Settlements
Algae Concentration in Coastal Waters
Oceans, Seas Coastal Zone
Percent of Total Population Living in
and Coasts
Coastal Areas
(17)
Fisheries Annual Catch by Major Species
Annual Withdrawal of Ground and
Water Quantity Surface Water as a Percent of Total
Fresh Water Available Water
(18) BOD in Water Bodies
Water Quality Concentration of Faecal Coliform in
Freshwater
Biodiversity Area of Selected Key Ecosystems
(15) Ecosystem
Protected Area as a % of Total Area

30
 Species Abundance of Selected Key Species
ECONOMIC

Theme Sub-theme Indicator

Economic GDP per Capita

Performance Investment Share in GDP
Balance of Trade in Goods and
Economic Trade
Services
Structure (2)
Debt to GNP Ratio
Financial Status (33) Total ODA Given or Received as a
Percent of GNP
Material
Intensity of Material Use
Consumption
Annual Energy Consumption per
Capita
Energy Use Share of Consumption of Renewable
Consumption Energy Resources
and Intensity of Energy Use
Production Generation of Industrial and Municipal
Patterns (4) Waste Generation Solid Waste
and Management Generation of Hazardous Waste
(19-22) Management of Radioactive Waste
Waste Recycling and Reuse
Distance Traveled per Capita by Mode
Transportation
of Transport
INSTITUTIONAL

Theme Sub-theme Indicator

Strategic
National Sustainable Development
Institutional Implementation of
Strategy
Framework SD (8)
(38, 39) International Implementation of Ratified Global
Cooperation Agreements
Information Access Number of Internet Subscribers per
(40) 1000 Inhabitants
Communication Main Telephone Lines per 1000
Infrastructure (40) Inhabitants
Institutional
Capacity (37) Science and Expenditure on Research and
Technology (35) Development as a Percent of GDP
Disaster
Economic and Human Loss Due to
Preparedness and
Natural Disasters
Response
Numbers in brackets indicate relevant Agenda 21 chapters.
Source: United Nations Economic and Social Council, see:
http://www.un.org/esa/sustdev/natlinfo/indicators/isdms2001/table_4.htm
Abb. 10 CSD Theme indicator Framework

31
One of the most popular and well-known indicator is the Human Development
Indicator (HDI). It has been used since 1993 by the United Nations Development
Programme in its annual Human Development Report. The HDI is a comparative
measure of life expectancy at birth, adult literacy rate and mean years of schooling,
and income as measured by real gross domestic product per capita as represented in
Abb. 11. The HDI is a one-dimensional scale index.

Dimension A long and A decent

standard
healthy life
Knowledge of living
Indicator Life Adult Gross GDP per
expectancy literacy enrolment capita
at birth rate ratio (GER) (PPP US$)
Adult GER index
literacy
index

Dimension Life Education index GDP index

Index expectancy
index

Human Development index

HDI

Abb. 11 The Human Development Index

Before the HDI itself is calculated, an index needs to be created for each of these
dimensions. To calculate these indicesthe life expectancy, education and GDP
indicesminimum and maximum values (goalposts) are chosen for each
underlying indicator. Performance in each dimension is expressed as a value
between 0 and 1 by applying the following general formula:
actual value - minimum value
Dimension index =
maximum value - minimum value
HDI is then calculated as a simple average. The goalposts for calculating the HDI
is given by Tab 5:
Indicator Maximum Minimum
value value
Life expectancy at birth (years) 85 25

32
Adult literacy rate (%) 100 0
Combined gross enrolment ratio (%) 100 0
GDP per capita (PPP US$) 40,000 100
Tab 5 Goalposts for calculating the HDI

Goalpost for
maximum value

Index
value
Indicator
value

Goalpost for 0
minimum value

Abb. 12 Dimension index for the HDI

Calculating the HDI

Once the dimension indices have been calculated, determining the HDI is
straightforward. It is a simple average of the three dimension indices.
HDI = 1/3 (life expectancy index) + 1/3 (education index)
+ 1/3 (GDP index)
= 1/3 (0.764) + 1/3 (0.876) + 1/3 (0.735) = 0.792

33
 HDI

0 0 0 0

Abb. 13 Calculating the HDI

In Tab 6 the top thirty countries are ranked according to the HDI index 2006.
1. Norway 7. Japan 13. Belgium 19. Spain 25. S. Korea,
2. Iceland 8. United States 14. Austria 20. New Zealand 26. Slovenia
3. Australia 9. Switzerland 15. Denmark 21. Germany 27. Portugal
4. Ireland 10. Netherlands 16. France 22. Israel 28. Cyprus
5. Sweden 11. Finland 17. Italy 23. Greece 29. Czech
Republic
6. Canada 12. Luxembourg 18. UK 24. Singapore
30. Barbados
Source: Human Development Report, 2006, United Nations
Tab 6 Top thirty countries (HDI range from 0.965 down to 0.885)

However, the HDI has received essential critics. First, it has been argued that the
number of indicators remains insufficient and that their selection is arbitrary.
Second, the explanatory power in respect to sustainable development of the HDI is
very low, it has no meaning whether the society is on an sustainable path or not.
The development of indicators as a measurement for sustainable development is it
is early beginning. Especially missing are indicators for social and institutional
aspects of sustainability. Furthermore, indicators measuring the use of renewable
and non-renewable natural resources and the value of biodiversity are still in a
rudimentary stadium.

2.1.8 Institutions

The milestone for sustainable development was set with the United Nations
Conference on Environment and Development (UNCED) 1992 in Rio de Janeiro,

34
Brazil, the so called Earth Summit. It main result is the so called action pan
Agenda 21.
The Agenda 21 is a comprehensive plan of action to be taken globally, nationally
and locally by organizations of the United Nations System, Governments, and
Major Groups in every area in which human impacts on the environment. The full
implementation of Agenda 21, the Programme for Further Implementation of
Agenda 21 and the Commitments to the Rio principles, were strongly reaffirmed at
the World Summit on Sustainable Development (WSSD) held in Johannesburg,
South Africa from 26 August to 4 September 2002. There are 40 chapters in
Agenda 21, divided into four sections:
Section I: Social and Economic Dimensions
including combating poverty, changing consumption patterns, population and
demographic dynamics, promoting health, promoting sustainable settlement
patterns and integrating environment and development into decision-making.
Section II: Conservation and Management of Resources for Development
including atmospheric protection, combating deforestation, protecting fragile
environments, conservation of biological diversity (biodiversity), and control of
pollution.
Section III: Strengthening the Role of Major Groups
including the roles of children and youth, women, NGOs, local authorities,
business and workers.
Section IV: Means of Implementation
including science, technology transfer, education, international institutions and
mechanisms and financial mechanisms

35
About the United Nations Division for Sustainable Development

Mission
The Division for Sustainable Development provides leadership and is an authoritative
source of expertise within the United Nations system on sustainable development. It
promotes sustainable development as the substantive secretariat to the UN
Commission on Sustainable Development (CSD) and through technical cooperation
and capacity building at international, regional and national levels. The context for
the Divisions work is the implementation of Agenda 21, the Johannesburg Plan of
Implementation and the Barbados Programme of Action for Sustainable
Development of Small Island Developing States.

Goal
Integration of the social, economic and environmental dimensions of sustainable
development in policy-making at international, regional and national levels;

Wide-spread adoption of an integrated, cross-sectoral and broadly participatory

approach to sustainable development;

Measurable progress in the implementation of the goals and targets of the

Johannesburg Plan of Implementation.

Priority Activities for the Division to Achieve These Goals

Facilitate intergovernmental negotiations, consensus-building and decision-making
through the provision of substantive support to the work of the CSD and other related
bodies;

Provide technical assistance, expert advice and capacity building to support

developing countries and countries with economies in transition in their efforts to
achieve sustainable development;

Facilitate inter-agency and inter-organizational cooperation, exchange and sharing of

information, and catalyze joint activities and partnerships within the United Nations
system and with other international organizations, governments and civil society
groups in support of sustainable development;

Promote and facilitate monitoring and evaluation of, and reporting on, the
implementation of sustainable development at the national, regional and international
levels;

Undertake in-depth strategic analyses to provide policy advice to the USG/DESA,

UN system and intergovernmental fora focusing on cross-cutting and emerging
sustainable development issues.

From the UNCSD webpage: http://www.un.org/esa/sustdev/about_us/aboutus.htm

36
References

Boulding, Kenneth E (1966): "The economics of the coming Spaceship Earth", in:
H. Jarrett (editor), "Environmental quality in a growing economy", Baltimore,
Johns Hopkins University Press, p. 3-14

Boulding, Kenneth E (1978): Ecodynamics: A New Theory of Societal Evolution

(A Sage View Edition). Beverly Hills, Calif.: Sage Publications.

Boulding, Kenneth E (1981): Evolutionary Economics. Beverly Hills, Calif.: Sage

Publications, 1981.

Costanza R, Ecological Economics: The Science and Management of

Sustainability. Columbia University Press New York 1991

Daly, Herman E. "Toward some operational principles of sustainable

development." Ecological Economics 2 (1990) : 1-6

Daly, Herman E. and Kenneth N. Townsend (1993),VALUING THE EARTH:

Economics, Ecology, Ethics

Hartwick, John M. 1977. "Intergenerational equity and the investing of rents from
exhaustible resources." American Economic Review 67(5):972-74.

Meadows, Donella H., Dennis L. Meadows, Jrgen Randers, and William W.

Behrens III. 1972. The Limits to Growth. New York: University Books

Phelps, E S '(1961): The Golden Rule of Accumulation: A Fable for Growthmen',

American Economic Review, vol. LII (September, 1961), 638-43

Solow: The Economics of Resources or the Resources of Economics", 1974, AER.

Solow: "Intergenerational Equity and Exhaustible Resources", 1974, RES.

United Nations, Indicators of Sustainable Development: Framework and

Methodologies, New York, 1996.

Weisbrod, B.A. 1964. Collective-consumption services of individual-consumption

goods. Quarterly Journal of Economics 78: 471-473.

37
3 Welfare and the Environment

Learning objectives
In this chapter you will
learn the economic concepts of efficiency and optimality
learn how incomplete markets lead to market failure
learn the concept of public goods and why they lead to market failures
learn that environmental damages are based on externalities
learn the concept of the Coase-Theorem and why it would not apply to
environmental problems in general

3.1 Introduction

In this chapter the concepts of economic analysis for environmental problems and
their solutions are developed. Economic analysis provides a set useful tools for
dealing with environmental problems. Economic tools deliver instruments to secure
a sustainable environmental outcome looking at incentives harmonizing the
relationship between the economy and the environment. Economists are using
models investigating complex problems. Models are a simplification of reality to
get answers to specific questions. Models are important to reduce the complexity
of the real world to get useful insights and hints. A model used by anyone are
maps. The are a simplification of the real world but useful to find the way through
an unknown city to the Siam City Hotel in Bangkok.

Abb. 14 A city map of Bangkok as a model

38
3.2 Efficiency and Optimality

Economics is essentially concerned with the ways in which scarce resources are
distributed among competing use: If resources were not scarce, there would be no
need for economics. Economists refers to resources as to any inputs to
production, such as capital, labour, but also to natural resources like wood,
minerals or energy resources. The fundamental questions are:
1 What shall be produced?
2 How much should be produced?
3 How should the result from production be distributed?
In answering these questions, the chief criterion for choosing among various
allocations is that the allocation should be efficient. Efficiency means that no
scarce resource should be wasted. Otherwise, it would be possible to use the
wasted resource to produce more outputs or to consume the resource to improve
someones utility. In other words: An allocation is inefficient if it is possible to
improve someones situation (i.e. production or consumption) without worsening
the situation of someone other(s). If there are no possibilities for rearranging the
allocation in such a way, a situation is Pareto-optimal if by reallocation you cannot
make someone better off without making someone else worse off, this allocation is
referred to as Pareto efficient, or Pareto optimal. Named after the Italian
economist Vilfredo Pareto (1848-1923).

Vilfredo Pareto
On efficiency

We will say that the members of a collectivity enjoy

maximium ophelimity (economic satisfaction, J.B.) in
a certain position when it is impossible to find a way
of moving from that position very slightly in such a
manner that the ophelimity enjoyed by each of the
individuals of that collectivity increases or decreases.
That is to say, any small displacement in departing
from that position necessarily has the effect of
increasing the ophelimity which certain individuals
enjoy, and decreasing that which others enjoy, of
being agreeable to some, and disagreeable to
others."

(V. Pareto, Manual of Political Economy. 1906: p.261,

1971 translation of 1927 edition, New York: Augustus
M. Kelley.).

Pareto-efficiency is a necessary criterion, but as a concept of "optimal", in any

ethical sense, it is definitely not sufficient. There are no ethical propositions about

39
the desirability of such a Pareto-optimal allocations. Thus, there is nothing inherent
in Pareto-optimality that implies the maximization of social welfare.
Sufficiency in allocation requires:
1 efficiency in consumption (exchange)
2 efficiency in production
3 Total efficiency

Efficiency in consumption
Given agents utility U as a function of a basket of goods, we have in a two agent
(A and B) and two goods (X and Y) case:

U A = U A ( X A ,Y A )
Formel (6)
U B = U B ( X B ,Y B )

Efficiency in consumption requires, that the marginal rate of substitution for (at
least) two agents A and B must be equal:

Formel (7) Efficiency: MRSA = MRSB

As long as MRSA MRSB, exchange can increase utility for at least one, without
decreased utility for the other. This result cab be derived from the Edgeworth-box.

Efficiency in production
Given two inputs, labour (L) and capital (K), which can be used to produce the two
goods X and, we have the following production function:

X = F ( K X , LX )
Formel (8)
Y = F ( K Y , LY )

Efficiency in production requires that marginal rate of technical substitution has to

be the same in the production of both goods:

Formel (9) Efficiency: MRTSX = MRTSX

If condition Formel (9) is not satisfied, it would be possible to reallocate

production inputs in such a way that more of one good can be produced without
producing less of the other.

Total efficiency
Total efficiency, or product-mix efficiency, requires the simultaneous equilibrium
of efficiency in consumption and efficiency in production:

Formel (10) Efficiency: MRSA = MRSB = MRTSX = MRTSX

40
This two goods two inputs economy can be easily extended to a n goods and an m
inputs economy. However, an economy fulfilling the three efficiency criteria
simultaneously is called static efficient.

Typically, in an economy with many goods and many resources, there are many
efficient allocations of resources. In order to select a particular allocation, a social
welfare function is necessary. The following chapter explains the concept of
maximizing social welfare. Chapter 2.2.1 describes the efficient allocation in a
market economy.

3.2.1 Maximizing social welfare

A key concept in economics is the use of social welfare as a measurement for the
wealth of a society. From the economical point of view, social welfare should be
maximized. Typically, social welfare can be understood as the sum of individual
welfare. In an intertemporal context, where social welfare is measured as a stream
of welfare over time, future welfare will be discounted by the social discount rate.
Kenneth Arrow showed, that it is impossible to just sum up individual welfare to
get a social welfare function. This is known as Arrows impossibility theorem.1 For
this reason economists are using the concept of a representative agent or
alternatively introducing a benevolent dictator, or social planner. The concept of
representative agents (for consumers and firms) is normally used to market
allocation models, the benevolent dictator concept can be seen as benchmark,
delivering a first best solution, for market economies. The following three sections
shows, why market allocations may fail to reach an efficient outcome. However,
maximizing social welfare can be written as:
T
Formel (11) max W = Wt e t dt
0

1
Arrow (1963) shows that there is no social choice rule simultaneously satisfying the
follwing properties:
Social preferences should be complete in that given a choice between
alternatives A and B it should say whether A is preferred to B, or B is
preferred to A or that their is a social indifference between A and B.
Social preferences should be transitive; i.e., if A is preferred to B and B is
preferred to C then A is also preferred to C.
If every individual prefers A to B then socially A should be preferred to B.
Socially preferences should not depend only upon the preferences of one
indidual; i.e., the dictator.
Social preferences should be independent of irrelevant alternatives; i.e., the
social preference of A compared to B should be independent of preferences
for other alternatives.

41
with W symbolizing the social welfare, which is the present value of accumulated
welfare over time t, where future welfare will be discounted by the social discount
rate . Formel (11) follows an utilitarian approach. Distributional effects,
regarding inter- and intragenerational justice are neglected.

3.2.2 Market economy and efficiency

In contrast to the concept of a social planner, a market economy is based on

decentralised decisions by buyers and sellers, in order to allocate resources. An
efficient allocation of resources in a market economy can be achieved if the
following conditions, called the perfect competition conditions are fulfilled:
Perfect competition in a well-defined market is defined by four conditions:
1. There is such a large number of buyers and sellers that none can
individually effect the market price. This means that the demand curve
facing an individual firm is perfectly elastic.
2. Resources must be freely mobile, meaning that there are no barriers to
entry and exit.
3. All market participants (buyers and sellers) must have full access to the
knowledge relevant to their production and consumption decisions.
4. The product should be homogenous.
When these conditions are fulfilled in any well-defined market, the market is
perfectly competitive; when they are fulfilled in all markets, the economy is
perfectly competitive.
Moreover, a well-defined market, is one in which there are:
5. all goods and services are private, there are no public
6. goods no externalities exist
These six conditions are necessary for a market economy to produce efficient
allocations.
For simplicity the economic analyses is done as partial equilibrium analyses. The
partial equilibrium approach examines the production and consumption of only one
good, ignoring the rest of the economy. Only those parts of the economy, which
have direct relevance to the problem being studied, are taken into consideration.
In Abb. 15 q is the level of a good produced and consumed. In the first diagram the
curve labelled B ( q ) represents the total benefit of the consumption of good q, and
the curve labelled C ( q ) represents the total cost of production for various levels.
Costs as well as benefit depends on the level produced or consumed. Costs and
benefits could be measured in money value. The net benefit NB ( q ) is the distance
between benefit and cost. The net benefit curve is depicted in the second diagram.
The maximum of net benefit is given by the largest distance between benefit and
cost. The slope of both curves are identical, i.e. the tangents to these curves have
the same slope at q* .

42
 cost C(q)

benefit B(q)

B(q*)

NB(q*)

C(q*)

q*
quantity q

NB(q*)

NB(q)

q* quantity q

S(q) =MC(q)

Consumer
Surplus
p*
Producer
Surplus

D(q) =MB(q)

q* quantity q
Abb. 15 Economic efficiency in an partial equilibrium approach

43
The slope of the cost and benefit curve results in the marginal cost curve MC ( q )
and the marginal benefit curve MB ( q ) . If consumers and producers are both price
takers, i.e. it is assumed, that the economy is perfectly competitive, .than the
marginal benefit curve is equal to the market demand curve D ( q ) and the
marginal cost curve is equal to the market supply curve S ( q ) . Economic analysis
it is common to use marginal rather than total functions. The drawn marginal
curves in the third diagram corresponds to the total curves in the first diagram. In
this case these are linear functions, i.e. straight lines. The demand curve has a
negative slope, since normally if there is an increase in price, demand goes down.
The market supply curve has a positive slope, since the higher the price, the more
producers like produce. The intersection of both curves represents market
equilibrium, where demand equals supply. Or, alternatively, where marginal
benefit is equal to marginal cost MB ( q ) = MC ( q ) . At this point the net benefit is
maximized. No other combination in price and output results in higher net benefit.
The welfare maximizing amount produced is given by q* , where
MB ( q* ) = MC ( q* ) = p* .

The net benefit is maximized by the market allocation, and as seen in the third
diagram, is equal to the sum of consumer surplus and producer surplus. The area
between the demand curve D ( q ) and zero and q* , represents the consumers
willingness to pay (WTP) for q* units of the good. The actual price the consumer
has to pay is p* . Total cost for the consumers is just p* q* . The difference
between total willingness to pay and total costs is the so called consumer surplus.
The producer surplus is just the revenue p* q* less total costs, which is just the
triangle beneath the marginal cost curve MC ( q ) = S ( q ) and zero and q* .

3.3 Incomplete Markets

As demonstrated in the previous chapter, perfectly competitive markets, defined by

the six conditions, generate efficient allocations of resources. However, if one of
these conditions fail, market outcome and the location of resources may be
inefficient. Hence, most market failure and therefore environmental problems,
results from incomplete markets. Most markets are incomplete because property
rights are not well defined, or asymmetric information occur. The first problem is
described in more detail in the next chapter. Asymmetric information occur, when
it is impossible to observe peoples characteristics or actions.
This can be described by the phenomena moral hazard and adverse selection.
Originally moral hazard was mentions d in the insurance industry, defined as a risk
to an insurance company resulting from uncertainty about the honesty of the
insured. Environmental problems result because an environmental agency or a
regulator cannot perfectly monitor pollution abatement. The polluter can shirk on
pollution control. The reason for this behaviour is, that the firm bears all the costs
of reducing pollution, but receives only a small amount of benefit. The result is too
much environmental damages than economically optimal. Adverse selection
occurs, when the quality of a product cannot be valued by the buyer. The classical

44
example is given by George Akerlof, describing markets for used cars. Only bad
cars, called lemons, will be on the market, while consumers cant be guaranteed,
that high quality cars will be sold, they wont buy cars at all. The market is down.
If consumers cant be sure, that catching tuna without doing any harm to dolphins,
they wont by tuna cans. Because the tuna can tells nothing about the fishing
methods. If consumers cannot distinguish between dolphin friendly fishing and not
dolphin friendly fishing methods, they wont pay a premium on the price. Hence
the standard fishing methods will be used in the tuna industry. If the buyers are
reluctant to by these products, the tuna producers will disappear from the market.
The collapse of the market can be prevented by labelling or certification. One
example of a certification is the Marine Stewardship Council (MSC), which is an
independent non-profit organisation that promotes responsible fishing practices.
The MSC has developed an environmental standard for sustainable and well-
managed fisheries. It uses a product label to reward environmentally responsible
fishery management and practices.

Abb. 16 MSC label (originally in blue)

3.4 The commons and public goods

Private and marketable goods are characterized by excludability and rivalry. One
argument for incomplete markets is, that there is non-exclusion and or rivalry.
Therefore, there are specific properties of consumption goods:
non-excludability
Individuals cannot, or only at prohibitive costs, be excluded from the consumption
of the good.
non-rivalry
The utility an individual obtains from the consumption of one unit of a good is not
diminished by the consumption of the same unit by another individual.

45
Goods can therefore be classified according to the criteria mentioned above:

excludable non-excludable
market goods
rival commons
(private goods)
public goods
non-rival club goods
(collective goods)
Tab 7 Classification of goods

Environmental problems occur where excludability is not assured. In this case, the
good might be overused. Further, resource use might be rivalry or non-rivalry. The
case of a non-excludable but rivalry good is called an impure public good also
known as the commons. One example of impure public goods are open-access
resources like fish stocks. Each fisherman has the incentive to catch as quickly as
possible before the other fishermen gets the catch. This leads to an economic
inefficient use of the fish stock, since this ends up in over-harvesting the fish stock
an expanding fishing effort to an economical inefficient level. This is known as
prisoners dilemma in game theory or as the tragedy of the commons. The
tragedy of the commons is a phrase introduced by the biologist Garrett Hardin
(1968) used to illustrate the conflict between individual interests and a common
good. Instead of taking something out of the commons, environmental problems
dealing with putting something in, i.e. pollution.
Assume two fishermen, fisher 1 and fisher 2. Each can choose one strategy out of
two:
Strategy 1: Harvest as much as possible to maximize the own share of the total
catch.
Strategy 2: Follow a sustainable harvest policy.
In case both fishermen follows strategy 1, they have to invest in fishing effort (high
power trawler), getting each a payoff of 10. In case only fisher 1 follows strategy 1
and fisher two follows strategy 2, fisher 1 receive a payoff of 25 and fisher 2
receives a payoff of only 5, since he will be at the fishing ground when fisher 1
already harvested the larger part of the stock. Otherwise it will be the opposite. In
case both fishermen fill follow strategy 2, the dont have to invest in
overcapitalization of the fishing fleet, hence they get both a payoff of 20. Abb. 17
illustrates the payoff functions.
fisher 2
maximize harvest sustainable harvest
policy
maximize
(10,10) (25,5)
harvest
fisher 1
sustainable
(5,25) (20,20)
harvest policy
Abb. 17 Prisoners dilemma in a simple fishing industry

46
Given fisher 1 choose strategy 1, the best answer for fisher 2 choosing strategy 1,
too. Because he would prefer a payoff of 10 to a payoff of only 5. Given fisher 1
choose strategy 2, the best answer for fisher 2 is choosing strategy 1, this gives him
a payoff of 25, instead of 20.
Given fisher 2 choose strategy 1, the best answer for fisher 1 will be choosing
strategy 15. Given fisher 2 choose strategy 2, the best answer for fisher 1 is
choosing strategy 1. Hence they will and up in an equilibrium, the so called Nash
equilibrium, with the payoff (10,10). Both could be better off, choosing strategy 2,
where they would end up with a payoff of (20,20). But this is not an equilibrium.
Where both non-rivalry and non-excludability is exhibited, an environmental good
can be considered as a pure public good. The difference between a impure and a
pure public good is not strict. For example, 100 years ago, fish stock was seen as a
public good, only since fishing effort raised to an industrial level (large fishing
trawlers etc) rivalry matters.
Whereas for a private good the efficient allocation is given where marginal costs
K i U i
equals marginal utility of consumers, = . If there is no rivalry, this makes
Yi Yi
no sense, since if a good (if the good has a negative value, like pollution, this might
be a bad) is produced, it can be used by one or million consumers. Hence,
individual utility (or benefits) must be summed up. This results in the following
welfare function for a public good:

Formel (12) W (Y ) = U1 (Y ) + U 2 (Y ) + ... + U n (Y ) K (Y )

Maximizing Formel (12) results in the first order condition:

W U1 U 2 U n K
Formel (13) =0 + + ... + =
Y Y Y Y Y
The determination of the efficiency condition for a two person case, is illustrated in
Abb. 18.

p
total
marginal utility
U1 U2
marginal costs
+ K
Y Y
Y
U2
Y

U1
Y
p*

Y* Y

Abb. 18 Efficient level of supply for a pure public good

47
Environmental problems result because the environment is a public good, either
pure or impure (commons). The environment has no well defined property rights,
this results in:
environment cannot be traded
there is no market for environmental goods
there is no price for environmental quality, hence, there is no signalling for
scarcity
there are externalities not recognized by the economic agents (for details, see
next chapter),
the environment will be overused
Furthermore, inefficiency in public goods results because an agent is able to
become a free rider on one others contribution. A free rider is defined as someone
who derives the benefits from a good or service without contributing to its supply.

3.5 Externalities

Externalities occur when an economic activity of one economic agent affect

another economic agents objective function (e.g. utility function, profit function)
and the relevant costs (negative external effect)and benefits (positive external
effect)are not reflected in market prices. An externality exists whenever the welfare
of an agent, this might be a firm or a household, depends not only of her own
activities, but also on the activities done by third parties.

social marginal
market demand cost (SMC)
for electricity D

private marginal
cost (PMC)

p*
pm

q* qm quantity

Abb. 19 The market for electricity

In Abb. 19 this is demonstrated by the market for electricity. Electricity is

produced by using fossil fuels, like coil and gas, in power plants. The output is not
only electricity but also unwanted emission like sulphur or carbon. The demand for
electricity is described by the (inverse) demand curve D. The private marginal

48
costs of producing electricity, is given by the PMC curve. The damage done by the
pollution (acid rain, greenhouse effect) is not part of the private marginal costs.
Society has to pay the electricity production costs and in addition to this, the
marginal damage costs. The marginal social cost curve (SMC) represents both
costs in Abb. 19.

In case where there is no control on emission, the market clearing price would be
p m and the market equilibrium production would be q m . But social benefit is
maximized were the social marginal cost curve intersects the market demand curve.
With social optimal price p* and optimal electricity production level q* .
Comparing the market equilibrium with the optimal social equilibrium, some
conclusions can be drawn:
1. Neglecting externalities results in to large output of the commodity.
2. Assuming pollution as a function of production, too much pollution is
produced.
3. The market product price is too low.
That there is no need to intervene, under special circumstances, is stated by Ronald
Coase. This statement is known as the Coase theorem.

3.6 Coase-Theorem

Ronald Coase argued that individuals could organise bargains so as to bring about
an efficient outcome and eliminate externalities without government intervention
(for example Pigovian taxes). The government should restrict its role to facilitating
bargaining among the affected groups or individuals and to enforcing any contracts
that result.
This result, often known as the Coase Theorem, requires that
property rights are well defined;
the number of people involved is small; and
bargaining costs are very small.
Only if all three of these apply will individual bargaining solve the problem of
externalities.
More general The Coase theorem states:
Affected parties to an externality will agree on an allocation of resources that is
both Pareto optimal and independent of any prior assignment of property rights, in
the absence of transaction costs.
The Coase theorem often is reduced to focus attention on property rights and
transactions costs, and the debate usually turns on whether and how transactions
costs can be reduced. But the Coase theorem is more complicated than these two
most popular aspects of the Coase Theorem.
Originally Coase used as an example a rancher's cows destroying his neighbouring
farmer's crops. But it is clearer to understand the problem to assume to firms, a

49
chemical plant and a water works plant located on a river, where the chemical plant
is upstream and the water works is downstream, see Abb. 20.

Chemical plant

Water works

Abb. 20 The upstream - downstream problem in waste water pollution

If the chemical plant is allowed to emit its waste into the river, the water works
suffers due to increasing costs of water purification. This situation is represented in
figure Abb. 21.
The benefit by the chemical plant is given by the marginal private benefit (MPB)
curve. The area under this curve is the total benefit. The benefit may result from
saving costs by not investing in a sewage treatment plant. Hence benefit is equal to
the water treatment costs. If the chemical plant has the right to pollute, it will save
all water treatment costs, hence it will emit the maximum amount of waste water
E , where MPB = 0 and therefore profit is maximized. The water works suffer
from the waste water, which can be represented by the marginal external cost curve
(MEC). The costs are due to the fact, that the water works have to invest in a larger
water-purification plant.
If the whole river is owned by the water-works, and the chemical plant has no right
to emit waste water into the river, the situation will be where there is no emission
by the chemical plant. This is described by point B in Abb. 21.
Both situations are not Pareto-efficient. If the chemical plant has the property rights
over the river, the eater works would be willing to pay the chemical plant up to
E * FCD for a reduction in waste water from E to E * . The area FCD represents
the potential for Pareto improvements. Both can better off if the water works
compensate the chemical plant for a reduction in water pollution. This is going on
as long as the MEC, that is the maximum amount of money the water works will
pay to reduction in water pollution, is above the MPB curve. The latter is the

50
amount of money the chemical plant want to have to be compensated for their loss
in benefit. A reduction below E * is not reasonable, since MPB is grater than MEC.
Pareto improvement is also possible if the water works controls the river water
quality. In this case the chemical plant would be willing to pay the water works up
to BAFE * for the right to increase it stream of waste water into the river from B to
E * . The maximum amount of money the chemical would be willing to pay for an
increase of one unit of waste water into the river is its marginal private benefit
(MPB), this is always larger as the money the water works is willing to accept for
compensation due to increasing water treatment costs, represented by the MEC
curve. An increase above E * is not meaningful, because marginal external costs
exceeds marginal private benefit.

marginal private marginal external

A benefit (MPB) cost (MEC) C

B D

E* E Emissions E
Abb. 21 Coases Theorem I

Since besides the Pareto optimal pollution level E * , any other pollution level E is
not Pareto efficient, and has the potential for Pareto improvements. As long as this
is the case, both parties will bargain as long as the potential in Pareto improvement
is vanished. The Pareto optimal solution is represented by the waste water level
E * . In case the property rights are with the chemical plant, the water works will
pay * per unit of waste water reduced to the chemical plant, which summed up in
compensation payment to the chemical plant to the areas (d+e) in Abb. 22. If the
property right are allocated to the water works, the chemical plant has to pay *
per unit of waste water running into the river to the water works, to compensate for
the increasing water treatment costs. The compensation paid to the water works is
represented by the area (b+c) in Abb. 22.
This result can be derived also by a non-cooperative Nash game. Lets assume that
the property rights are given to the chemical plant.

51
 m arginal private m arginal external
A benefit (M PB) cost (M EC)

a f

F
*
b e
c d

E* E Emissions E

Abb. 22 Coases Theorem II

Table Abb. 23 summarizes the pay-offs each player receives. If there are no
negotiations the chemical plant gets a benefit represented by the area (a+b+c+d),
for the water works, the water treatment costs are represented by the area
(c+d+e+f). Note that, if only one player likes to get into negotiations, the other not,
the pay-off would be identical. In the case both players decide to negotiate the
chemical plant gets as private benefit the areas (a+b+c) plus the payment (d+e)
from the water works as compensation for reducing waste water emissions. For the
water works, the cost reductions in water treatment are represented by the area
(d+e+f), but the water works have to pay (d+e) as compensation to the chemical
plant. Hence water works net benefit is equal to the area f.
water works
no negotiation negotiation

no negotiation (a+b+c+d, -c-d-e-f) (a+b+c+d, -c-d-e-f)

chemical plant (a+b+c)+(d+e), (d+e+f) -
negotiation (a+b+c+d, -c-d-e-f)
(d+e)
Abb. 23 Game theoretic approach of the Coase theorem

Given the strategy, that is negotiate or dont negotiate , of the second player, the
first player has to choose his best answer, and vice versa. The resulting equilibrium
is called non-cooperative Nash equilibrium. It can be seen that the strategy
(negotiation, negotiation) is a Nash equilibrium. There is no incentive to switch to
a no negotiation strategy. But note: If one player choose as his strategy no
negotiation, there is no guarantee, that the Nash equilibrium (negotiation,
negotiation) will be reached, because the other player is indifferent, whether to
choose negotiation or no negotiation.
Often the Coase theorem is mentioned as a prisoners dilemma problem, but note
that this is not a prisoners dilemma problem, since the Nash equilibrium as
described above is Pareto efficient.

52
This results in the main criticism against the Coase theorem: Coase states, that
since a Pareto optimal solution exists, and both players are in an Pareto efficient
situation, they will end up in the Pareto optimum. Coase gives no answer to the
bargaining process.
In case of negotiation costs (i.e. transaction costs) , the game theoretic approach
shows that the (negotiation, negotiation) is a Nash equilibrium only if e > and e
> holds. That is, transaction cost must be sufficient small.
water works
no negotiation negotiation

no negotiation (a+b+c+d, -c-d-e-f) (a+b+c+d, -c-d-e-f- )

chemical plant (a+b+c)+(d+e)- ,
negotiation (a+b+c+d- , -c-d-e-f)
(d+e+f)-(d+e)-
Abb. 24 Game theoretic approach of the Coase theorem with transaction costs

In the real world numerous parties would be involved in such a bargaining process.
The costs of coming to an agreement may exceed its benefits very quickly. And the
expense involved in bringing many parties to an agreement is not the only
transaction cost. In addition (or part of the transaction costs) there are search and
information costs in finding the parties involved and informing them of exchange
opportunities. Costs for monitoring to ensure that agreements are kept, must be
beard, too. If these costs exceed the benefits, then the agreement will not happen.
In the case of most pollution problems, this is an insurmountable problem. It is
impossible for millions of people to reach a unanimous agreement on controlling
greenhouse gases.
Further, the Coase theorem fails in the presence of incomplete or asymmetric
information. If the claimant has no information on the extent of the damage, a
Pareto efficient outcome would not be reached.

Conclusion
The Coase theorem states that in the absence of transaction costs, externalities will
be internalised and results in a Pareto optimal outcome independent of any prior
assignment of property rights. A game theoretic analyses demonstrates, that the
Coase theorem did not deliver a solution for internalizing externalities, because
Coase did not analyses the bargaining process, but states the axiomatic Nash
equilibrium as the Pareto optimal outcome. The Coase theorem suffers from too
many practical and theoretical flaws to be considered a serious proposal for
environmental policy. Even if a few working examples could be found, they would
be extremely rare.

53
Ronald Coase
Ronald Coase (born December 29, 1910 in
Willesden, Middlesex, England) is a British-
American economist.
Professor Coase is currently Clifton R. Musser
Professor Emeritus of Economics at the University
of Chicago Law School. He has been affiliated with
the University of Chicago since 1964. Earlier he
served on the faculty of the Dundee School of
Economics and Commerce (1932-1934), the
University of Liverpool (1934-1935), the London
School of Economics (1935-1951), the University of
Buffalo (1951-1958), and the University of Virginia
(1958-1964).
He won the Bank of Sweden Prize in Economic
Photo: David Joel Sciences in Memory of Alfred Nobel in 1991.

Coase is best known for two articles in particular: The Nature of the Firm (1937),
which introduces the concept of transaction costs to explain the size of firms, and
The Problem of Social Cost (Coase, Ronald H. The Problem of Social Cost. J. Law &
Econ. 3, p. 1. 1960), which suggests that well defined property rights could overcome
the problems of externalities.
Coase's transaction costs approach is currently influential in modern organizational
theory, where it was reintroduced by Oliver Williamson.

54
References

Akerlof, George(1970): The Market for 'Lemons': Quality Uncertainty and the
Market Mechanism, Quarterly Journal of Economics, Vol. 84, S. 488-500
Bromley, Daniel W. 1991. Environment and Economy: Property Rights and Public
Policy, Oxford: Blackwell Publishers.
Coase, R.H. 1960. The Problem of Social Cost. Journal of Law & Economics, Vol
III, October,.
Hardin, Garrett 1968, The Tragedy of the Commons, Science 1968 162: 1243-1248

55
 Part II:

4 Environmental Policy Instruments: Targets

Learning objectives
In this chapter you will
learn the concept of pollution targets
learn the difference of flow and stock pollutants
understand the concepts of marginal damage and marginal abatement costs
learn to determine the an optimal pollution level

4.1 Introduction

The management rule No 3 from chapter 2.1.2 tells society the rate of emissions of
pollution should be no greater than the rate at which that pollution can be processed
or absorbed by the environment. As already seen, this seem not always a helpful
management rule. The problem of determining the level of pollution still exists.
Therefore, it is necessary to distinguish between stock and flow pollutants. This
problem is addressed in chapter 4.2. In chapter 4.3 concepts of determining the
optimal level of pollution are discussed. After the target level of pollution has been
chosen,

4.2 Flow versus stock pollutants

Environmental damages can be caused by stock and flow pollutants. Flow

pollutants cause environmental damage while they are being produced, and the
damage ceases when emissions stop or soon after. A flow pollutant is a pollutant
that the environment can absorb. Noisiness, for example caused by air traffic, stops
immediately after the aircrafts fly away or the airport will be closed. The emission
of sulphur dioxide SO2 and nitrogen oxide NOx accounts for human health

56
problems and acid rain1, which causes damages to vegetations in particular to
forests. Whereas the health problems caused by inhalation will cease soon after a
stop of both pollutants, the problem of acid rain is more complicated. It is not the
acid rain itself causing the damages, but it is the increased acidity in the soil which
causes the damages to the forests. The acidity in soil is caused by cumulating the
acid elements of acid rain. It is the size of this stock rather than the rate of addition
that causes the damage. Even in case of a total cease in emission of SO2 and NOx ,
the acidity in the soil will last for a longer time period, since the assimilative
capacity of the environment is less than the rate of emissions.
The latter problem is caused by stock-damage pollution. Stock-damage pollution
occurs where emission flows into the environmental media causes damages by
accumulation of pollutants. A stock pollutant is a pollutant that the environment
cannot absorb One example for a stock pollutant is carbon dioxide CO2. Carbon
dioxide is not a toxic element, it essential part of the earth's atmosphere, and
necessary for plants to produce oxygen. But CO2 emissions add to the total stock of
atmospheric CO2, which is the main cause of global warming, which is responsible
for further environmental damages like rising see level or increasing
desertification. It is not the flow of CO2 which causes the environmental damage,
but its the accumulated stock of CO2 in the atmosphere. An extreme case of stock-
damage pollution is that in which the assimilative capacity of the environmental
media is zero. This applies to a lot of heavy metals, like lead, mercury or cadmium
or to some synthetic chemicals like dioxin, PCBs or DDT. These pollutants reach
human bodies by means of the food chain, and causes health problems like cancer
or mental damages. Figure Abb. 25 summarizes different kinds of pollution.

flow into harmless form:

steam from a cooling tower

Emission flows flow pollution damage:

Economic into environmental
activity noise
media:
water, air, soil
stock pollution damage:
waste oil

Abb. 25 economic activity and forms of pollution damages

4.3 Optimal pollution level

As seen in the previous chapter, environmental damages occur because of emission

flowing into the environmental media. Why would this flows not be set equal to

1
Acid rain is caused by sulphur, released by burning fossil fuels, and nitrogen from the air.
Together with oxygen sulphur dioxide and nitrogen dioxide are formed. These diffuse into
the atmosphere and react with water to form sulfuric and nitric acids which are soluble and
mixed up with the rain.

57
zero to avoid any environmental damages? The answer to this question looks at the
first sight a little sudden: Pollution is beneficial! Pollution is produced not because
consumers want to have it, but for some technical reasons it is a by-product.
Producing desired goods and services come along with pollution. For example
producing electricity from fossil fuels comes along with the by-product carbon
dioxide. Reducing the input of fossil fuels for producing electricity, but to held
electricity production constant, other more expensive forms of electricity
production is needed.1 Thus, society benefits from the lower costs of burning fossil
fuels for power generation instead of using more expensive alternatives, like solar
energy. In this sense pollution is beneficial. On the other side pollution causes
damages, hence costs. Accumulated carbon dioxide in the atmosphere gives raise
to the greenhouse effect, which is assumed to result in rising see levels and more
hurricanes and tornados. Building higher dikes and rebuild destroyed buildings
costs money. Hence, this is the well known world of costs and benefits, economists
know to deal with. In a first step the optimal pollution level for a flow pollution
will be derived, followed by the determination of a stock pollution problem and the
last section deals wit a combined flow-stock damage problem.

4.3.1 Optimal flow-pollution level

From an economic perspective, problems of environmental damages arise because

the allocation of resources are not optimal. As seen in chapter 3 markets fail
because the costs of polluting activities do not fully reflect its harmful impact on
the environment. The upper panel in Abb. 26 shows a simple static version for a
flow pollutant, where E stands for the quantity of pollution emission per period,
B(E) for the total benefit from emitting the quantity of pollution emission E and
D(E) for the total damage done by polluting the quantity of pollution emission E.
Note that benefits as well as damages are depending only on the magnitude of
pollution flows. Hence, damage and benefit functions are simply:

Formel (14) Damages of pollution: D=D(E)

Formel (15) Benefits of pollution: B=B(E)

1
Note, if the alternatives would not be more expensive, they would be used for power
generation already

58
 B(E)
D(E)

total benefits
B(E)

total damages
D(E)
maximum net
benefits

Emissions E
MB(E)
MD(E)
dB dD
dE dE

marginal damages
MD(E)

*
marginal benefits
MB(E)

E* Emissions E

Abb. 26 Total and marginal costs and benefits

The slopes of both functions B(E) and D(E) as shown in Abb. 26 have the general
form often assumed for economic analyses. The damage or costs of pollution will
rise with the amount of emissions. Further it assumed that the damage or costs are
rising with an increasing rate.
dD d 2D
Mathematically: > 0 and >0
dE dE 2
dD
= D ( E ) is the marginal damage (or cost) function, labelled MD(E) in the
DE
lower panel of Abb. 26. The Marginal damage is increasing with increasing
emissions. As the level of pollution increases, the damages associated with the
marginal unit of pollution becomes larger and the rate at which they become larger
is increasing. The marginal damage function is upward sloping: Quantity matters!
An intuitive example of daily life will be helpful to demonstrate this: Drinking a

59
glass of whiskey a day may have no harmful effect on your body, drinking 1 bottle
a day may result to liver damage, drinking 2 bottles of whiskey you will become
addicted to alcohol und will be unable make your living by working, and drinking
3 bottles you might die due to alcohol poisoning.
The benefit function even will be upward sloping, but it will rise with a decreasing
rate as emissions increase.
dB d 2B
Mathematically: > 0 and <0
dE dE 2
dB
Again, = D ( E ) is the marginal benefit function, labelled MB(E) in the lower
DE
panel of Abb. 26, and the marginal benefit curve is downward sloping. The reason
for this is that pollution abatement costs depends on the emission level. If there are
no restrictions of emissions, that is, it is costless to pollute, a firms will produce at
the cost minimizing output level, emissions will be at maximum. Assume a power
plant, if there are no restrictions on sulphur, the sulphur emissions will be maximal.
To reduce a small amount of sulphur emissions a simple and cheap
desulphurisation plant will be sufficient. But to reduce the sulphur emission at a
larger amount a more sophisticated and therefore more expensive desulphurisation
plant is needed. That is, abatement costs rise with increasing level of emissions
reductions.
The principle of diminishing marginal benefits (utility) is well known from the
consumer preferences, the of something we consume, the less satisfaction we got
from additional consumption.
However, for some pollutants the damage and benefits functions might have
different properties.
The optimal pollution level is where net benefit, i.e. NB=B(E)-D(E), will be
maximal. This is at emission level E* in Abb. 26. The simple unconstrained
optimization problem is given by:

Formel (16) max NB = B( E ) D( E )

E

from the first order condition we get:

NB B D B D
Formel (17) = =0 =
E E E E E
Hence, the optimal level of pollution is given where marginal benefits of pollution
B(E) equals marginal damage of pollution D(E), i.e. graphically the intersection of
the marginal benefit curve with the marginal damage curve. This determines the
optimal level of pollution: E*. If society produces more emissions than E* than
marginal damages are larger as marginal benefits. A reduction by one unit of E
reduces the environmental damages at an larger amount (measured in money units)
as the reduction in the benefits, i.e. marginal damages decreases, marginal benefits
increase. Net benefits increase while reducing emissions. Conversely, if the
emission level is less than E* , marginal benefits are higher than marginal damages,
increasing emissions results in higher net benefit.
At the intersection of the marginal damage and the marginal benefit curve, the
optimal level of emission E* is determined. But even the value of marginal damage
and marginal benefit is determined. This value is given by * . Since in our model

60
there is no market, and hence, no market price for emissions, * is called a
shadow price. This price will become important discussing environmental policy
instruments in chapter 5.
While explaining the slope of the marginal benefit curve by abatement costs, an
alternative diagram is presented in Abb. 27. The abatement cost reflect the cost of
reducing pollution to a lower level, so that there are fewer damages. This cost
includes labour, capital and energy necessary to reduce emissions.

marginal damages
MD(E)

*
marginal abatement
cost MAC(E)
A B

E* E Emissions E
Abb. 27 Efficient level of emissions

Note that in general the marginal abatement cost curve could be identical to the
marginal benefit curve. But the marginal benefit curve might reflect other aspects,
not mentioned in the MAC, in particular opportunity cost from reducing the levels
of production or consumption.

marginal damages
MD(E)

D F
marginal abatement
cost MAC(E)
A B
C G
E' E* E'' E Emissions E
Abb. 28 Cost minimizing emission level

61
The economical optimal level of pollution again will be E*, where the marginal
damage (cost) curve MD intersects with the marginal abatement cost curve MAC.
It is the level that minimises the total costs of pollution which is the sum of total
abatement cost and total damages. Total abatement costs are represented by the
area B and total damages are represented by area A in Abb. 27, at the optimal
emission level E*. The area under the marginal damage, respectively the marginal
abatement cost function shows the total damages, respectively the total abatement
costs. That the sum of total abatement cost and total damage is minimal at the level
E*, can be demonstrated using Abb. 28. At emission level E, total damage are
represented by the area C. Total abatement cost are represented by the areas
A+B+D+G. Compared to the sum of total cost in the case of emission level E*,
which is represented by the areas A+B+C+G, total costs will rise by the amount
represented by area D. This is the efficient loss due to excessive abatement. An
efficient loss arise from too moderate abatement, for example at emission level E.
Total abatement cost are represented by the area G and total damages are
represented by the areas A+B+C+F. Compared to the optimal level E*, this results
in higher total costs, characterized by the area F. In Tab 8 these results are
summarized.

Emission level: E* Emission level: E Emission level: E

Total damage A+C C A+B+C+F
Total abatement B+G A+B+G+D G
cost
Sum A+B+C+G A+B+C+D+G A+B+C+G+F
Net effect +D +F
compared to E*
Tab 8 Total costs at different emission levels

4.3.2 Optimal stock-pollution level1

In case of a stock pollution problem the level of the pollutant in the environment
grows over time as the pollutant is accumulated. The pollutant cannot be absorbed
by the environment. As mentioned earlier, CO2 accumulated in the atmosphere
causing the greenhouse effect is an example for s stock-pollutant, since it needs
100 to 200 years to decay. The atmosphere can be seen as a sink for carbon
dioxide. Since the regeneration rate is very low, it takes up to 200 years to
regenerate the atmosphere, this problem is seen as a problem similar to non-
renewable resource problems. In case of a non-renewable resource, extraction is
taken out of a stock, whereas in the environmental problem emissions are put into a
sink. Regard, that recycling, for example in the case of copper, can be seen as some
kind of regeneration. This allows for the use of the same mathematical instruments,
i.e. optimal control theory.

1
A similar analysis can be found in Perman, R. et.al. (2003), chapter 6 and 16,

62
Dealing with stock pollution problems, time must be explicitly introduced into the
analysis. Environmental pollution becomes a dynamic process of accumulated
emissions generated by production or consumption activities. The decay of the
pollutants, which might be zero in case of heavy metals, occur by natural
processes, reflecting the environments self-cleaning or assimilating capacity.
As in the case of a flow-pollutant, benefits results from emitting the quantity of
pollution emitted at time t B ( Et ) . Alternatively. the concept of abatement costs
can be used. The next differences in a stock-pollutant problem is that damages do
not result from the flow of emissions rather from the level of accumulated pollution
at time t, hence damage is a function of the pollutant stock, D ( St ) . whereas the
symbol St stands for the level of the pollution stock at time t. Hence, damage and
benefit (or marginal abatement cost) functions are simply:

Formel (18) Benefits of pollution: Bt = B ( Et )

Formel (19) Damages of pollution: Dt = D ( St )

In addition to the flow-pollutant problem, which was an unconstrained

optimization problem, in a stock-pollutant problem, we have to solve a constrained
optimization problem. The constraint is given by the change in the pollution stock.
The stock of pollution at time t is given by the accumulated pollution minus the
self-cleaning capacity St whereas is a constant exponential decay rate.

t
Formel (20) St = [ Et St ]d
0

The initial pollution stock is given and non-negative:

Formel (21) St = 0 = S0 0

Equations Formel (20) and Formel (21) can be easily written as an equation of
motion for the pollution stock:

dSt 
Formel (22) St = Et St
dt
Again, damage is related to stock as an increasing and convex function of the
pollution stock:

Formel (23) D = D ( St ) with D ' > 0, D '' > 0

Note that this is a complex and difficult intertemporal problem: current emission is
beneficial today, but current emissions creates damages in the future.
For analysing the optimal level of pollution the concept of a social planner or an
environmental regulator will be used. His aim is to choose that emission time path,
that maximizes the present value of the aggregated stream of benefits less
environmental damages over an infinite time horizon. Alternatively, the regulator
could minimize the sum of total damages and total abatement costs. However,
using the maximizing net benefit approach, the optimisation problem is given by:

63

max B ( Et ) D ( St ) e t dt
Et
0

s.t.
Formel (24) S t = Et St
and
St = 0 = S0 , Et 0, for all t

where > 0 is the social discount rate. Hence, this optimisation problem is a
standard optimal control problem with the pollution stock St as the state variable
and the emission level Et as the control variable. The current value Hamiltonian
for problem Formel (24) is given by:

Formel (25) H ( t , St , Et , t ) = B ( Et ) D ( St ) + t ( Et St )

According to the Pontyagin maximum principle1 for problem Formel (24) there
exits an optimal path for the state variable , the optimal path for the control that
variable Et* and the co-state variable t satisfies the following conditions:

Formel (26) H ( t , St* , Et , t ) H ( t , St* , Et* , t ) , E

that is, Et* maximizes H ( t , St* , Et , t ) for all E , where is the set of all
admissible levels emissions.
The necessary condition for a maximum is given by:

H ! B
Formel (27) =0 + t = 0 B ( Et ) = t
E Et

Equation Formel (27) states that along an optimal path, marginal benefits must be
equal to the shadow price of one unit of pollutant emission t . This result
represents the static efficiency, as derived already from the flow-pollution problem.
However, the shadow price is negative since pollution is a bad
Note, that for a maximum the second order condition must be satisfied. Due to the
concavity assumption in problem Formel (24), the second order condition is
satisfied.
The next condition to be satisfied is:

H D
t = t t = t + + t
Formel (28) St St
t = ( + ) t + D ( St )

Equation Formel (28) gives the condition for dynamic efficiency.

The co-state variable t expressed shadow price for one unit of pollution emitted in
the environment. In case of a stock pollutant, the environment can be seen as a

1
For more details on optimal control theory, see e.g. Seierstad and Sydsaeter (1987)

64
waste deposit. The shadow price is just a measurement for the scarcity of the
environment as a waste deposit.
Furthermore, for the infinite horizon case the following terminal condition must be
satisfied:

Formel (29) lim t ( St St* ) = 0

t

The either the pollution stock must be at its optimal level S * or shadow price must
be zero. The latter case will be only effective is there would be no damages from
the pollution stock. The environment as a waste deposit would not be scarce.
Now the social planner (or the regulation authority) can determine the optimal
emission trajectory to the optimal level of the pollution stock using the equations
Formel (27) and Formel (28), and given the initial endowments.
But what can be said about the optimal stock level? The optimal stock level, once
reached should be sustained forever. Economically spoken, the search goes for the
optimal steady-state pollution level. A steady state is characterized by a stable
behaviour of the economic relevant variables. In this case it means that the
pollution stock should not change, once reached its optimal level. The pollution
stock can only be constant, when the emissions flowing into the stock are equal to
the decay rate.
The steady-state is given by:

Et
Formel (30) St = 0 0 = Et St St =

Since in a steady-state there is no change in pollution stock level, the shadow price
will be constant, too. Hence, Formel (28) can be written as:

D ( St )
Formel (31) ( + ) t = D ( St ) t =
+
Putting Formel (27) and Formel (31) together, results in:

D ( St )
Formel (32) B ( Et ) =
+
Formel (32) states, that marginal benefits of polluting activity must be equal to the
net present value of marginal pollution damages in a steady state. Marginal
damages are discounted at a rate, which is the sum of the social discount rate plus
the decay rate . The decay rate acts as a discount rate.
Rearranging Formel (30)yields:

B ( Et ) + B ( Et ) = D ( St )
Formel (33) 1
B ( Et ) + B ( Et ) = D ( St )

E
From Formel (30), S = , damages can be written as a function of emission:

D ( S ( E ) ) .Differentiation by using the chain rule of differentiation, yields:

65
 D S
D ( E ) =
S E
E
solving for S = , yields:

D 1
D ( E ) =
S
Hence, Formel (33) can be rewritten as:

D ( E ) = B ( E ) + B ( E )

respectively:

Formel (34) D ( E ) = B ( E ) 1 +

Given the values for the parameters and and the functional form for the
damage and benefit, the steady-state solution can easily be obtained.

Example

Let D ( S ) = S 2 and B ( E ) = 500 E E 2 and

= 0.2 and = 0.05
E
Inserting S = , we get

2
E
= ( 5 E ) = 25E
2
D= 2

0.2
D = 50 E
B = 500 2 E

Using Formel (34), we get : 50 E = ( 500 2 E )(1.25 ) . Solving for E:

50 E = 625 2.5E
2.5 E = 75
E = 30
E 30
And for S = = = 150
0.2
Steady-state emission level is 30 pollution units and the pollution stock will always
be at a level of 150 pollution units.

An higher social discount rate as well as a higher decay rate result in higher steady-
state emission level and hence in a higher pollution stock, and vice versa:
, E , S .

66
Given the decay rate will be zero, = 0 , obviously, no steady-state exists. Once the
steady-stat pollution stock level is reached, emissions ceased and pollution damage
will stay forever.
Once the steady-state level is determined, and given the initial conditions, the
optimal trajectory form initial conditions to the steady-state situation can be
derived. Recall the necessary conditions from the maximum principle (Formel
(27)and Formel (28)). Taking the time derivative of Formel (27) B ( Et ) = t ,
yields:

Formel (35) t = B ( Et ) E t
As noted earlier, a dot on a variable represents time derivative.
Substituting this in Formel (28) yields:
B ( Et ) E t = ( + ) t + D ( St )

Inserting Formel (27) gives

Solving for B ( Et ) yields the equation of motion for the emission:

B ( Et ) E t = ( + ) B ( Et ) + D ( St )

( + ) B ( Et ) D ( St )
Formel (36) E t =
B ( Et )

Formel (36) and Formel (22) are a system of two differential equation, which can
be solved.
Example (proceed)

Let D ( S ) = S 2 and B ( E ) = 100 E E 2 and

= 0.2 and = 0.05

E t =
( + ) B ( Et ) D ( St )
B ( Et )
0.25 (100 2 E ) 2 S
E t =
2
E t = 0.25E + S 12,5
And from Formel (22):
St = Et St
St = Et 0.2St

67
References

Bromley, D.W. (1995), The Handbook of Environmental Economics, Oxford.

Hartwick, John M./Olewiler, Nancy D. (1998), The Economics of Natural

Resource Use, 2nd ed., Reading u. a.: Addison-Wesley:

68
5 Environmental Policy Instruments:
Instruments

Learning objectives
In this chapter you will
learn the policy instruments to achieve an environmental target
learn to evaluate alternative policy instruments:
Command and control regulation
Charges and taxes
Pricing and standard approach
Emission permits
Liability laws

5.1 Introduction

In chapters 3 the necessity to internalize external costs were derived and in chapter
4 the optimal pollution level was determined. In a market economy with
decentralized decision making agents, and hence decentralized decision on
pollution, the regulatory authority has to impose pollution control instruments to
prompt polluters to behave in the desired way. In chapter 5.2 criteria for the
selection of pollution control instruments will be evaluated. Any policy control
instrument should be both effective as well as efficient. Effectiveness, that the
control instrument really have the intended effect. Efficiency implies that the
instrument should not only have the intended effect, but must be achieved at the
lowest possible costs. In the following section different pollution control
instruments will be presented and their effectiveness and efficiency will be
discussed.

69
 Environmental Problems

cause Market failure Gouvernement failure

regulation Bargaining
policy law Economic incentive
instruments instruments (no ow sufficient
low transaction costs)

Command
and Control liability rules price rationing quantity rationing tradable
property rights
(transaction costs)

Pigou tax tradeable permits

Price-standard
approach

Source: Ptzold (1996)

Abb. 29 Cause of environmental problems and choose of regulation instruments

5.2 Evaluative criteria

Effectiveness
The effectiveness of a pollution control instrument describes the success in
achieving the desired level of pollution. This criteria becomes more important for
flow pollutants, than for stock pollutants. For stock pollutants, a higher pollution
rate today can be compensate by a lower rate tomorrow. High noise destroys the
ear drum (tympanic membrane), therefore, it is important to restrain noise under a
harmful level, whereas it is not as important to reach a certain level of carbon
dioxide emission level in a given period, but only to restrict accumulated emission
level to the desired level.

Cost efficiency
A stated environmental target should be achieved by the lowest possible cost.
Comparing two different pollution control instrument, that one should be chosen,
that achieved the stated target at the lowest cost. Cost efficiency is a comparative-
static concept, ignoring dynamic effects. Cost-efficiency is also referred to as static
efficiency.

70
Conditions for cost-efficiency can be easily derived. Assume that there are
i = 1, 2,..., n polluters (e.g. firms). The emission level of polluter i is denoted by Ei ,
n
The regulation authority sets the total allowable emission to E = Ei . Without
i =1
max
any pollution control the individual emission level would be E . As already i
mentioned earlier, the benefit from emission is just the abatement cost. However,
lets assume that firms i abatement cost is given by K i (Vi ) , whereas Vi represents
the level of reduced emissions : Vi = Eimax Ei .
The total cost of reducing total emissions is given by:
n
Formel (37) K (V ) = K1 (V1 ) + K 2 (V2 ) + ... + K n (Vn ) = K i (Vi )
i =1

Regarding that the regulation authority wants set the level of emissions at E, that is
the level of emissions must be reduced by V, hence:
n
Formel (38) V = V1 + V2 + ... + Vn = Vi
i =1

The cost minimizing problem is given by:

n
min K (V ) = K i (Vi )
i =1

Formel (39) s.t.

n
V = Vi
i =1

The Lagrange function is given by:

n
n

L = K i (Vi ) + V Vi
i =1 i =1

Fro first order conditions we get:

K i
Formel (40) = for all i.
Vi

Formel (40) gives the condition for cost efficiency: Cost efficiency requires that the
K
marginal abatement costs MACi i are identical for all polluters i. again is
Vi
the shadow price for a unit of emission, it is the reduction in costs if the emission
ceiling would be relaxed by one (infinitesimal) unit.
In Abb. 30 two firms with different marginal abatement costs are considered. Both
firms would produce the same amount of emissions E1max = E2max , when there is no
pollution control. Compared to firm 1, firm 2 has higher marginal abatement cost
for reducing each unit of emission. The cost efficient (cost minimizing) solution is
given by MAC is equal to the shadow price . Firm 1, with lower marginal

71
abatement costs has to reduce V1 , whereas firm 2 has only to reduce the amount
V2 .

MAC MAC marginal abatement

marginal abatement
cost MAC1 (V1) cost MAC2 (V2)

V2 E V2 E
E2
max
E1 E1
max E2
Firm 1 Firm 2

Abb. 30 Cost efficiency conditions and different marginal abatement costs

The same result can be achieved arguing with benefits instead of abatement costs.
The maximizing problem looks as follows:
n
max U ( E ) = U i ( Ei )
i =1

Formel (41) s.t.

n
E = Ei
i =1

The Lagrange function is given by:

n
n

Formel (42) L = U i ( Ei ) + E Ei
i =1 i =1

The first order conditions are:

U i
Formel (43) = for all i..
EVi

Dynamic efficiency
Dynamic efficiency describes how the pollution control instrument will be able to
encourage polluters to invest in emission reducing technologies. That is, the
importance on the incentive to encourage R & D in environmental technology to
achieve emissions reductions at lower costs.

72
Flexibility
The criteria of flexibility focuses on the adjustment time needed to react to
changing environmental, social, technological or economical conditions.

Transaction costs
Transaction costs summarizes all costs directly and indirectly connected to an
pollution control instrument. Most important transaction costs are:
Enforcement costs, which are costs of making sure the other party sticks to
the terms of the contract and if this turns out not to be the case, taking
actions through the legal system (e.g. fine),
Monitoring costs, which are costs such as those incurred in observing the
behaviour of the agent and ensuring compliance.
Search and information costs, which are costs such as those incurred in
determining that the desired emission target,
Bargaining costs, which are the costs required to come to an acceptable
agreement with the other party to the transaction, drawing up an appropriate
contract, etc..
Common for all control instruments is the necessity, that emissions and/or ground
level concentration of pollutants or exposure can be monitored and can be
sanctioned in case of failing. Normally the transaction costs of enforcement and
monitoring would be the same for all control instruments.

Political and social acceptability

It is important how people understand, evaluate, and respond to the control
instrument imposed by the regulation authority. There are differences in social
customs and norms among regions or countries. Control instruments must be
culturally adoptable. For example, Scandinavian countries are less reluctant to the
imposition of higher taxes than Anglo-Saxon countries.

Tab 9 summarizes the selection criteria.

Criterion Description
Effectiveness Achieving the stated emission target
Cost-efficiency Achieving the emissions target with minimal costs
The instrument is a continual stimulant for agents (firms,
Dynamic efficiency
households) to act in the desired direction (R&D)
The instrument does not have a negative impact on
Equity
income distribution
The instrument can be adjusted when new information is
Flexibility
gained
Transaction costs The instrument does not generate high costs upon

73
 information demand
Political and social
acceptability
Tab 9 Criteria for the selection of a pollution control instrument

5.3 The traditional approach: Command and control

(CAC) regulations

Traditionally, environmental control instruments chosen were heavily dominated

by direct regulation commonly referred to as command-and-control (CAC)
approaches. Emission standards, that is setting bounds or limits on emissions per
quantity and per period, which might cubic metres (m3) air or water per a year or
even an hour period. For example, sulphur dioxide emissions, emitted by power
plants, should not exceed a 50 mg/m3 on a daily average. Emission standard can
also be imposed on limiting the maximal pollution level in an area (ground level
concentration of pollutants or exposure. An example is the ambient or ground-level
concentration., especially in urban areas. The environmental authorities can impose
a general ban on motorised traffic if for example ozone concentration exceeds 240
g/m3, microgram per cubic metres Hence, standards can be used for flow as well
as for stock pollutants.
In Europe, especially Germany, this is known as immission. The problem is, that
it is pronounced exactly the same way as emission. Immissons are defined as
disturbing effect on the environment done by emission, that is the arrival of
pollution from a remote source of polluting substances. Typical, what matters are
the immissions rather than the emissions, because it is the concentration of a
pollutant in an area or location which has harmful impacts. Thats, why the most
important law regarding reductions of emissions in Germany is called the Federal
Immission Protection Law (Bundesimmissionsschutzgesetz, BImSchG).
Setting emission standards using command and control regulations, requires a
penalisation scheme which must be credible. If polluters deviate from the specified
emission level, polluters have to pay a fine. Let p ( Ei ) the firm is probability to be
detected on cheating more emissions than allowed. In case that the probability that
cheating will be detected, is equal to one, emissions can be perfectly monitored.
The probability of detection is a function of excess emission, i.e. the higher the
excess pollution, the higher is the probability to be detected. The fine is given by Z,
which might be a lump sum fine or depending on the level of excess emission.
However, assuming a lump sum fine, the cost of cheating is given by: p ( Ei ) Z .
Let Vi ( Ei ) the abatement costs with respect to the emission standard Ei . As a
necessary condition for a credible punishment strategy set out by the regulatory
authority. the following inequality must be hold:

74
Formel (44) p ( Ei ) Z > Vi ( Ei )

Note, that the cost of cheating rises with higher monitoring activities p and/or
higher fines Z .

Technology-based standards
A technology-based standards approach specifies a particular abatement
technology that must be used by polluters. The regulating authority may require
firms to use the state of art or the best available technology for pollution
abatement. For instance, cars are required to have a catalytic converter, as pollution
control system. Technology-based standards may either specify a particulate
emissions control device or a process change to achieve pollution prevention.
Any command and control regulation imposing ceilings or bounds to emission
levels, means, that the allowable emission level can be seen as a costless
production input. Regarding allowable emissions as costless input, there is no
incentive reduce emissions further, since this is equivalent to waive a costless
production input. Hence, there is no incentive to invest in even existing
technologies, let alone the investment in R&D activities. For a lot of control
instruments regulation authorities impose different restrictions production facilities
regarding the vintage of capital. They often impose less restrictions on existing
facilities compared to new installed facilities. This too, is a hindrance in the
development for new technologies. It is less costly to use the old, but depreciated
machine, but high allowable emissions instead a new machine, with higher
emission standards. Therefore, it is better not to tell the regulation authorities, that
there is a new less polluting but costly technology available. This is known as the
Chief engineers cartel of silence1.

Criterion Valuation
Effectiveness Improvements to better environment can be achieved, but
total amount of pollution cannot be determined.
Cost-efficiency Impeding less costly alternatives, even when available.
Since it is unlikely, that all firms have the same abatement
costs, at least some firms will incur higher-than-necessary
abatement costs
Dynamic efficiency Impeding R&D activities, since firms may only use the
technology mandated by the government and fail to search
for less costly or cleaner technologies
Flexibility Less flexibility. Once a technology is embedded,
Transaction costs Low transaction costs, implementation by legal authorities.
Political and social High acceptance, since
acceptability

1
A phrase introduced by the German economist Holger Bonus.
See, Bonus, H. 1986, Reform der Umweltpolitik, pp. 355-361, in: Vaubel, R./Barbier, D.
(eds.): Handbuch Marktwirtschaft, Pfullingen.

75
Tab 10 Evaluating the criteria for technology-based standards

Performance-based standards
The regulating authority set uniform control targets for all regulated firms. This
may require polluting firms to decrease emissions of pollution by a particular
amount each period (year, month, day or hours) or require that firms not exceed a
particular level of emissions each period. Unlike technology-based standards firms
are given some choice over how the target is actually met.

Cost-efficiency and performance-based standards

Under a strict command-and-control approach in which standards are uniformly
imposed across different polluters, there is cost-inefficiency because those firms
with high abatement costs are forced to decrease their emissions as much as firms
with lower abatement costs. Both can be better of, if the firm with high abatement
costs reduce emission less than the firm with the low abatement costs, leaving total
emission reduction unchanged.
To demonstrate the cost-inefficiency of performance-based standards a simple two
firm model is used.
Assume two firms i = 1, 2 with different marginal abatement costs MAC1 < MAC2
for all abatement levels. The unconstrained emission level is given by: E1max = E2max
for both firms. Total emission in case of no abatement policy is given by 2 E max .
The regulations authority wants to reduce total emission level to 2 E 0 . To reduce
the emissions from E1max to E 0 firm 1 has to bear total costs presented by the area
A in Abb. 31. For firm 2 total costs are represented by the areas B+F+G in case
firm 2 reduces emissions from E2max to E 0 . It can be easily demonstrated, that this
is not cost-efficient. If firm 1 would reduce its emission to a larger amount, for
example to the new level E1 , total costs rise by the area C+D. To let total
emissions unchanged, firm 2 will be able to reduce its emission reduction to the
higher emission level E2 , that is, 2 E 0 = E1 + E2 . Firm 2 has now total costs of B.
The cost decrease for firm 2 is given by G+F, the cost increase for firm 1 is given
by C+D. As it can be seen, the areas C+D+H must be equal to the area F. Hence,
social benefit is given by the areas G+H, if firm 1 reduce more and firm two
reduces less emissions. Cost minimizing solution is given, where marginal
abatement costs are equal: = MAC1 = MAC2 .

76
 MAC MAC marginal abatement
marginal abatement
cost MAC1 (V1) cost MAC2 (V2)

2
D H
G

1
F B
C A
E E
0 0
E1 E E2
max max
E1 E E2
Firm 1 Firm 2

Abb. 31 Abatement cost and performance-based standard

A performance-based standard can be only cost efficient, if firms marginal costs

are identical. Alternatively, firms individual marginal abatement costs must be
known by the regulation authority, to set individual cost-efficient emissions levels.
Due to extremely high information costs, and firms have to reveal their production
technology, this is not practical. Furthermore, the regulation authority must
establish such standards with imperfect information about the costs and benefits of
pollution abatement, so it is possible for the costs of a particular standard to exceed
its benefits.

Criterion Valuation
Effectiveness More effective than technology-based standards, since the
desired total emission level can be allocated to individual
polluters. But reallocation is necessary, if new potential
polluters entering the market.
Cost-efficiency The performance-based standard is more cost-effective
than the technology-based standard. It allows each polluter
to follow its own self-interest by pursing the least costly
abatement method.
Unless polluters have the same marginal abatements costs,
performance-based standards are not cost-efficient..
Further, standards must be imposed with imperfect
information about the costs and benefits of pollution
abatement, so it is possible for the costs of a particular
standard to exceed its benefits.
Dynamic efficiency There is no incentive to go beyond the emission standard
set by the regulatory authority, but firms with high
marginal abatement costs may have incentive to invest in
R&D activities to find less costly abatement technologies.
Flexibility moderate flexibility, emission standards can be changed by
legal regulations.
Transaction costs low transaction costs
Political and social acceptance high

77
acceptability
Tab 11 Evaluating the criteria for performance-based standards

Emission standard are a useful control instrument in case that environmental

problems are so damaging that a total ban is necessary. For example, the ban on
chlorofluorocarbons (CFCs) used in air conditioning systems, which are known to
be potentially damaging to the ozone layer. International attention to CFCs resulted
in a meeting of world diplomats in Montreal in. The 1987 Montreal Protocol called
for drastic reductions in the production of CFCs. On March 2, 1989, the European
Community agreed to ban the production of all CFCs by the end of the century. In
1990, the Montreal Protocol was strengthened by calling for a complete elimination
of CFCs by the year 2000. By the year 2010 CFCs should be completely eliminated
from developing countries as well.
Standards can be set in situations where pollution is concentrated in particular
locations, so called pollution hot spots. Hot spots leads to greater pollution
damage than if the same total amount of pollution were more evenly distributed.
An example for hot spot problems are soot particle concentration, emitted by diesel
engines, in inner cities.

So, command and control policies are not totally useless, they can be useful in
some cases, especially when monitoring costs are very high, for example littering.
In this case make all littering illegal, if detected the pollutant has to pay a penalty.
The probability to be detected and to pay the penalty (fine) is the expected cost of
littering. If the expected costs of littering is higher then the expected benefit of
littering, littering will not happen.
In case of hazardous pollutants, like radioactive waste or CFCs, the level of
emissions should be at or near zero. This is represented by Abb. 32. Further,
command and control instruments can be sued in emergency situations, like smog
or ozone alert, particulate matter emissions, or forest fires (ban on fire).
damage;
cost
marginal
damage function

marginal
abatement cost

Emissions
Abb. 32 Optimal zero emission level

78
5.4 Price rationing: charges and taxes

An emission charge is a fee or a tax, collected by the environmental authority

levied on each unit of pollutant emitted. The economic ideas behind imposing fees
or taxes is straight forward: Because pollution costs the emitting firm or household
money, they seek to reduce the amount of pollution.
Besides taxes on emissions, taxes can be imposed on polluting inputs (taxing oil
rather than taxing carbon or sulphur), and on environmental damaging products
(cars, heavy metals). Similar to taxes are pollution abatement subsidies. Subsidies
can be interpreted as negative taxes, and result in an identical outcome in reducing
emissions. This can be demonstrated by using Abb. 33.
Assuming a given tax rate of or alternatively a subsidy rate of , with = .
Without any pollution control, an industry (or a single firm) the emission level
would be at E max . If an emission tax of is imposed, the industry would reduce
emissions from E max to E * , since at this level marginal benefit after tax is zero,
which means that benefit is at its maximum. Contrarily, if the industry reduces its
emissions from E max to E * , it will do this, only if it would be compensated by
for each unit abated. This compensation is the subsidy. Hence, both instuments
have the same effect on the abatement level. But they are different in their effects
on income distribution.
In the case of taxes, the industry has to bear extra costs of per unit of pollution,
whereas the industry gains additional income from an abatement subsidy. The
industry will reduce pollution as long as their marginal abatement costs (i.e. the
marginal benefit) is less than the subsidy for a unit of abatement. Total Subsidy for
the industry is equal to the areas a + b , i.e. E max E * , in Abb. 33. The areas
b represents the losses in profit for the industry, net gain therefore is represented by
the area a. An emission tax would cost the industry E * , i.e. the area
c + d + e + f . In addition to the tax payment the industry loses also profit due to
reduced output, represented by the area b.
Due to the net gain in the case of a subsidy, there is an incentive to enter the
industry and build up new production capacities, and hence more emissions. The
industry will be beyond the Pareto-optimal size. Further, before a subsidy is
implemented, the industry has an incentive to escalate the level of emissions in
order to obtain a higher benchmark level on which the subsidy is calculated.
Charges or taxes assume that the polluter has no rights to use the environment for
receiving emissions and is thus a charge for using property belonging to the
society. Whereas pollution subsidies assume that the polluter has the rights to use
the environment, and that the society has to compensate the polluter for not using
the environment.

79
MD
MB marginal benefit marginal damage
before tax/subsidy

=
e
c f
b
d

E* marginal benefit
after tax/subsidy
Abb. 33 Comparing pollution tax and pollution abatement subsidy

Environmentally related taxes are an important part of total tax revenue. The
figures below show total revenues from environmentally related taxes in per cent of
GDP and total tax revenues in OECD member countries respectively. In these
diagrams, taken from the OECD/EEA database on instruments used for
environmental policy and natural resources management
[http://www2.oecd.org/ecoinst/queries/], revenues from fees and charges are not
included.

80
 Weighted average
1995 2003
Arithmetic average
United States
United Kindom
Turkey
Switzerland
Sweden
Spain
Slovak Republic
Portugal
Poland
Norway
New Zealand
Netherlands
Mexico
Luxembourg
Korea
Japan
Italy
Ireland
Iceland
Hungary
Greece
Germany
France
Finland
Denmark
Czech Republic
Canada
Belgium
Austria
Australia
0 1 2 3 4 5 6
Per cent of GDP

Abb. 34 Revenues from environmentally related taxes in per cent of GDP

81
Arithmetic average
Weighted average 1995 2003
United States
United Kingdom
Turkey
Switzerland
Sweden
Spain
Slovak Republic
Portugal
Poland
Norway
New Zealand
Netherlands
Mexico
Luxembourg
Korea
Japan
Italy
Ireland
Iceland
Hungary
Greece
Germany
France
Finland
Denmark
Czech Republic
Canada
Belgium
Austria
Australia
0 2 4 6 8 10 12 14 16

Per cent of total tax revenue

Abb. 35 Revenues from environmentally related taxes in per cent of total tax
revenue

82
An OECD survey published in 1989 [2. Economic Instruments for Environmental
Protection, OECD Publications, Paris, 1989.] reported 150 cases of the use of
economic instruments (without in 14 member countries; of these, 80 involved
environmental charges or taxes, 40 were related to subsidies. And the other
economic instruments were instruments such as deposit-refund systems and trading
schemes.

5.4.1 The Pigovian taxes

A tax or charge is placed on polluters based on the actual or estimated damage (i.e.
external cost) to the environment. A damage function is used to determine how
pollution damage varies with the level of pollution emitted and what the monetary
value of the damage is. This is then related back to the activity of the polluter. The
damage function must be as complete as possible to be able to find the optimal
level of pollution. Arthur Pigou proposed a tax as a means of equating private and
social cost. The tax would be levied on each level of pollution (the marginal net
private benefit has to be paid on each unit of activity). The polluter then aims to
maximize the private benefits subject to the tax. The tax is in effect optimal
because it achieves the social optimal optimum. The level of tax would be set equal
to the marginal external cost (i.e. marginal pollution damage) at the optimal level
of pollution.

MD
MB marginal benefit marginal damage
before tax

marginal abatement
cost MAC

E* marginal benefit E
after tax

Abb. 36 Pigovian tax

The cost-efficiency can easily be seen. Firms assumed to minimize total cost, that
is, the sum form abatement coats K (Vi ) and the tax payment depending on the
actual emission level. Lets assume that the regulation authority impose a simple

83
unit tax, that is tax is proportional to emission level, hence Ei , with as the tax
rate. Emission level after taxation is just Ei = Eimax Vi , i.e. the difference between
the emission level without any pollution control and emission reduction. Firm is
cost function is given by:

Formel (45) Ci (Vi ) = K (Vi ) ( Eimax Vi )

Minimizing Formel (45) results in the first order condition:

Ci K i !
= =0
Vi Vi
Hence,

K i
Formel (46) MAC (Vi ) =
Vi

Firm i reduces pollution to the level, where the marginal abatement cost are equal
to tax rate. Formel (46) repeats the cost efficiency condition in Formel (40), with
= .

Firm 1 Firm 2
Abb. 37 Efficiency of a uniform tax on two firms with different technologies

The individual abatement efforts depend on the individual technologies and the
amount of the tax rate t. To reach the overall emission target E0 the tax rate has to
be adjusted by a trial and error process. This makes the implementation of an
effective tax rate time consuming. Especially since short term and long term price
elasticities of demand differs significantly. In the short run ( 1-2 years), firms or
consumers might not react to a large amount to the imposition of a tax for example
a tax on gasoline, since driving to and from work is necessary. In the long run (< 5
years), more energy efficient cars would be bought or alternatively, more and better
public transport system would be implemented.
The following table shows short run and long rum price elasticities of demand for
energy goods in the residential sector.
Products Short run price elasticities Long run price elasticities
Electricity - 0.030 -0.157
Natural gas - 0.102 -0.364

84
Motor gasoline -0.193 -0.600
Source: Liu 2004, p. 12
Tab 12 Estimates of price elasticities of demand for OECD Countries

Advantages and disadvantages of Pigouvioan taxes:

Cost-efficiency is guaranteed, because firms will reduce emissions as long as the
marginal abatement costs is equal to the tax rate:

K i
Formel (47) =
Vi

That is, marginal abatement costs are identical for all firms, regardless of the
individual cost functions. There is no incentive for firms to bargain over emissions,
because marginal costs are identical. This is not the case in setting standards, where
marginal abatement costs are different, and this gives reason for trading emissions.
Effectiveness is only given by a trial and error process, because it is not possible to
estimate the optimal tax in advance, due to sluggish reaction of polluters. This trial
and error process might be seen as a non-consistent environmental policy by tax
payers, and hence results in a deficiency of acceptance. On the other hand,
imposing a tax is relatively easy and has nearly no transaction costs. Dynamic
efficiency is given, since firms have always an incentive to reduce emissions. This
can be done by doing research and development activities in finding new
technology, which results in lower abatement costs.
But the main problem with Pigouvian taxes are, that it is nearly impossible to find
out the marginal net private benefit and the marginal damages costs. It follows that
one would not get an optimal solution by imposing the optimal taxes. One only will
find an acceptable level of pollution and taxes.
Tab 13 summarizes the valuation of a Pigouvian tax.

Criterion Valuation
Effectiveness Overall emission target can only be reached by adjustment
through a trial and error process.
Cost-efficiency Cost-efficiency is given
Dynamic efficiency Dynamic-efficiency is given.
Flexibility moderate flexibility, tax rates can be changed due to the
political process.
Transaction costs Besides the trial-and-error process, low transaction costs
Political and social acceptance moderate to high, traditional policy instrument
acceptability
Tab 13 Evaluating the criteria for taxes and charges

Arthur Cecil Pigou

85
 Arthur Cecil Pigou (born November 18, 1877
Ryde, Isle of Wight, died March 7, 1959
Cambridge, UK) was an English economist. Pigou
was a Professor of Political Economy at
Cambridge University from 1908 to 1943. In 1920,
he published the influential book The Economics
of Welfare. It formed the basis for modern public
economics. Pigou's view that taxes and subsidies
could be used to control externalities such as air
and water pollution have been implemented into
environmental policy.

5.4.2 Pricing and Standards Approach by Baumol and Oates

The Pigouvian tax allows for a Pareto-efficient solution for the determination of the
emission levels. However, this requires information preferences of all households
and the production technology of all firms, as well as all damages attributed to the
particular pollution. In reality these information are not available, hence a Pareto-
efficient solution, which is the first-best solution in theory, will be an illusion.
Baumol and Oates (1971), therefore, recommend that government should fix some
socially desirable level of pollution and implement this arbitrary environmental
standard with minimal overall costs. This results in a second-best solution. As the
Pigouvian tax, the pricing and standards approach is not able to enforce a given
emission standard E0. This only would be possible if the regulation knows how
individual emissions react to the tax. Again, the regulation authority has to adjust
the tax rate by a trial and error process until the overall emission target E0 is
reached. Therefore, the Baumol-Oates tax is regarded as a tool to achieve efficient
resource allocation in a limited sense. Under the Baumol-Oates tax, an optimal
pollution level is not guaranteed, because the tax rate is not set to be equal to
marginal damage cost. However, since all the polluters are expected to equalize
their marginal abatement costs to the tax rate, total abatement costs are minimized.
Therefore, the Baumol-Oates tax is regards as s second-best solution, since it is not
Pareto-optimal, but cost-efficient.
Taxes and charges are difficult to change within a short period and hence do not
deal well with short term crisis periods of severe environmental concerns. Taxes
and charges work well for pollution problems, when the ecological effectiveness is
not as important as it may be for hot spot problems. For example taxes and charges
are useful for emissions reductions of pollutants like CO2, SO2.
In case of hot-spot pollutants, it may be necessary to regulate activities beyond
taxes or charges, for example to impose a total ban on motor vehicle travel at
certain times for reducing ozone emissions.

86
 Angestrebter
Euro Standard

T2

T1

S2 S S1 A Ausma der
Schdigung
Abb. 38 5.4.2 Pricing and Standards Approach

William J. Baumol
William J. Baumol was born on February 26, 1922
in New York City. He received his BSS at the
College of the City of New York in 1942 and his
Ph.D. at the University of London in 1949. He is the
Harold Price Professor of Entrepreneurship and
Academic Director of the Berkley Center for
Entrepreneurial Studies in the Stern School of
Business at New York University; and senior
economist and professor emeritus at Princeton
University.

Wallace E. Oates

87
 Wallace E. Oates was born on March 21, 1937 in
Los Angeles, California Today he is a Professor of
Economics at the University of Maryland and a
University Fellow at Resources for the Future. He
received his Ph.D. in Economics at Stanford in
1965 and joined the faculty at Princeton University.
He began at Maryland in 1979. He teaches in the
areas of public economics and environmental
economics.
In numerous writings including The Theory of
Environmental Policy (1975, revised edition 1988),
with William Baumol, he studied the design and
implementation of taxes on polluting activities and
systems of tradable emissions allowances. He
worked on the design of regulatory programs for
pollution control with the U.S. EPA, the OECD, and
other federal and state agencies.

Criterion Valuation
Effectiveness Overall emission target can only be reached by adjustment
through a trial and error process.
Cost-efficiency Cost-efficiency is given
Dynamic efficiency Dynamic-efficiency is given.
Flexibility moderate flexibility, tax rates can be changed due to the
political process.
Transaction costs Besides the trial-and-error process, low transaction costs
Political and social acceptance moderate to high, traditional policy instrument
acceptability
Tab 14 Evaluating the criteria for the pricing and standard approach

5.5 Quantity rationing: marketable (transferable)

emission permits

Another market and incentive-based policy instrument are marketable permits, also
known as tradable or transferable permits. The owner of a permit has the right to
emit or pollute a certain amount, given by the permit. The total emission amount is
set by the regulator or the environmental agency and splittet up into individual
permits. If one polluter want to emit, he must have a permit regarding the level of
pollution, otherwise he has to buy additional permits.

88
There are two basic approaches to design of a marketable permit system. An
environmental authority can issue a quantity of permits for each receptor point
defined in terms of an allowed contribution of pollution concentration at each
point. This creates a separate market at each receptor point. A firm woupp0ld need
permits for all receptor points which it affects. This is known as the Ambient
Permit System (APS) and refers not to source emissions by to effects of pollution
at particular points. It can achieve a least cost outcome and is simple: it needs no
information on firm abatement costs. However, it can be cumbersome to polluting
firms as they have to have a permit for each receptor affected. As well, pollutants
with localized affects can create hot spots that do not coincide with designated
receptor points. Examples are pollution in a crowded city or the release of carbon
monoxide. This is also known as nonuniformly mixed pollutants. Here weight of
emission entering the system and where they enter (location) are both very
important.
The second method is the Emission Permit System. A region is divided into zones
and within each, sources would trade emission entitlements on a one-for-one basis.
This is simple for polluters but does not create a least cost solution. Polluters with
varying dispersions coefficient are aggregated in the same zone. One-for-one
trading does not take into account the differences in concentration. Thus, policy
measures simply focus on controlling the total weight of emissions in a manner
which minimizes the cost of control. Examples are greenhouse gases, chemicals
depleting the ozone layer. This is also known as uniformly mixed pollutants. The
damage caused by these pollutants depend on the amount entering the atmosphere.
It is insensitive to where the emissions are injected into the atmosphere.

Pollution permits may be issued in to ways:

1. by giving them away for free or for charge, orientated on actual or
historical emission level. This principle is known as grandfathering, or
2. by auctioning, where payments are revenue for the environmental agency.

Grandfathering
The governmental authority distributes the emission permits at no charge among
the polluters. The polluters are allowed to trade the permits in a free market. The
governmental authority has to choose a distribution rule, how the individual
amount of permits are distributed among the existing and new polluters. However,
for the moment assume, that this distribution rule is determined, for example
allocation is based on historical emission levels. But reduced to met the aggregate
desired emission level.
Typically, the initial allocation will not meet the polluters desired level of
emissions. Some polluters want to buy additional permits from the market.
Whereas others might sell some of their initial allocated permits. Whether to buy or
to sell permits depends on the individual marginal abatement costs. Polluters with
relative high marginal abatement cost will try to buy additional permits as long as
the market price for emission permits is less than their marginal abatement cost. On
the other side, some polluters will sell some of their initial allocated emission
permits, as long as the market price of emission permits is higher than their
marginal abatement cost. In a perfect competitive market, supply and demand for

89
would result in an equilibrium market price for emission permits and the amount of
traded emission permits. This is illustrated in Abb. 39. The number of traded
permits is less than the total amount of issued by the governmental environmental
authority, because trade only takes place for emissions permits as to adjust to the
desired level.

Supply of
permits

Demand for
permits

Emission
permits
Abb. 39 Market price of emission permits if initial allocation is free

Auctioning
In an auction, the emission permits will be sold to the buyers. For simplicity
assume, that an auctioneer collects the bids from the polluters. Note, that the
polluters will bit no more than their individual marginal abatement cost. When
ranked in descending order the resulting function can be interpreted as the demand
curve for emission permits. If there is a perfect competitive market, with no
strategic behaviour, the demand curve is identical to the aggregate marginal
abatement cost curve, as shown in Abb. 39.
If the total number of emission permits issued by the governmental authority it is
represented by the vertical line at the desired numbers of permits (identical to the
allowed level of emission) is given by M*, in Abb. 40, the market equilibrium
price is given by the intersection with the aggregate marginal abatement cost curve.
The market equilibrium price M would be identical to that which would be
emerged if emission permits would be allocated on an arbitrary basis with trade in
a free market, afterwards.
Regardless whether the initial allocation is done by grandfathering or auction, the
amount of aggregate abatement is the same, because it depends only on the total
numbers of emission permits issued. Even, the initial allocation has no impact on
the equilibrium emission permit price.

90


Marginal aggregate
abatement cost

Number of
permits
Abb. 40 Market price of emission permits if initial allocation is given

Grandfathering Auctioning

Regulation authority

Firms Others

Buy and sell

Markets for permits

Abb. 41 Permit distribution scheme: Grandfathering versus Auctioning

91
Criterion Valuation
Effectiveness The stated emission target is achieved by the amount of
permits
Cost-efficiency Cost-efficiency is given. But maybe disturbed by the way
of issue.
Dynamic efficiency Dynamic-efficiency is given. Firms want to minimize
costs, i.e. buying less permits.
Flexibility The amount of permits can be adjusted easily by buying
and selling.
Transaction costs In general low, but might be high in cases of exemption for
certain industries
Political and social moderate/high
acceptability
Tab 15 Evaluating the criteria for transferable permits

Tab 16 summarizes the evaluation for the main pollution controls.

Criteria CAC Regulation Market based instruments (MBI)

Tax or charge Tradable
Emission Permits
Static (cost) No Yes Yes, if market is
efficiency not too thin
Dynamic (cost) No, even contrary Yes Yes
efficiency incentives
Effectiveness No No Yes
Only with
complete
information
administrative Low Depends Depends on the
costs initial allocation
mechanism
Barrier to enty Standars for new Neutral Depends on the
ones, old one may initial allocation
be protected mechanism
Polluter pays Yes Yes Yes, if auctioned
principle
Politics of Risk of rent- Risk of opposition Neutral
implementation seeking behaviour if not refunded

92
Tab 16 Policy selection for important pollution controls

5.6 Environmental Liability Law

In general liability rules are related to property rights. If Pollution is regarded as a

private good, the liability is equivalent to give the property right to the injured
party of the damage. The enforcement would be done through civil law. But in case
where the pollution is a public good, an environmental agency or the government
ha to act in public interest, enforcing the liability rules on behalf of the injured
parties. The aim of environmental liability laws is to provide compensation for the
victims of environmental damages.
The economic impact of liability laws is not, that the injured party gets
compensation for the damage already occurred. The main economic objective is,
whether liability laws are able to induce potential polluters to take precautions
against environmental damages.
Guiding principles (e. g. in German liability law) are:
Causation principle (principle of causal responsibility):
The party responsible for an environmental damage is held liable for any costs
(problem: alternative causation, multiple causation)

Precaution principle:
The precaution principle aims at avoiding environmental damages and enables
authorities to intervene at any stage (i. e. not only when emission limits or certain
threshold values have been exceeded)

Cooperation principle:
The cooperation principle refers to the participation of all parties concerned
(private and public) in any decision making process in connection with
environmental issues. These parties (citizens, firms, environmental interest groups,
public administration) have to be heard during all planning proceedings and
admission procedures.

Two alternative liability rules can be distinguished:

Negligence rule:
A polluter is not held liable for a damage if he has taken "due care" (i. e. if he has
taken the legally stipulated technical precautions and has observed the legal
threshold values of emissions etc.)

Strict liability rule:

A polluter is held liable for an environmental damage whenever he has caused it,
no matter what precautions he has taken or if he has violated any threshold values

93
Under the negligence rule the environmental law the environmental liability law
can be in order with the traditional environmental policy instruments. All
instruments require the measurement and even some settings of emission limits.
But under the traditional environmental policies, the polluter pays always,
regardless whether the emissions cause any environmental damages. Whereas
under the negligence liability rule the polluter has to pay only if the emissions
cause a damage.
While under negligence liability rules the victim of an environmental damages
receives the payment as a compensation, most fines are paid to governmental
agencies.
Under the strict liability rule the external effect resulting form environmental risky
activities is completely internalized, because the polluter has to bear the whole
environmental risk of his action. Strict liability can be compatible with the
efficiency criteria. This is only for the negligence rule the case, if the governmental
authority knows the abatement costs and sets the individual emission limit
according to the efficient level.

One example of environmental liability rules is the European Union

Environmental Liability Directive (ELD), the ELD was agreed in April 2004 and
has to be implemented by April 2007 in EU member states..

The ELD is intended to implement the polluter pays principle. The thinking
behind the polluter pays principle is that by making businesses financially and
legally accountable for any environmental damage they cause, they will be more
cautious about what they do. It should prevent environmental harm and, if that does
not work, the costs of putting things right should be borne by those causing the
damage.

The ELD applies to business-related activities. It gives strict liability for harm to
biodiversity, water and land, arising from a list of regulated activities considered
potentially hazardous including:

- Genetically modified organisms

- Waste disposal and release of pollutants to water and air

- Water abstraction

It also gives fault-based liability for harm to biodiversity only from any other
activity, such as fisheries or forestry.

The business or person causing the damage would have to undertake (and pay for):

- preventive action without delay

- immediate clean up and control

- long-term remedial action

94
In Germany, the environmental liability law (Umwelthaftungsgesetz, UHG)
became enacted in 1991. Most critical in the use of the environmental liability law
was the causation principle. It was very difficult, to prove that a firm was indeed,
responsible for the environmental damage. Therefore, the law take of the less
restrictive strict liability rule. Figure Abb. 42 represents the causation principle in
the German environmental law.

95
 The damage can provably assigned to the polluting machinery

yes no

liability Is the polluting

machinery be able
to do the damage?

yes no

Causation principle no liability

Was the machinery in
compliance with the
law?

yes no

no liability Is the damage done

in case of proven by other sources?
causation: liability

yes no

no liability liability
Source: Feess 1998
Abb. 42 The German environmental liability law

96
Criterion Valuation
Effectiveness The strict liability rules results in an efficient outcome.
Whereas the negligence liability rule results in an efficient
outcome, only if the abatement costs are known and the
emission limit is set equal to the pareto-efficient level.
Cost-efficiency Cost-efficiency is given
Dynamic efficiency Dynamic-efficiency is given.
Flexibility No need for flexibility.
Transaction costs transaction costs could be low but maybe prohibitive high
for many types of pollutants.
Political and social high acceptance, because the polluter has to pay.
acceptability
Tab 17 Evaluating the criteria for liability rules

97
References

Baumol, William / Oates, Wallace (1971): The use of standards and prices for
protection of the environment, in: Swedish Journal of Economics, 73, S. 42-54.
W. Baumol and W. Oates. The Theory of Environmental Policy, Cambridge
University Press, Cambridge Ma., 1989.

Liu, Gang (2004), Estimating Energy Demand Elasticities for OECD Countries a
Dynamic Panel Data Approach, Discussion Papers No. 373, Statistics Norway

Ptzold, J. und G. Mussel: Umweltpolitik, Berlin, Sternenfels 1996

Joskow, Paul L./Schmalensee, Richard/Bailey, Elizabeth M. (1998), The Market

for Sulfur Dioxide Emissions, American Economic Review, 88/4, S. 669-685.
Schmalensee, Richard et. al. (1998), An Interim Evaluation of Sulfur Dioxide
Emissions Trading, Journal of Economic Perspectives, 12/3, S. 53-68.
Stavins, Robert N. (1998), What Can We Learn from the Grand Policy
Experiment? Lessons from SO2 Allowance Trading, Journal of Economic
Perspectives, 12/3, S. 69-88.

98
 Part III:

6 International environmental problems

Learning objectives
In this chapter you will
learn to why international environmental problems differ from national
environmental problems,
learn, who international cooperation can be enforced
see, how the climate change problem is an international environmental
problem and why it is difficult to receive an agreement.

6.1 Introduction

Many environmental problems are global like the climate problem or on a more
regional level like the sulphur problem. In international environmental Problems
many countries benefit from an emission reduction in one country, whereas the
cost is carried alone by the country that make the reduction. This gives raise to the
problem ho an international agreement can be achieved and sustained.

6.2 Co-operation versus non-cooperation

In case where a international environmental externality is unidirectional, the

country causing the environmental damage will ignore the damage its activities
impose on other countries. This is the so called non-cooperative outcome. If all
externalities are internalized, that is, the polluting country maximizes the net
benefit of all countries, including itself, the cooperative outcome can be found. The
difference between the (higher) cooperative outcome and the (lower) non-
cooperative outcome identifies the potential gain of cooperation.
Typically, the analytical tool to analyse the behaviour in an international
environmental setting where externalities spill over national boundaries is game
theory. Game theory is used in analysing situations, where the outcome of a action
by one agent (player) depends on the action of other agents (players). In
international environmental problems where pollution spills over boundaries,

99
pollution abatement actions done by one country will give benefits the own country
but also to other counties, too. Note, that it might happen, that there are no benefits
from abatement to the abating country at all, if the source of pollution is near the
boundary, for example, chemical industry is located along a river just before the
river crosses the border. Otherwise, if a country decides not to spend money on
pollution abatement, it can obtain benefits if other countries do abatement activities
on pollution.
The simplest form of a game can be described by a two-player (i.e. countries)
game, where each player can choose between either choose to pollute or abate. The
game is only played once. Both players are symmetric, they are have similar
pollution and abatement costs. Pollution abatement is regarded as a public good
and both countries get benefits out of it. Each countrys unit of pollution abatement
costs 15 units of money to the abater, but confers 10 units of benefit to both
countries. If both countries abate, each receives benefits of 20 units, i.e.net benefits
are 5 units each. The outcome or payoff are indicated in Tab 18.

country 2
pollute abate

pollute (0,0) (10, -5)

country 1
abate (-5, 10) (5,5)
Tab 18 Simple two-player pollution abatement game

Given the strategy of one country, i.e. pollute or abate, the best answer for the
second country is always choosing pollute. Hence, both countries end up in a
(pollute, pollute) equilibrium, known as the non-cooperative Nash-equilibrium. A
Nash-equilibrium is described by the situation were each player is doing the best
possible strategy, given what the others are doing. Or more formal: If there is a set
of strategies with the property that no player can benefit by changing her strategy
while the other players keep their strategies unchanged, then that set of strategies
and the corresponding payoffs constitute the Nash-equilibrium.

John Forbes Nash

100
 John Forbes Nash Jr. was born on June 13, 1928 in
Bluefield, West Virginia.
In 1948 Nash received bachelor's and master's degrees
in mathematics from the Carnegie Institute of
Technology, which is now Carnegie-Mellon University, in
Pittsburgh, Pennsylvania. Two years later, at age 22, he
completed his doctorate at Princeton University,
publishing his thesis Non-cooperative Games in the
journal Annals of Mathematics. He joined the faculty of
the Massachusetts Institute of Technology in 1951 but
resigned in the late 1950s after short periods of mental
Photo: The Nobel illness. He then began an informal association with
Foundation 1994
Princeton.

In 1994 he received the Bank of Sweden Prize in Economic Sciences in Memory of

Alfred Nobel as a result of his game theory work as a Princeton University graduate
student.

In the absence of any cooperation, each country will maximize ists own net
benefit. This is where the own marginal abatement cost is equal to the own
marginal benefit of abatement. In Abb. 43 this is at the intersection of the MAC
curve with the MBi curve. A* is the resulting level of abatement. This is the non-
cooperative Nash solution to the pollution abatement game. In case countries
cooperate, they want to maximize the global net benefit of abatement. Assuming
identical countries, global net benefit is just the sum of everys country net benefit.
In case of asymmetric counties, the problem of allocating the net benefit arises.
The global net benefit of abatement receives its maximum at which a countrys
own marginal cost of abatement os equal to the global marginal benefit of
abatement. The cooperative solution is given by the abatement level A** in Abb.
43.

Global marginal benefit of

abatement Own marginal
MB abatement cost
MAC

Own marginal
benefit of
abatement
MBi

A* A**
Abatement
Abb. 43 Potential gains to cooperation

101
Obviously, the cooperative solution demands greater abatement efforts, but results
in greater net benefit. Note, that the gain of cooperation depends on the slope of the
MBi curve and the MB curve. The larger the difference of the slopes, the more
difficult is the possibility to reach a cooperative solution, since this favours free
riding. Note, that the relative slope of the MBi and MB curve is determined by the
number of countries. The gain depends further of the relative slopes of the MAC
and the MBi curves.
The model described above allows only for to extreme solutions: cooperation or
non-cooperation. A third alternative is a partial cooperation solution: Some
countries agree to reduce pollution to a negotiated amount, other countries act
independently by choosing their individual abatement level. The Kyoto-agreement
is an example of such an partial cooperative solution. The feasibility to reach an
international agreement in climate gas reduction is described below. Before, some
institutional arrangements to reach collusive or cooperative behaviour are
discussed.

6.3 International agreements in climate gas reduction

Modelling the impacts of policy instruments to reduce the emissions of greenhouse

gases has become very popular in the recent years. The new generation of
Integrated Assessment Models AIM) incorporate the well-known global energy-
economic models, like OECD GREEN, Global 2100/2200 and the Edmonds-
Barns-Reilly Model, as one basic building block as essential part in a cost/benefit
analyzing environment. One drawback of the global energy-economic block in
computable general equilibrium models is that they are neglecting the dynamics of
policy instruments, the interdependencies of costs and benefits of mitigation
policies and hence the willingness of nations to participate in an international
agreement to reduce greenhouse gases.
Particularly, the behaviour of fossil fuel suppliers, acting strategically if confronted
by the threat of any measurements to reduced greenhouse gases, is purely
recognised in existing computable energy-economic models.
The aim of this chapter is to discuss some of the problems arising with the
consideration of dynamic and interdependencies within the context of global
warming modelling.

6.3.1 The greenhouse gas problem

The greenhouse problem can be characterised by the following features:

The damage is not caused by the flow of emissions but merely by the global
accumulated stock in the atmosphere. Therefore neither the region nor the time of
emissions (within a range of some decades) is relevant for the damage. This gives
the theoretical advantage, that a carbon emission tax or some kind of certificates

102
are reasonable instruments for environmental policy.1 The optimal time-path of
global emissions must be determined in such a way, that the greenhouse gas
concentration should not exceed a critical value and within which time period this
upper limit should be reached.
Not only the stock restriction for greenhouse gas concentration in the atmosphere
must be considered, even the exhaustibility of fossil fuel stocks, especially of oil
and natural gas, is essential for the determination of the extraction time path, and
hence the emission path of carbon.
On the other hand this peculiarity creates all possible problems of incentives of
international co-operation: The individual free-rider position both vis--vis other
regions or future generations is a severe impediment for any environmental policy.
Furthermore, the costs of mitigate greenhouse gas emissions in any country
depends on the response of other countries.
Since the damage is caused by the stock of greenhouse gas emissions we have very
long time horizons for the calculation of damages done by greenhouse gases.

This raises three further problems: First, since all these future damages can only be
calculated by means of some long-term simulation models there is a high degree of
uncertainty stemming from the unavoidable complexity of the models and the large
number of very uncertain parameters. Today we have reliable information only on
a certain range of substitution possibilities, technologies, demand reactions, etc.,
but the long term adjustments will probably go far beyond that range of known
parameters.
The second consequence of the very long-term structure of the problem is the
economic evaluation of costs of the reduction of greenhouse gas emissions today
(whose costs have to carried by people in the next decades) and the benefits in
form of avoided catastrophes or other losses far in the future. In other words: The
rate of discount and/or the degree of risk aversion vis vis potential catastrophic
events determine any good cost-benefit argumentation.
The third problem is the degree of confidence into the quality of modelling:
Whereas in many other areas, modelling can be understood as one helpful method
among others to a better understanding of complex problems, there is in fact no
alternative to modelling with respect to the very long run cost-benefit
considerations.

6.3.2 Impacts of different kinds of policy instruments

Existing energy-economic models typically takes a form of international agreement

among all countries, aggregated to several regions, to cut back emissions by some
percentage compared with a specific base year (Toronto type). Each region choose
a given policy instrument (mainly emission taxes) to reach this target. It is well

1
Since there is a uniform damage caused by each unit of greenhouse gases (and no
hot spots) all possible disadvantages of the Pigou tax or of tradeable permits are not given
here.

103
known that this gives not an efficient outcome. The reasons are twofold: First, the
same global reduction can be achieved at a lower costs through a different
distribution of regional emission reductions. Second, since the climate is affected
through cumulative emissions, an exogenously given reduction path is not cost
minimising. The time when a certain unit is emitted is not as important as
cumulative emissions are considered compared to current emissions.
The energy-economic models consider different types of policy instruments (but
largely taxes) to mitigate the problem of global warming but stipulates passive
behaviour of all agents. For example, the strategic and dynamic reaction of fossil
fuel suppliers are neglected in nearly all of the global energy-economic models,
like Global 2100, GREEN and the Edmonds-Reilly-Barns (ERB) model.
In general, the range of policy instruments to reduce the problem of global
warming is quite large.1 The world models, typically using the top-down approach,
have focused on a tax on the carbon content of fossil fuel consumption. Less
attention is made on tradable permits. In this world models it is assumed, that any
region chooses its policy instruments, in general this is the tax rate on the
consumption of fossil fuels, in such a way that an exogenously given emission-path
is met. This is only one kind of a tax regime. Alternatively, taxing energy
consumption or a combination of energy/carbon taxation is also possible. Another
kind of taxation would be to tax the production of carbon or energy and other
greenhouse gases. Whatever kind of taxation scheme is chosen, from the point of
view of a benevolent UN-planner a cost-effective solution is easy to implement.
But the distributional effects are quite different. The distributional effects are
essential for a country if it decides to join an international agreement or not. Due to
the exhaustibility of fossil fuels each producing country gets a so-called Hotelling
or scarcity rent. Any measure to reduce the consumption of fossil fuels will have a
rent extracting effect to the burden of the producer. To reach a great number of
participants in an international agreement, some form of side payments would be
necessary. Some computable world models allows for trade in emission rights to
capture side payments in their models.
Since the greenhouse problem is due to the level of concentration of greenhouse
gases in the atmosphere the problem of determining the optimal global emission
path is not trivial. One of the problems that should be solved is how fast the
concentration ceiling should be reached. Energy-economic models cant give the
answers to this specific problem. Integrated assessment models, connecting the
energy-economic models together with physical and climate models are necessary
to get an answer to this problem. Until now, the evaluation of different kinds of
policy instruments is done only under the consideration of a given emission path.
Due to the complexity of modelling the global warming problem most energy-
economic computable equilibrium models are static. One exception is Global
2100/2200 by Manne/Richels, which is a dynamic optimisation model, but has
shortcomings in modelling international trade and shows only five geopolitical
regions. But since the greenhouse gas problem is a stock- and not a flow-
restriction, static modelling yields to misleading results. It is already a very heavy
task modelling dynamic behaviour in an interdependency world 2, but incorporating
international negotiations into computable world models seems nearly impossible.

1
An overview will be given in the forthcoming Second Assessment Report of the IPCC,
Working group III, chapter 11.
2
A first approach is done by Fisher et al., 1994.

104
A variety of policy instruments to control greenhouse gas emissions could be
applied on multitude levels (see Abb. 44). In general, a tax regime or a system of
tradable emission rights could be implemented on the global as well as on the
individual level. But whateve level is chosen, the aim of any policy instrument is to
influence the behaviour on the individual level, i.e. households and firms, which
affect the atmosphere by their economic activities. On this individual level are the
decision making subject, deciding how much they would reduce their greenhouse
gas emissions or, alternatively looking for possibilities to avoid the costs of any
policy instrument. Especially a unilateral imposition of policy instruments on the
national level give raise to leakage effects. GHG-emitting industries will move
where environmental restrictions are less costly. Furthermore, some countries
might gain by attracting such kinds of industries. For example, fossil fuel
producing countries might invest in energy intensive industries and would become
large exporters of energy intensive goods. The extent of the leakage effect depends
on the number of participating countries in an international agreement to mitigate
greenhouse gas emissions and the kind of policy instrument chosen. The problem
how policy instruments affect the international trade pattern, and therefore give
raise to leakage effects and hence to the willingness to participate in an
international agreement, should be recognised and integrated in energy-economic
models.

world models

global level
international agreement

regional level region 1 region 2 ... region n

big suppliers
of fossil fuels
national level ...

group level ...

households,
individual level ... firms
leakage effects
bottom-up modelling

Abb. 44 Figure 1: Institutional levels for policy instruments

105
In the following paragraphs some policy instruments will be discussed shortly with
respect to the willingness to join an international agreement to mitigate greenhouse
gases.

6.3.3 Taxes

The basic idea of using a tax as a policy instrument to mitigate current and future
emissions of greenhouse gases is as follows: raise the price in such a way that the
demand for greenhouse gas emitting products will met a desired emission path. In
the case of a world-wide planner maximising a utility function, a optimal tax
scheme can be derived easily. In this case it is insignificant whether the tax is
imposed on the consumption or the production of greenhouse gases. But if we have
individual nations who have to decide how an optimal tax regime should look like,
then the question whether the tax should levied on the consumption or on the
production of greenhouse gases (or fossil fuels as the main source of greenhouse
gases) is of importance. In the former case the tax revenue would be collected by
consuming countries, in the latter case te tax would be collected by fossil fuel
producing countries. The distributional effect are total different. In the case of an
excise tax the burden falls totally on the producer countries as long as the supply
side is modelled as a perfect competitive market. Hence, market supply price have
to decline compared to a situation without any taxation. Imagine OPEC would
internalise a carbon tax at the wellhead, would the consumer countries join such an
agreement? On the other hand all models imposing taxes on the consumption of
fossil fuels.1 Why should OPEC participate in such agreement? Price for fossil
fuels would decrease drastically. OPEC could attract energy-intensive industries
from participating countries if it stay outside of an agreement.
This problem might be avoided if the tax would be imposed on both, on the
consumption and on the production of greenhouse gases or the total international
tax revenue, collected by some international institution, should be shared among
consuming and producing countries according to some redistribution rule.
However, this make an international agreement much more complicated.
Therefore, a world wide tax regime, covering all countries in an international
agreement seems very unrealistic.
The decision makers have to set the tax rate (independent whether the tax would be
imposed on consumption or production, independent whether carbon or energy
would be taxed) considering all the reactions of energy consumers over a period
covering the next 150-200 years. This would be political (lack of credibility) and
technical (no knowledge of the production function in 2100) infeasible. This
argument is valid whether the tax is implemented on a global or a national level.
Furthermore, a tax applied on the global level, reduces the range for national policy
instruments. If a tax is implemented on a global level, individual countries cant
choose other instruments.
Alternatively, instead of a global carbon tax, a domestic tax may be implemented
in two ways.

1
One exception is Whalley/Wigle (1991), who are analysing the effects of a tax imposed
on the procuction of fossil fuels.

106
First, each country choose its own tax rate to maximise its net benefit. In this case
tax rates will vary across countries due to different consequences of global
warming for different countries. Besides the problem of free riding, some countries
may act strategic in such a way to attract polluting industries from abroad and
benefit from leakage effects.
Second, a domestic tax is chosen to reach a given emission path. It is well known
that this is not cost effective (intertemporal and international) due to the non-
tradable quota character. Joint implementation may seen as an instrument to
enforce cost effectiveness. Or an alternative is to let the quota be tradable.

6.3.4 Tradable Permits

A tradable permit scheme imposed on the international levels allows individual

nations to choose among the total range of domestic policy instruments. Trading
permits lead to cost-effective allocation of emissions between countries, but the
amount of costs (price for emissions rights) are uncertain.
Incentives to participate in an international agreement to mitigate greenhouse gas-
emissions depend on the initial quota allocation scheme.1 Grandfathering and GDP-
weighted emissions are advantageous to the industrialised world, whose
greenhouse gas-emissions have reached already their maximum level. It is
disadvantageous to industrialising countries, whose greenhouse gas-emissions will
rise drastically (China and Far East), these countries wont participate. If such
scheme is implemented, greenhouse gas-emissions will decline over the next
decade, but in the long run one have to expect rising emissions from the non-
participating countries. A scheme of equal per capita emissions shows the opposite
effect, industrialised countries are more injured, due to high per-capita emissions,
than industrialising countries, with low per-capita emissions. A high free lunch
option will lower the costs for buying emission rights. Using Joint Implementation
results in lower costs in the short run, but might results in higher costs in the long
run, due to the delay of reducing emissions in early periods.
Therefore, economists should look how initial quota allocation regimes should be
designed such to reach an international agreement in which all individual nations
would participate.
To be cost-effective permits must be tradable not only among nations/individuals
but also over the whole time period. Note, for the concentration level it is
insignificant whether a unit of carbon is emitted today or in 50 years. There is no
institutional framework to guarantee the validity of such kinds of permits.
Therefore the emission path must be chosen in the first period, thereafter permits
can be emitted valid for short periods. The cost-effectiveness of the chosen
emission path depends on the number of participants in an international agreement.

1
In the case of carbon, one can have tradable permits on the use or on the production of
fossil fuels, resulting in different distribution schemes and in the case of limited
participation in an international climate agreement have different economic consequenses
(see Hoel 1992). Whether permits on the use or on the production of fossil fuels, there is a
rent extracting effect in both cases.

107
6.3.5 Joint Implementation

Joint Implementation is seen to reduce the cost of greenhouse gas-emission in

industrialised countries. Instead of reducing emissions in their own country,
industrialised countries invest in greenhouse gases emission reduction measures in
other - mainly developing - countries. The idea behind this is cost-effectiveness: To
reduce a given amount of greenhouse gases emissions in an industrialised country
costs much more than the same amount of reduction in a developing country. But
Joint Implementation is not a policy instrument designed for a global solution of
global warming. It might be a first step to implement an international tradable
permit system. But if such system is established market forces ensure cost
effectiveness. There will be no need for Joint Implementation.

6.3.6 Participation in an international agreement to mitigate

greenhouse gases-emissions

The aim of an international agreement to mitigate greenhouse gases is to achieve a

particular concentration target in such a way that cost-effectiveness is reached.
Such a target can be achieved by several ways. Abb. 45shows three alternative
individual greenhouse gases emission paths, A, B, and C.
The area under each emission curves is equivalent to the same net-accumulation of
greenhouse gases to time T, which might be some 150 years ahead. The aim is to
identify that emission path that minimises the costs of reaching the desired
concentration level. If a country has great potential for no-regret policies, a path
like C should be chosen. In case of only small no-regret potential and capital stock
rigidities, time path A seems more appropriate. The same is true for global
emission paths, a particular concentration target may be achieved by different time
paths of emissions, some more costly than others. World energy-economic models
can do so by mitigation measures taking place where it is cheapest to do so. But the
problem of burden sharing is ignored. Due to the problem of burden sharing, it is
much more complicated for a set of countries to select a global cost-effective
emission path than for a world wide planner. Individual countries or regions are
interested how the damages of global warming and the mitigation costs are
distributed among them. This might affect the willingness to participate in an
international agreement.

108
emissions

todays emission level

time
today 2150 T

Abb. 45 Alternative emission paths under the same greenhouse gases

concentration

Due to the global dimension of the greenhouse effect, all greenhouse gases
emitting countries should be participants in an international agreement. Even if all
countries gained by reducing global warming, it would be very difficult to reach a
global agreement. But if some countries would gain and other would lose, the
implementation of an international agreement becomes an enormous task. It is
necessary to explore the cost and effectiveness of different kinds of international
agreements to reduce greenhouse gases.1
As seen above, there is a variety of different emission paths achieving a desired
concentration level. But it might be that a certain emission path, like A, is in favour
of countries iA and will costs countries iC more than it benefits from greenhouse gas
abatement, these countries would prefer emission path C.

1
A first approach is taken by Edmonds et al. (1995). Using the Edmonds/Reilly/Barns
model, they are analyzing the effects of a uniform carbon tax, tradable permits and
individual national targets ( non-tradable permits) on the regional costs and benefits. Due to
the static structure of the ERB model it is assumed that participants in an international
agreement agree to hold emissions constant at rates equal to those at the time of initial
participation.

109
 GHG-reduction
over the next 10 years

leakage effect = 0
with leakage effect > 0

free lunch
options
probability of
0 1 n participation

Abb. 46 Probability of participation in an international agreement to reduce

greenhouse gases-emissions

The number of participating countries in an international agreement depends on the

amount of GHG reduction over a given time period. Figure 3 shows the probability
of participation in an international agreement to reduce greenhouse gases. The
black line in Abb. 46 shows the probability of an individual nation or region to
participate in an international agreement to reduce greenhouse gases emissions. As
long as there is a free lunch option it is plausible to expect that all n nations or
regions will join such an agreement. But if greenhouse gases reductions become
costly, nations whose discounted stream of cost compared to the discounted stream
of profits are higher, will not participate. If leakage effects are regarded, costs will
rise, and hence the number of potential participants decrease. Or, to reach the same
reduction level, the number of participants must be higher in case of leakage effects
than without, see the dotted line in Abb. 46.
What can economists say about the problem of participation and stability of an
international agreement?
It is necessary to analyse the cost and benefits (therefore we need integrated
assessment models disaggregated on national level or since this seems infeasible on
a regional level), each player would get as participant in such an international
agreement.
Although it easier to find out how much the cost are then to get the benefits, this is
complicated, too. First, each country has to bear the direct costs of abatement. A
second source of costs is due to the interdependence of costs of policy response
among countries. Any climate policy will affect the prices for fossil fuels and
hence the price for energy intensive goods. In case of decreasing fossil fuel prices,
non-participating countries might raise their greenhouse gases-emissions. This is
the well-known problem of leakage effects. Further OPEC member countries will

110
suffer from a decrease in oil price, which affects their willingness to participate in
an international agreement negatively.

6.3.7 Need for future research activities

The economics of the global warming problem is much more complicated than it is
recognised in the computable energy-economic models available today. New
approaches mentioned the greenhouse gas problem as a capacity problem for the
atmosphere, but the exhaustibility of the resource stock together with strategic
fossil fuel suppliers is still neglected.
The economic analysis of global warming policy response has not mentioned
enough the dynamics of the greenhouse gases problem, and hence the dynamics of
policy instruments. An other weakness in the economic analysis is in the
interdependence of costs and benefits of policy response among countries (see
Fisher et al., 1994). Furthermore, both problems should be treated jointly.
The new generation of models have to meet the following requirements:
Since the problem of global warming is a stock problem, countries should be
modelled as forward looking dynamic optimises.
Due to the important problem of participation in an international agreement,
leakage effects are essential. Hence, to incorporate international trade in the
models unalterable.
Furthermore, nations or regions should be modelled as strategic players,
maximising some utility function. The Nash-Cournot outcome should be
used as a benchmark for international co-operation or carbon coalitions.
The effects of different types of policy instruments on the participation in an
international agreement should be analysed.
Since this is an enormous task, economists may start to find some answers to the
following problems:
Empirical investigation: leakage effects depending on different schemes:
energy prices including greenhouse gas-measure in some regions, energy
prices without greenhouse gas-measure in other regions.
Distributional effects of various greenhouse gas instruments on big suppliers
of fossil fuels.
Confrontation of a dynamic perspective of world energy markets
(exploration and transformation process of almost sure reserves into
producing sources) with changed incentives from a global warming policy.
Market structure and competitive forces (competitive fringe with
significantly higher cost than OPEC-suppliers) in the oil and gas market via-
-vis a global warming policy.
Distributional effects of various global warming policy instruments with
different redistribution schemes on the regional or national level and
incentives to participate in an international agreement.

111
References

Blank, J. and W. Strbele (1995). The Economics of the CO2-Problem: What about
the supply side?. Discussion Paper,No. 147/95, University of Oldenburg.
Edmonds, J., M. Wise and D.W. Barns (1995). Carbon Coalitions, Energy Policy,
Vol. 23, No. 4, pp. 309-335.
Fisher, B.S., M. Hinchy and K. Henslow (1994). A dynamic game approach to
greenhouse policy. ABARE Conference Paper 94.2. Presented on the Tsukuba
Workshop 1994.
Hoel, M. (1992). Tradeable Emission Quotas for CO2: Quotas on Use of Carbon or
on Production of Carbon?. Working Paper 1992:1, CICERO, Oslo, Norway.
Richels, R. and J. Edmonds (1994). The Economics of Stabilizing CO2
Concentrations, Paper presented at the Tsukuba Workshop, 1994.
Whalley, J. and R. Wigle (1991). The international incidence of carbon taxes. in:
Global Warming: Economic Policy Responses, R. Dornbusch and J. Poterba (eds.)
MIT Press, Cambridge,Mass.

112
7 Cost benefit analysis1

Learning objectives
In this chapter you will
learn about the theoretical background of cost-benefit-analysis
learn the meaning and reason for discounting the future
learn how the stages of an actual cost-benefit analysis will be set out

7.1 Introduction

As already seen in previous chapters, zero pollution objective is not necessarily an

ideal policy. As shown in chapter4.3 to determine the socially optimal level of a
pollutant in the environment, is were the marginal abatement cost function (or
alternatively marginal benefits from pollution), which describes the costs to society
per unit of pollution reduced is equal to the marginal damage (or alternatively the
marginal social cost) function. In this case, the level E* is identified as the optimal
level of pollution as demonstrated in Abb. 47. Typically, we will find that when
pollution is high, incremental abatement is relatively inexpensive, but the cleaner
the environment, the more expensive it is to achieve further gains.

1
This chapter is mainly taken from the OECD study Cost-Benefit Analysis and the
Environment - Recent Developments. Paris 2006.

113
MB
MSC marginal social costs
of pollution

MB* marginal benefits

MSC* from pollution

marginal abatement costs

E* Pollution

Abb. 47 Optimal level of pollution: Marginal cost equals marginal benefits

In the case of private goods consumers will expand consumption as long as

marginal utility from consuming the good is less or equal the price of that good. On
the other side, producers will expand production as long as marginal costs are less
or equal the price attained. Pareto-optimality is given when marginal costs are
equal to marginal utility (i.e. price).If there are non-marketed benefits and costs
due to external effects and/or the good has a public good character, market price
doesnt reflect all costs and benefits. For this purpose cost-benefit analysis (CBA)
was developed. Typically used for public projects, CBA provides a systematic
method to specify all benefits and all costs.
Cost-Benefit Analysis (CBA) estimates and totals up the equivalent money value
of the benefits and costs of projects to establish whether they are worthwhile or
not. These projects may be dams or a oil pipeline through a natural wilderness.

The idea of this economic accounting originated with Jules Dupuit, a French
engineer whose 1848 article is still worth reading.

But the practical development of CBA came as a result of the impetus provided by
the US Federal Navigation Act of 1936. This act required that the U.S. Corps of
Engineers carry out projects for the improvement of the waterway system when the
total benefits of a project to whomsoever they accrue exceed the costs of that
project. Thus, the Corps of Engineers had create systematic methods for measuring
such benefits and costs. Earlier, the British economist, Alfred Marshal (1842 -
1924), formulated some of the formal concepts that are at the foundation of CBA.

7.2 Methods of costs-benefits analysis

The essential theoretical foundations of CBA are: benefits are defined as increases
in human wellbeing (utility) and costs are defined as reductions in human
wellbeing. For a planned project or policy to qualify on cost-benefit analysis, its

114
social benefits must exceed its social costs. The term society is simply the sum of
individuals in a certain region.
Various decision rules may be used for comparing costs and benefits. The correct
criterion for reducing benefits and costs to a unique value is the net present value
(NPV) or net benefits criterion. The correct rule is to adopt any project with a
positive NPV and to rank projects by their NPVs.
The notion of total economic value (TEV) provides an all-encompassing measure
of the economic value of any environmental asset. It decomposes into use and non-
use (or passive use) values, and further sub-classifications can be provided if
needed, see figure . TEV does not encompass other kinds of values, such as
intrinsic values which are usually defined as values residing in the asset and
unrelated to human preferences or even human observation. However, apart from
the problems of making the notion of intrinsic value operational, it can be argued
that some peoples willingness to pay for the conservation of an asset,
independently of any use they make of it, is influenced by their own judgements
about intrinsic value. This may show up especially in notions of rights to
existence but also as a form of altruism. Any project or policy that destroys or
depreciates an environmental asset needs to include in its costs the TEV of the lost
asset. Similarly, in any project or policy that enhances an environmental asset, the
change in the TEV of the asset needs to be counted as a benefit. For instance,
ecosystems produce many services and hence the TEV of any ecosystem tends to
be equal to the discounted value of those services.

Source: OECD, Cost-Benefit Analysis and the Environment - Recent Developments, 2006,
p. 87
Abb. 48 Total Economic Value

Cost-benefit analysis can be done:

Verbal: Listing and comparing costs and benefits and make a judgement on this
basis.
Quantitative: Measuring costs and benefits in physical units: material flow analysis
Monetary: Identifying, quantifying, and comparing the costs and benefits
measured in money value of a proposed policy action

115
The latter one is the most ambitious, but preferred method. The verbal method has
the disadvantage of a subjective valuation of environmental effects. The decision
maker has to make the value judgement whether a project harming the environment
should be realised or not. In case of realising the project, the negative
environmental effect (cost-benefit difference) would be valued less. But this
judgement is done by the political decision maker, not necessarily reflecting the
societys valuation.
The quantitative method can only be used in case of comparing alternative
projects. This can be done looking at CO2-emissions of different carriers in gram
per tonne kilometre as shown in Abb. 49. To carry one tonne of a good, one
kilometre, a barge emits 33.4 grams of CO2, a train 48.1 grams and a truck 165
grams. Obviously, the barge is the best alternative for transportation. But this
works only as long as the economic analysis results in the same order.

Abb. 49 CO2-emissions of different carriers in gram per tonne kilometre

Should the economic analysis yields another order, as shown in Abb. 50. Again as
with the verbal method, the ecological and the economical valuation must be put
together. Again, the political decision maker has to make the decision by her value
judgement.

Abb. 50 Costs of one tonne transporting goods from A to B

116
The third approach to CBA is to express the costs and benefits to be valued in
monetary terms. The procedures for doing this in case of benefits are described in
Chapter 10.

Source: OECD: Cost-Benefit Analysis and the Environment - Recent Developments, 2006,
p. 88
Abb. 51 Methods for valuing total economic value

7.3 The Problem of Discounting

Some advances have been prompted by the alleged tyranny of discounting the
fact that discounting has a theoretical rationale in the underlying welfare
economics of CBA, but with consequences that many seem to find morally
unacceptable. This unacceptability arises from the fact that distant future costs and
benefits may appear as insignificant present values when discounting is practised.
In turn, this appears to be inconsistent with notions of intergenerational fairness.
Current activities imposing large costs on future generations may appear
insignificant in a cost-benefit analysis. Similarly, actions now that will benefit
future generations may not be undertaken in light of a cost-benefit analysis.
The weakness of the conventional approach, which assumes that one positive
discount rate is applied for all time, is that it neither incorporates uncertainty about
the future nor attempts to resolve the tyranny problem. Additionally, the

117
assumption of a constant discount rate is exactly that an assumption. The
escapes from the tyranny problems centre on several approaches. First, many
studies find that very often (but not always), people actually discount
hyperbolically, i.e. people actually do use time-declining discount rates. If what
people do reflects their preferences, and if preferences are paramount, there is a
justification for adopting time-declining discount rates.
Second, there is also uncertainty about future interest rates: here it can be shown
that uncertainty about the temporal weights i.e. the discount factor is consistent
with a time declining certainty equivalent discount rate. Introducing uncertainty
about the state of the economy more generally can be shown also to generate time-
declining rates, if certain conditions are met.
Third, by positing the tyranny problem as a social choice problem in which
neither the present nor the future dictates outcomes, and adopting reasonable
ethical axioms can be shown to produce time-declining rates. In terms of the
uncertainty and social choice approaches, the time-path of discount rates could be
very similar with long term rates declining to the lowest possible rates of, say,
1%. But time-consistency problems remain and some experts would regard any
time-declining discount rate as being unacceptable because of such problems.
Others would argue that the idea of a long-run optimising government that never
revises its optimal plan is itself an unrealistic requirement for the derivation of an
optimal discount rate.
The key question is: How to choose an interest rate for reducing future costs to
give them a present value today?
Setting a general discount rate for new projects has important implications for the
environment:
- A low discount rate is often favoured by economists since they argue that
investing a high proportion of current income is a good way of providing
for the future
- A high discount rate may also be favoured since it discourages investment
(and by implication environmental damage) in the present
Most projects have lifetimes of 20-30 years with many of the big costs arising
early in a project e.g. from construction whereas the stream of benefits from a
project occur over a much longer period of time. But for many huge construction
projects, some of the costs only become apparent in the long run. Consider the
building of a new nuclear power station. Environmentalists would argue that there
is a long list of costs from waste management and decommissioning which stretch
over 100 years into the future whereas no social benefits exist to offset these costs
beyond year 30 or 40 (where the nuclear power station might reasonably be
expected to be ready for closure).
The value of decommissioning costs over 100 years away is almost negligible no
matter what discount rate we use. This makes discounting difficult to justify.

118
7.4 Stages of a cost-benefit-analysis

By conducting a well-executed cost-benefit analysis t it is required to follow a

logical sequence of steps. The first stage involves asking the relevant questions:
- What policy or project is being evaluated?
- What alternatives are there?
For an initial screening of the contribution that the project or policy makes to social
wellbeing to be acceptable, the present value of benefits must exceed the present
value of costs. Determining standing i.e. whose costs and benefits are to count
is a further preliminary stage of CBA, as is the time horizon over which costs and
benefits are counted. Since individuals have preferences for when they receive
benefits or suffer costs, these time preferences also have to be accounted for
through the process of discounting. Similarly, preferences for or against an impact
may change through time and this relative price effect also has to be accounted
for. Costs and benefits are rarely known with certainty so that risk ( defined as
probabilistic outcomes) and uncertainty (i.e. when no probabilities are known) also
have to be taken into account. Finally, identifying the distributional incidence of
costs and benefits is also of relevance.

119
References

Hanley, N. and C.L. Spash (1993), Cost Benefit Analysis and the Environment,
Edward Elgar, Cheltenham.
Johansson, P.-O. (1993), Cost-Benefit Analysis of Environmental Change,
Cambridge, Cambridge University Press.
OECD (2006): Cost-Benefit Analysis and the Environment - Recent
Developments. Paris
Pearce, D.W. (1986), Cost-Benefit Analysis (2nd edition), London, Macmillan.

120
8 The Economics of the CO2-Problem

Learning objectives
In this chapter you will
learn the environmental aspect of the CO2-problem
learn the resource aspect of the CO2-problem

8.1 Introduction

By now, every energy economist has understood what we call the greenhouse gas
problem (GHG). And facing the severity of the problem, the scientific community
has several computable general equilibrium models, which more or less uniformly
calculate some optimal tax rate especially for different sets of CO2-reduction goals.
Most of these models be-long to the class of so-called top-down-models. These
models dominate the discussions at international conferences and in the journals.
On the other side, very many energy economists point to existing, more or less
obvious, inefficiencies in real-life energy systems: by reducing these inefficiencies,
they offer a free-lunch for CO2-reduction. From this bottom-up analysis some
kind of no-regret-strategies are developed. Since both kinds of model builders
meet at the same conferences, it is astonishing to observe that communication
problems exist between them.

Marginal Marginal
damage cost

MD2

C1 C2 MD 1
A B
% reduction of
CO 2-emissions
over the next
100 years

Abb. 52 Qualitative structure of cost-benefit considerations

121
For a cost-benefit analysis we assume for the moment that both the damage
function and the cost function for reducing CO2-emissions can be found somehow.
Most energy experts would agree that in qualitative terms we may have a situation
like that shown in Figure 1.
The free lunch option takes into account the considerable net-benefit improvements
in an interval of some 10-20 % reduction of CO2 emissions (a move from A to B).
These improvements stem from:
Reductions of individual inefficiencies in firms and households.
Reductions of governmental subsidies and other policies, which currently
enforce the use of CO2-intensive fuels.
Additional positive external effects like reduced SO2- or NOx missions if
the burning of fossil fuels is reduced.
This type of improvement is the central concern of most bottom-up models,
showing in detail how and where such inefficiencies may be removed. Therefore,
typically, bottom-up models come up with rather cheap CO2 reductions. This
may be true for the first 10 - 20 % and for an intermediate time horizon of CO2
policy.
The reduction of CO2-emissions from B to C is costly in terms of GDP loss,
consumption loss or other economic categories. Global GHG models compute
some optimal shadow prices for necessary reductions. The shape and the position
of the marginal damage curve depend strongly on the assumed discount rate and
the time horizon of the calculation, and the fact that severe nonlinearities (such as a
significant and rapid change of the Gulf Stream in the northern Atlantic) do not
prevail due to the climate changes. Recent research results of natural scientists
cannot preclude such sudden events, which makes an economic evaluation in terms
of a cost-benefit analysis rather meaningless. Still, there is a lot of uncertainty
about the long-run damages: in economic terms we might therefore argue whether
the optimal point of CO2 reduction is C1 or C2 .

8.2 Specificity of CO2 as an environmental problem

Nowadays, it is well-accepted knowledge that the CO2 problem is a very specific

environ-mental issue. The main characteristics are given by:
There is no (reasonable) end-of-pipe technology preventing CO2
emissions. Therefore, the only way to reduce CO2 emissions is by
substitution either of fossil fuel by capital (including know-how) or by
fuels that are less CO2 intensive (natural gas, nuclear power, renewables).
The damage is not caused by the flow of emissions but merely by the
global accumulated stock in the atmosphere. Therefore neither the region
nor the time of emissions (within a range of some decades) is relevant for
the damage. This gives the theoretical advantage that a CO2 emission tax
or some kind of certificates are reasonable instruments for environmental
policy. On the other hand, this peculiarity creates all possible problems of
incentives of international cooperation: the individual free-rider position
both vis--vis other regions or future generations is a severe impediment
for any environmental policy.

122
 There is a one-to-one function between CO2 emissions and the burning of
certain types of fossil fuels (hard coal, brown coal, oil, natural gas). This
allows for a very simple form of taxation: one need not put a tax on some
measured CO2 emission but instead on the specific fossil fuel.
Since the damage is caused by the stock of CO2 we have very long time
horizons for the calculation of damage done by CO2.
This raises three further problems. First, since all these future damages can only be
calculated by means of some long-term simulation models there is a high degree of
uncertainty stemming from the unavoidable complexity of the models and the large
number of very uncertain parameters. Today we have reliable information only on
a certain range of substitution possibilities, technologies, demand reactions, etc.,
but the long term adjustments will probably go far beyond that range of known
parameters.
The second consequence of the very long-term structure of the problem is the
economic evaluation of costs of the reduction of CO2 emissions today (whose costs
have to carried by mankind in the next decades) and the benefits in form of avoided
catastrophes or other losses far in the future. In other words: the rate of discount
and/or the degree of risk aversion vis--vis potential catastrophic events determine
any good cost-benefit argumentation.
The third problem is the degree of confidence into the quality of modelling:
whereas in many other areas, modelling can be understood as one helpful method
among others to a better understanding of complex problems, there is in fact no
alternative to modelling with respect to the very long run CO2 cost-benefit
considerations.
From our point of view, we realize that well-trained environmental economist
makes use of a certain chain of reasoning, where he or she does not take into
account the following second aspect of the CO2 problem (for an excellent example,
see Barrett (1995).

8.3 Specificity of CO2 as a resource problem

Since the CO2 emissions to a large extent can be attributed to the burning of fossil
fuel, it is natural to ask: What determines fuel prices without a CO2 restriction and
what will be changed if some CO2 restriction has to be taken into account? This
question may be looked at from the point of view of the benevolent world-
economy planner or alternatively by looking at the mechanisms that work on the
markets for oil, gas and coal in the long run. The main problem of any modelling
effort will then be to put these two aspects, environ-mental policy
recommendations on the one hand and resource pricing on the other, together.
Since all, computable economic greenhouse gas models share one common feature
namely, the ultimate transition to a CO2 free backstop technology we will use
this elementary approach to clarify some theoretical arguments. We will start with
a very basic model where we assume, for analytical purposes, that there is a very
large potential of the atmosphere to accumulate CO2 without any damage to the
climate. Then the resource pricing is solely determined by the scarcity of the
resource from a finite stock. We assume that there is a net utility derived from
consumption, which is either C from fossil fuel or Z from a backstop technology.

123
The latter may be given by a large-scale nuclear or solar technology with constant
unit cost k. Then the planners optimization problem is given by:

Formel (48) [
max e rt U ( Ct + Z t ) k Z t dt
]
0

s.t. S t = Ct stock of resource

So > 0 given, St 0
k>0 given backstop cost
The Hamiltonian approach of dynamic optimization yields:

[ ]
H = e rt U (Ct + Z t ) k Z t tR e rt Ct
Formel (49) H
Ct =0 : U ' (Ct + Z t ) = tR
R
e rt
SH = t + r tR : tR = oR e rt
t

Boundary condition: S T = 0, TR = k .
The solution of this simplest type of model in the world of natural resource
economics is the well-known transition problem to a backstop-technology . The
price path in a competitive world of general equilibrium corresponding to the
optimal solution m is sketched in figure 2. The solution has two phases: First, all of
the resource stock is used up in finite time on a so-called Hotelling path (C > 0, Z =
0). Thereafter, we have the sudden transition at time T to the use of the backstop
technology in phase II (C = 0, Z > 0). In this simple model we do not have research
and development, putty-clay capital stock in energy production, exploration
activities to enlarge the initial (known) resource endowment, etc. All theses aspects
have been dealt with separately in resource economics during the past 20 years. But
the main message is clear already in this basic analytical framework: There is a
resource (scarcity) rent mR that is equal to the price of the resource in a perfect
competitive market. In the more sophisticated resource models this rent also
stimulates further exploration for widening the resource base. The rent then not
only equilibrates supply and demand over time, but also has a dynamic incentive
function. Of course, this ideal Hotel-ling logic is distorted by many factors in real
life energy markets . But for a long-run perspective most economists accept the
basic logic of the Hotelling principle. Even if we al-low for exploration activities or
some monopolistic or oligopolistic elements, the main arguments still hold in
qualitative terms, even, if we thereby get a modified price path over time.

124
 U'(C+Z)

U'(C+Z)

R R rt
= e
0

C+Z
C0 Z Phase I Phase II

Abb. 53 Price-path with transition to a backstop-technology without

environmental constraint

8.4 Resource pricing with an environmental constraint

Let us again for simplicity assume that we have a clear cut given upper limit for the
total acceptable accumulated stock of CO2, which will be given the letter M* in the
following model. If the fictitious UN planner has to take this upper limit into
account as an additional constraint, he or she has to solve the following
optimization problem:

Formel (50) [
max e rt U ( Ct + Z t ) k Z t dt
]
0

s.t.

S t = Ct stock of resource

M t = M t + Ct stock of accumulated CO2 = M

S0 > 0 , M0 > 0 given, St 0

k>0 given backstop cost

Mt M * CO2-constraint

125
The Hamiltonian of this modified optimization problem is given by:

Formel (51)

[ ]
H = e rt (Ct + Z t ) k Z tK e rt Ct + t e rt ( M t + Ct )
H
Ct
=0 (
:U ' Ct + Z ) = tK t

e rt MH = t + r t : t = o e ( r + ) t
t

K
e rt
SH = t + tK : tK = oK e rt
t

Only if the shadow price for using the atmosphere as a garbage storage (for CO2)
is zero (l = 0 for all times), i.e. we have no scarcity from there, we have the
coincidence of this modified model with the standard backstop model above. If the
additional constraint (M M*) is binding, then we have the situation drawn in
figure 3. From the point of view of the UN planner, we get a quite different price
path. The initial price (-l0 + m0 K) now consists of two components, which
actually describe two quite different scarcities: while there is still a scarcity rent
for the resource (given by mK), this is now much smaller than in the case above.
This stems from the fact that this scarcity rent mK is derived from the resource use
in phase III, where there is no longer an atmospheric CO2 restriction. In phases I
and II the price path is dominated by the CO2 restriction. This restriction is
reflected in the dynamics of l.
The institutional requirements for pricing of a global good like the use of the
atmosphere pose a difficult problem of their own and are quite different from
resource pricing. Contrary to stocks of resources, which are either owned by
countries or by companies, there are no individual property rights of the
atmosphere, or any other institutional frame-work to cope with the problem. This
raises the question:

126
 U'(C+Z)

U'(C+Z)
K
+

}0
}K0
C+Z t
C0 C* Z Phase I Phase II Phase III Phase IV

Abb. 54 Changing the (optimal) price path via an environmental constraint

If we do not have the benevolent UN-planner but instead decision makers in the
resource producing countries (oil and gas producers, coal producers, ...) and the
energy consuming countries, how can we implement a regime of resource
management over time, that to a large extent reflects the message of model II? In
fact, this message requires that the evaluation of fossil fuels is drastically changed
by the CO2 restriction: for all owners of fossil fuel stocks this additional restriction
means a heavy loss in terms of rent mR - mK : To some ex-tent the discovering of
the CO2 restriction means a partial expropriation of resource owners . The supply
side of fossil fuels matters essentially for the CO2 problem. The discusion has
shown that the economics of greenhouse gases necessarily must simultaneously
look at the problem from three perspectives: 1.Economics of natural resource
supply under a certain environmental restriction. 2. Environmental economics tells
us how to implement schemes to prevent free-riding or leakage effects. 3. Energy
economics tells us what will happen in the energy markets with respect to shifts
between the different types of energy sources and what kind of sectoral effects will
come up when a certain CO2 scheme is implemented. It will not be adequate to
look on some induced substitution process on the demand side energy, but
similarly important is understanding possible reactions of resource suppliers. As a
next step we therefore look into the different modelling efforts that were developed
in the recent years to cope with the CO2 problem, and how they solve this problem.
Some of these models are optimization models, using some kind of UN planner:
here we may ask, whether the supply side is modelled adequately. Other models try
to give a real-life picture of energy demand and supply mechanisms: here we may
ask whether, and eventually in which way, the rent-depressing effect of a CO2
policy is modelled.

127
References

McDonald, S.L. (1994). The Hotelling Principle and In-Ground Values of Oil
Reserves: Why the Principle Over-Predicts Actual Values, Energy Journal, 15 (3):
1 - 17.
Fankhauser,S. (1994). The Social Costs of Greenhouse Gas Emisisons: An
Expected Value Approach, Energy Journal, 15 (2): 157 - 184.
Golombek, R., Braten, J. (1994), Incomplete International Climate Agreements:
Optimal Carbon Taxes, Market Failures and Welfare Effects, Energy Journal, 15
(4): 141 - 165.
Manne, A.S., Richels, R.G. (1992). Buying Greenhouse Insurances, Cambridge,
Mass.
Nordhaus,W, (1991). The Cost of Slowing Climate Change: a Survey, Energy
Journal, 12 (1): 37 - 65.
OECD (1994). Reference Manual, Paris.
Watkins, G.C. (1992). The Hotelling Principle: Autobahn or Cul de Sac ?,
Energy Jour-nal, 13 (1): 1 -24.

128
9 Valuing the Environment

Learning objectives
In this chapter you will
learn to understand different methods for evaluation environmental goods
learn about the concept of the travel cost approach
learn about the hedonic pricing concept
to be introduced to the basic concepts of contingent valuation
and learn the drawbacks of the methods

9.1 Introduction

If a polluter makes an irreversible damage to a local natural site, the question, how
this damage can be determined in money value is of importance. What is the
damage done by an oil tanker run aground and spilling oil on the coast line and the
coastal ecology? If a local council has to decide whether to protect a recreational
area (forest) or to set up a residential area on this site, the value of the recreational
area must be determined. The value of environment can be looked by different
perspectives: The ethical view disputes about anthropocentric and non-
anthropocentric approaches. Whether environmental regulation should serve
human interests alone or should serve wider interests, e.g. plants, animals and
ecosystems, and if the ecosystem has a right of its own. The political view has to
deal with interests groups and their political power. This chapter focuses on the
economical view, and this implies an anthropocentric approach. To evaluate the
environment different methods for measuring the value of non-market goods are
developed. These methods can be distinguish between direct and indirect
methods.
Indirect methods are used if the value of the environment cannot be derived
directly, but indirectly from markets for related goods. People reveal their value for
an environmental good through the price of a related marketable good. Methods
using related marketable prices are travel cost method and hedonic pricing. In case
there are no observable related market prices, methods like conjoint analysis or
choice models can be used. In these methods, people are asked what combination
of a limited number of attributes (state of the environment) is most preferred. Each
combination has set of attributes and a price.
Direct methods must be used if there are no related goods. The simplest case is, if
the environmental good has an observable market price. But if the price is not
observable, the people must be asked directly about their value for the

129
environmental good. All of these direct but not observable, therefore hypothetical,
methods are known as contingent valuation.
Another distinction can be made whether the valuation could be done based on
actual market behaviour or whether behaviour is not observable and therefore
hypothetical scenarios must be used instead. Such data is obtained through
respondent's statements of preferences for hypothetical products. Therefore,
evaluation methods using hypothetical approaches are called stated preference
methods, whereas methods using observable behaviour are called revealed
preference methods.

Revealed preference approaches Stated preference approaches

Based on actual market behaviour Based on hypothetical scenarios
Response to new alternatives cannot Preferences for new alternatives can be
predicted directly educed
Attributes are correlated Attributes uncorrelated by design
Tab 19 Revealed vs. stated preference aproaches

An overview is presented in Tab 20.

Method Observed Behaviour Hypothetical

Direct Market price Contingent valuation
Simulated market
Indirect Travel cost Choice models
Hedonic prices Conjoint analysis
Source: Tietenberg (2006), p.38
Tab 20 Classifying environmental evaluation methods

The most important methods will be discussed below.

9.2 Revealed preference methods

9.2.1 Travel cost method

Travel costs methods are among the oldest environmental valuation techniques.
They first were used in the USA for valuating national parks, especially for
planning and managing outdoor recreation activities, like cross country skiing,

130
hiking, canoeing etc. Since these activities are provided at a low or zero price, the
question the national park managers were confronted was, how could the economic
value of such activities be measured. The idea behind the travel cost method is
simple; every user pays a price measured by her travel cost. The consumers
surplus can easily derived from integrating all visitors travel costs. The travel cost
method assumes a weak complementarity between the environmental good and
the expenditure for consuming this environmental good. Typical such
environmental goods have a high aesthetical value and/or a high recreational value.
To use these environmental goods, people have to travel to these areas and they to
bear the travel costs from their home to that area. Travel costs include
transportation costs, admission charge, but also the time for travelling and for
visiting that environmental good. The travel cost method was first proposed in
1947 by Harold Hotelling in a letter written to in a letter to the director of the
National Park Service. Asked how to measure the economic value of national
parks. Hotelling stated that people usually have to travel considerable distances and
thereby bear money costs. People will travel to a national park as long as their net
satisfaction from visiting the park is positive. Hence those visitors with the largest
distance travelled, will getting zero net satisfaction, i.e. the value of the park is
equal to their transportation costs. All visitors with less distance get a surplus, all
visitors with a larger distance would get a net loss, hence they stay at home.

9.2.2 Hedonic Pricing

Hedonic1 pricing techniques are based on the assumption that agents value the
characteristics of a good rather than the good itself. Hedonic models use market
data like prices and then break down the data into its components or characteristics.
A chance in the level of these components or characteristics can reveal the prices
(value) of these components or characteristics. Typically hedonic pricing methods
use property values as a source of information for valuing environmental goods.
For example, assume that two houses are offered on the housing market. These
houses are totally identical, everything is the same, but these houses are located in
different neighbourhoods. Would these two houses receive the same price? This
would only be the case, if all the characteristics of the neighbourhoods would be
identical, too. Neighbourhood characteristics with influence on the house price are
local infrastructure, like shops, pubs, public traffic, schools, libraries etc, but also
such thinks like crime rate or average income. Besides these socio-economic
characteristics, environmental characteristics can be found too: air quality, noise
from a nearby airport or highway, open space nearby, distance to a local landfill
etc. The hedonic pricing method assumes that peoples valuation of environmental
components can be derived from the amount of money they are willing to pay for
theses components through the housing market. Typically, a house in a air polluted
neighbourhood will receive lower prices on the housing market than a house in a
clean neighbourhood. The problem is to calculate the impact of one characteristic
on the price of the good, here the price of housing. The statistical technique used to
solve this problem is known as multiple regression analysis. These techniques are
used to find out the hedonic or implicit price for each component. Therefore, the

1
Hedonic comes from the Greek word hedone and means pleasure, enjoyment

131
consumer surplus corresponding with variations in, for example, air quality can be
estimated.
To proceed the hedonic price technique, first data on house prices and/or rents p j
must be collected, along with data on site characteristics, Si (number of rooms,
room sizes, lot size etc), the neighbourhood characteristics, N i (crime rate, number
of shops, etc), and the environmental characteristics, Ei (air quality, scenic view
etc).
Thus the price of a house j can be described as follows:

Formel (52) p j = p ( Sij ,..., Smj ; N ij ,..., N nj ; Eij ,..., Eqj )

The price of house j is determined by the m elements of the site characteristics, the
n elements of the neighbourhood characteristics and the q elements of
environmental characteristics.
Figure xx demonstrates the effect of better air quality. If the air quality rises from
E1 to E 2 , the prices for housing will increase from p1 to p 2 . The price change
represents the value of the characteristic air quality.

House prices

p2

p1

E1 E2 Air quality

Abb. 55 House prices as a function of air quality, other things being equal.

The hedonic pricing techniques can only be used for environmental goods, which
are linked to the particular market, i.e. the housing market. For carbon emissions
resulting in the greenhouse effect, the hedonic pricing method will not work.
Future changes in the characteristics will have a bias on current prices. If an air
polluting plant will shut down in a couple of years, housing prices reacts already
today.

Similar to the hedonic price approach is the hedonic wage approach. The latter is
based on the idea that an individual will choose the region or city in which she
resides in order to maximize her utility. The decision to reside in a certain city or

132
region is determined by a bundle of positive and negative factors. Wages adjust to
compensate people for negative city/regional characteristics. If there is a choice to
choose to live in a sunny and warm weather city or to live in a cold and rainy
weather city, normally, people will choose to live in the sunny and warm weather
city. Labour supply in this city will rise, wages will go down. For living in the cold
and rainy city, workers must be compensated by higher wages for their willingness
to reside in that city.
The hedonic wage approach is less appropriate for measuring environmental
values. Wages are less flexible than housing prices; wage might be regulated by
(nationwide) union agreements.
Therefore, the hedonic wage approach can be used in calculating individual risks.
Workers in risky (health) occupations, for example working with toxic substances,
demand and get higher wages for taking on the risk.

Revealed preference methods, like the travel cost approach and hedonic pricing can
only estimate the use value of the environment, and only if the environmental value
has a measurable impact on peoples behaviour. Revealed preference methods use
peoples actual behaviour as a base for environmental valuation.

9.3 Stated preference methods

9.3.1 Conjoint Analysis and Choice Modelling

Conjoint analysis and choice modelling are stated preference techniques for
decomposing preferences into the contribution of each of a number of attributes.
Both methods can be used for prediction in situations where prices are not
observable and cross-section or time series regression models are not working.
Conjoint analysis and choice modelling address these problems by using an
experimental design to vary the attribute levels across hypothetical environmental
states which can be described to survey respondents. Respondents are being asked
a series of questions about their preferences for alternative alternatives
environmental states on the basis of selecting the alternative which results in the
highest utility. The idea is that an environmental good can be broken down into its
attributes. A natural park can be described by the number of trees, the age of the
trees, the diversity of its inhabits, diversity of recreational activities. Each of these
elements making up a generic natural park is known as an attribute.
In a conjoint analysis the respondent ranks a list of combinations of environmental
attributes into preference order. Statistical techniques are used to get the
relationship between attributes and preferences. If one of the attributes is price, it
would be possible to use the resulting preference function to derive the willingness
to pay for changes in the levels of the attributes.
In a choice modelling study, each respondent evaluates a set of environmental
states and indicates which one would be chosen. The alternatives are described in
terms of a common set of attributes, called choice sets. The choice sets are
differentiated one from the other by the attributes taking on different levels. This is

133
repeated several times for different choice sets. The aggregate choice frequencies
can be modelled (usually multinomial logit) to infer the relative impact of each
attribute level on choice. Respondents choices of their preferred alternatives
demonstrate their willingness to give up one attribute against another. If one of the
attributes used to describe the alternatives has monetary value, it is possible to
estimate the respondents willingness to pay for additional non-market
environmental benefits. Tab 21 shows an example of an choice modelling
questionnaire.

Option A Option B Option C

(status quo)
Park size 1,000 km2 800 km2 600 km2
No. of wildlife species 60 50 30
No. of recreational activities 4 4 8
Jobs 20 18 50
Cost as tax increase per household 30 25 20
Choose your preference; O O O
Tab 21 Choice model for valuing a natural park

9.3.2 Contingent valuation

The methods above assume that the environmental good can be used directly: The
travel costs methods assumes, that people use the recreational area, and hedonic
pricing assumes, that environmental goods are characteristics of a marketable good.
But what about environmental goods, which are not directly used, but which values
are associated with more intangible use of the environment, like aesthetic aspects
or benefits from the existence of environmental goods. Even if not using the
Amazonian rain forest, people in Europe might give it a value of its own, just for
its existence.
The simplest version of a contingent valuation method just to ask respondents to
state their maximum willingness to pay for an environmental quality improvement,
which is called an open-ended question form. Another form of question is called
an close-ended question, respondents are asked whether they would be willing or
not to pay a particular amount for an environmental quality improvement.
An example of an open-ended question could be the following one:
The trees in the nearby forest must be cleared to finance the local kindergarten by
selling the wood on the market. Alternatively, local residents have to by a
surcharge on their local council tax. What is the maximum that you be willing to
pay per capita per year for not clear cutting the forest?

The close-ended question could be as follows:

134
The trees in the nearby forest must be cleared to finance the local kindergarten by
selling the wood on the market. Alternatively, local residents have to by a per
capita on the local council tax. What would you be willing to pay per capita per
year for not clear cutting the forest? Please mark:
< 80 O
80-89 O
90-99 O
100-109 O
> 100 O
A more severe version of a close-ended question is just to ask whether or not to
accept a given proposal, that is, a take-it-or-leave-it question.
Alternatively, bidding games can be used too. As long as the respondent agrees to
accept a payment for better environmental quality, the payment will be raised. The
bidding game ends, when the respondent refuses to accept the offer. His
willingness to pay is determined.
In the questions above the maximum amount an individual would be willing to pay
(WTP)to secure the environmental quality improvement, alternatively people could
be asked to state the minimum amount they would be willing to accept (WTA) to
forgo the environmental damage. There are two main types of question for the
valuing environmental quality : What is the maximum amount of money you
would pay for the environmental good if it saved or restored?; this elicits the
(hypothetical) willingness to pay (WTP) or maximum buy-price. The opposite of
this question is: What is the minimum payment you would accept as
compensation for the good if that good is sold or destroyed?, eliciting the
(hypothetical) willingness to accept (WTA) or minimum sell-price. Furthermore,
people can be asked whether the utility level should be unchanged, that is whether
the environmental quality should be unchanged (case A in Tab 22) or if the damage
already occurred, they should be compensated (case D). Alternatively, people can
be asked to assume that the environmental damage has taken place (ex-post), and
how much they would be willing to pay to reach the actual environmental quality
(case B) or how much compensation they would be willing to accept for the
foregone environmental quality (case C)

environmental damage environmental damage

ex-ante ex-post
willingness to pay willingness to pay to willingness to pay to
secure a benefit prevent a loss
Case A Case B
willingness to accept willingness to accept a willingness to accept
compensation for an compensation for a
foregone loss foregone benefit
Case D Case C
Source: Pearce, Markandya (1989)

135
Tab 22 Willingness to pay vs. willingness to accept concepts I

The effects can be demonstrated using an indifference curve diagram. In Abb. 56

the status-quo is described by the national income level of Y * and environmental
quality level of E * . The utility is described by the indifference curve I * .All
combinations in income and environmental quality along an indifference curve
result in the same utility level. Holding income constant, but receiving a better
environmental quality results in a higher utility level, which is represented by an
indifference curve further away from the origin.
Case A
How much would the society be willing to pay to secure the environmental quality
E instead of remaining at the environmental quality level E * ? If the society chose
to have the same utility level, society will spend the amount of A for securing the
status quo.

Case B
Assume, the environmental degradation already occurred. the environmental
quality is E . How much would the society be willing to pay to revoke this loss?
Again, if the society chose to have the same utility level, society will pay the
amount of B to prevent the loss in environmental quality.

Case C
Assume, the desired environmental quality E was not realized. How much would
the society be willing to accept as a compensation for this foregone benefit? If the
society chose to have the same utility level, society will accept the amount of C as
a compensation for not realizing the environmental quality level E .

Case D
How much would the society be willing to accept a compensation for an foregone
loss in environmental quality, i.e. E instead of E * ? If the society chose to have the
same utility level, society will accept the amount of D as a compensation for the
loss of environmental quality.

136
 Income

D
C
*
Y
B A Ibetter
I*
Ibad

E E* E Environmental quality

Source: Feess (1998) p. 316

Abb. 56 Willingness to pay vs. willingness to accept concepts II

Conventional wisdom suggests that there should be no difference between the

money amount specified in the willingness to pay (WTP) or willingness to accept
(WTA) concept. But empirical studies have shown that WTA is usually
substantially larger than WTP. In surveys about valuing environmental goods, a
much larger gap between WTA and WTP is found in contingent valuation
approaches than in experiments with real money transactions.
There is one technical reason for this: As it can be seen in Abb. 56 the
willingness to accept questions results in a higher money amount compared to the
willingness to pay questions. This effect is due to the dimishing marginal rate of
substitution along an indifference curve. Another reason for this is that the
respondents dont take the offer to get compensation for the environmental as a
serious option, especially if that offer comes from an governmental agency. If
respondents want to express their general support for improvements in
environmental quality, they announce large numbers. Whereas in announcing their
WTP amount of money, they are more cautious, because the government is always
keen to collecting money. Furthermore, WTP is constrained by income, while
WTA is potentially unconstrained.
An general problem with contingent valuation is, that there is a fundamental
difference between hypothetical decisions and actual decisions. Respondents name
higher willingness to pay prices, because the want to feel good or want be seen on
the right side etc. Contingent valuation is used to calculate environmental goods,
because there is nothing like a market price for that kind of goods. But why should
individuals have a precise belief about the value of an environmental good?

137
Stated preference methods, like conjoint analysis and contingent valuation have in
common, that they are based on surveys in which people are asked directly about
their willingness to pay for changes in environmental quality. The most common
stated preference approach is the contingent valuation method.

138
References

Kahn, Matthew E., "Environmental Valuation Using Cross-City Hedonic Methods"

(June 2004). http://ssrn.com/abstract=556739
Smith, V. Kerry, "Pricing What is Priceless: A Status Report on Non-Market
Valuation of Environmental Resources" . http://ssrn.com/abstract=31974
Krutilla, J.V. and A.C. Fisher.1975. The Economics of Natural Environments:
Studies in the Valuation of Commodity and Amenity Resources.

139
10 Biodiversity

Learning objectives
In this chapter you will
learn the fundamental principals of biodiversity
learn to consider the value of biodiversity, and
be informed about policy response to diversity and about international
institutions to preserve biodiversity

10.1 Introduction

Evolution has shown that species have evolved and disappeared throughout
geologic time because of climatic changes and the inability to adapt to survive
competition and predation. A steady rate of extinction is a normal process in the
course of evolution, and is called the background rate of extinction. But since the
1600s, humans have rapidly accelerated the rate of extinction because of
population growth and resource consumption. There is evidence that most of the
world's habitats are changing faster than most species can evolve, or adapt to such
changes. The current global extinction rate is estimated at about 20,000 species per
year, exponentially greater than the background extinction rate. This results in al
loss of biodiversity.
The loss of biodiversity over the last 35 years is measured by the Living Planet
Index. The index currently incorporates data on the abundance of 555 terrestrial
species, 323 freshwater species, and 267 marine species around the world. While
the index fell by some 40% between 1970 and 2000, the terrestrial index fell by
about 30%, the freshwater index by about 50%, and the marine index by around
30% over the same period.

140
From: Millennium Ecosystem Assessment, 2005. Ecosystems and Human Well-being:
Biodiversity Synthesis. World Resources Institute, Washington, DC.
Abb. 57 The Living Planet Index, 19702000

Types of Species (Number of

species)

Woodland, park and garden birds (24)

Farmland birds (23)

Forest butterflies (89)

Farmland butterflies (206)

Heath and scrub butterflies (92)

Wetland butterflies (29)

-40 -35 -30 -25 -20 -15 -10 -5 0

trend from 1980 to 2002 (%)

Source: The European environment - State and outlook 2005
Abb. 58 Trends in birds and butterfly populations in EU-25 (% decline)

141
A definition of biodiversity (or biology diversity) is given by the United Nations
Environment Programme (UNEP) in its Guideline for country studies on biological
diversity in 1993:
The variability among living organism from all sources, including inter alia, terrestrial,
marine and other aquatic ecosystems, and the ecological complexes of which these
are part: this includes diversity within species, between species and of ecosystems.

This definition considers three levels of biodiversity:

1. Population
genetic diversity among individuals within a single species. Allows for
evolutionary and adaptive potential of the species. A higher number of
population results in a higher extend of biodiversity.
2. Species
the number of distinct species within a community of organism in a
particular location.
3. Ecosystems
diversity of ecosystems in a particular regional area.
Hence, biodiversity is not only the amount of distinct species, biodiversity must be
considered in terms of genetic diversity, too. Even, if the number of extant species
shows no change, the diversity of the gene pool in the remaining population may
decline.
The process of evolution and environmental changes have driven species to
extinction and by mutations created new species better adapted to the new
environment. This process occurred as long as life exists. Species appears and
disappears, like the dinosaurs or the mammoth. But over the last hundred of years,
human actions have increased the rate of extinction, drastically. This is the reason
why economics plays a role concerning biodiversity.
Economic activities influence, mainly by decreasing, the level of biodiversity,
through extinction. Since diverse biological systems facilitate environmental
functions, such as climate and surface temperature regulation, carbon cycling, soil
fertility maintenance, production of food, source of generic materials used in
pharmaceuticals, and biodiversity as the basis for crop and livestock variability,
any decrease in biodiversity will result in fewer life-support services and will have
economical impacts. On the other hand, protecting species has opportunity costs in
terms of reduced resources for other goods, like universities or kindergartens.

10.2 Valuing biodiversity

For simplicity the net benefit of conserving a species can be written as a function
of habitat area a and the species distinctiveness d. The value of distinctiveness
measures the difficulty in finding a substitute in terms of genetic or chemical
constituents.

142
Formel (53)
B ( h, d ) = p ( a ) vd ( h, d ) + ve ( h, d ) + u ( h, d ) d ( h )

B ( h, d ) : Discounted expected net benefit of conserving a species.

p ( h ) : Probability, that a species survives. Simply given as a function of remaining

habitat area h. The value of conserving a species is determined by the sum of three
components:
vd ( h, d ) : the value a species is expected to provide chemicals or genetic material
with commercial value, the so called direct value of distinctiveness.
ve ( h, d ) : the contribution a species gives to ecosystem services.

u ( h, d ) : the aesthetic or non-use value of a species.

d ( h ) : opportunity costs in terms of forgone development opportunities for the

habitat area h.

10.3 Policy response and international institutions to

preserve biodiversity

Convention on Biological Diversity (CBD)

Signed by 150 government leaders at the 1992 Rio Earth Summit, the Convention
on Biological Diversity is dedicated to promoting sustainable development.
Conceived as a practical tool for translating the principles of Agenda 21 into
reality, the Convention recognizes that biological diversity is about more than
plants, animals and micro organisms and their ecosystems it is about people and
our need for food security, medicines, fresh air and water, shelter, and a clean and
healthy environment in which to live.
The convention has three main goals:
conservation of biological diversity (or biodiversity);
sustainable use of its components; and
fair and equitable sharing of benefits arising from genetic resources.

The Conference of the Parties (COP), is the governing body of the Convention,
consisting of all governments (and regional economic integration organizations)
that have ratified the treaty. and advances implementation of the Convention
through the decisions it takes at its periodic meetings.
To date the Conference of the Parties has held 8 ordinary meetings, and one
extraordinary meeting (the latter, to adopt the Biosafety Protocol, was held in two
parts). From 1994 to 1996, the Conference of the Parties held its ordinary meetings
annually. Since then these meetings have been held somewhat less frequently and,
following a change in the rules of procedure in 2000, will now be held every two

143
years. To date the Conference of the Parties has taken a total of 216 procedural and
substantive decisions.
The Ninth meeting of the Conference of the Parties to the Convention on
Biological Diversity will be held in Bonn, Germany (19 - 30 May 2008).
The Conference of the Parties uses expertise and support from several other bodies
that are established by the Convention. In addition to committees or mechanisms
established on an ad hoc basis, two main organs are:
The CBD Secretariat.
Based in Montreal, it operates under the United Nations Environment Programme.
Its main functions are to organize meetings, draft documents, assist member
governments in the implementation of the programme of work, coordinate with
other international organizations, and collect and disseminate information. In
addition, the COP establishes as it sees fit. For example, it created a Working
Group on Biosafety that met from 1996 to 1999 and a Working Group on the
knowledge of indigenous and local communities.
The Subsidiary Body on Scientific, Technical and Technological Advice
(SBSTTA)
The SBSTTA is a committee composed of experts from member governments
competent in relevant fields. It plays a key role in making recommendations to the
COP on scientific and technical issues.
Article 25 of the Convention on Biological Diversity establishes an open-ended
intergovernmental scientific advisory body known as the Subsidiary Body on
Scientific, Technical and Technological Advice (SBSTTA) to provide the
Conference of the Parties (COP) and, as appropriate, its other subsidiary bodies,
with timely advice relating to the implementation of the Convention. As a
subsidiary body of the COP, SBSTTA is to report regularly to the COP on all
aspects of its work. Multidisciplinary and open to participation by all Parties,
SBSTTA comprises government representatives competent in the relevant field of
expertise. Its functions include: providing assessments of the status of biological
diversity; providing assessments of the types of measures taken in accordance with
the provisions of the Convention; and responding to questions that the COP may
put to the body.
SBSTTA has met 12 times to date and produced a total of 129 recommendations to
the Conference of the Parties, some of which have been endorsed in full by the
latter. Such endorsement makes these recommendations de facto decisions of the
Conference of the Parties. Parts of other recommendations have also been
endorsed, and many others have been taken up in modified form.
The Thirteenth meeting of the Subsidiary Body on Scientific, Technical and
Technological Advice will be held in FAO, Rome, Italy (18 - 22 February 2008).
The Conference of the Parties (COP) has established seven thematic programmes
of work (listed below) which correspond to some of the major biomes on the
planet. Each programme establishes a vision for, and basic principles to guide
future work. They also set out key issues for consideration, identify potential
outputs, and suggest a timetable and means for achieving these. Implementation of
the work programmes depends on contributions from Parties, the Secretariat,
relevant intergovernmental and other organizations. Periodically, the COP and the
SBSTTA review the state of implementation of the work programmes:

144
 Agricultural Biodiversity
Dry and Sub-humid Lands Biodiversity
Forest Biodiversity
Inland Waters Biodiversity
Island Biodiversity
Marine and Coastal Biodiversity
Mountain Biodiversity

145
References

Brown, Garner M./Shogren, Jason F. (1998), Economics of the Endangered

Species Act, Journal of Economic Perspectives, 12(3), S. 3-20.

Daly, Herman E. "Toward some operational principles of sustainable

development." Ecological Economics 2 (1990) : 1-6
Daly, Herman E. and Kenneth N. Townsend (1993),VALUING THE EARTH:
Economics, Ecology, Ethics
Innes, Robert/Polasky, Stephen/Tschirhart, John (1998), Takings, Compensation
and Endangered Species Protection on Private Lands, Journal of Economic
Perspectives, 12(3), S. 35-52.
Solow, Robert, (1974): The Economics of Resources or the Resources of
Economics", 1974, AER.
Solow, Robert, (1974):"Intergenerational Equity and Exhaustible Resources",
1974, RES.
Convention on Biological Diversity (CBD): http://www.cbd.int

146
11 Biological Resources

Learning objectives
In this chapter you will
learn the economics of renewable resources
learn, why open access is inefficient and regulation in necessary
learn the concept of Individual Transferable Quotas
learn, why regulating renewable resource stocks is difficult

11.1 Introduction

In the traditional economic theory market entry is in generally as the key

assumption, which leads to an efficient and optimal resource allocation. In
contradiction to the standard theory open access in natural renewable resource
markets leads to inefficiencies. This becomes particularly clear by the example of
the fishery industry. Open access gives rise to a lot of economic and ecological
problems: Inefficient use of factor inputs, overfishing, and even the extinction of
fish species. The economic analysis of these problems can be originated to the
seminal work of H. Scott Gordon (1954) and Anthony D. Scott (1957). Whereas
Gordons paper offering a simple model describing the rent dissipation process
under an open access regime, Scotts paper was more normative, and addresses the
question, how the fishery industry should be managed to achieve an optimal
outcome. Most of the economic literature on renewable resource management deals
with the question Scott raised by using sophisticated dynamic optimal control
models. In these models a social planner tries to maximise the present value of
rents. These kinds of models are applied to one-species and to multi-species
systems. The latter are often compare the Nash non-cooperative solution to the
joint management equilibrium solution. But, besides of the enormous intellectual
effort done to reach at least some basic necessary conditions for an optimal steady-
state resource use, these models are only of little practical meaning for fisheries
management. Real world fisheries doesnt occur under pure open access nor under
a rent maximising regime. The latter requires the allocation of exclusive property
rights for the marine resource. Even since most of the worlds fisheries comes
under some kind of national or international jurisdiction, there is no exclusive
property rights nor pure open access found in the fisheries. Since some kind of
regulation rules the coastal and the high seas fisheries, it should be questioned, how
fishing firms react to regulations. Even the motivation and the behaviour of the
regulator should be mentioned. Why and what kind of instruments are applied to
regulate the fisheries? This paper addresses the question what should be considered
in modelling the economics of fisheries to get a sustainable use of marine living

147
resources. A special focus lies on the individual transferable quotas (ITQ), whether
they are particularly well suited for a sustainable use in fisheries management or
not.
This chapter begins with a short overview of the basic economic models used in the
renewable resource theory. A short description of real life fishing management
models is given in section 2. In section 3 the concept of individual transferable
quotas are discussed. Section 4 mentioned the question whether aquaculture may
be an alternative or not. Section 5 concludes this chapter.

11.2 Economic modelling of marine living resources

11.2.1 The Schaefer-Gordon Model

Schaefer (1954) assumed that the population dynamics of a single-species fish

stock is a function of its size and weight. The biomass will grow towards some
maximum weight, the carrying capacity, where it will remain. The growth function
b g
F X is often represented as a logistic function as illustrated in figure 1.1 and can
be represented mathematically by:

Formel (54)

bg c bg h bg bg
X t = F X t , t = aX t bX 2 t = rX t 1 b gFGH
X t
K
b gIJ
K
In equation Formel (54), r represents the intrinsic growth rate and K they carrying
capacity.

.
X

MSY

F(X)

X
0 XMSY K

Abb. 59 Sustainable yield and biomass in the Schaefer model

148
The Schaefer growth curve represents an idealized simplification of a regeneration
function. The Schaefer model is deterministic, it assumes complete information
about the relevant biological data. It regards a homogeneous resources stock under
constant environmental condition for spatially evenly distributed species.
If the stock is used for example by fishery activities, then the equation for the stock
dynamics (equation Formel (54)) changes to:

Formel (55) b g bg
X = F X Y t

bg
The variable Y t describes the catch quantity, which is harvested in time t. If the
catch is covered away by the increase in biomass exceeding the natural mortality,
the yield can be sustained, hence:

Formel (56) b g
F X =Y
Each point on the logistic growth curve in figure 1.1 represents thus the sustainable
yield of fish with respect to the stock. With exception of the maximum sustainable
yield (MSY) each catch quantity is attainable with two stock levels.
In order to use the resources stock, factors of production must be used as
combination of work and capital. This input is described as effort E. For
simplification effort is described as the number of the catch hours or days per
season. Thus yield is a function effort and of the stock itself:

Formel (57) b g
Y = G E, X = E X
With given stock the yield increases as effort rises. With given effort the yield
increases as the stock increases and vice versa. Formally this corresponds to a
production function, which the stock and the catch expenditure enter as input
factors, obtaining the catch quantity as output. Just, the Schaefer curve can easily
be transformed to an effort-yield curve, i.e. yield is a function of effort. Assuming
that a unit of landed fish can be sold on the market at a constant price p, the effort-
yield curve can be illustrated as the fishing industries total revenue curve TR.
Assuming further a constant cost c per unit of effort, total costs TC are just a linear
function of effort. Both are shown in Abb. 60.

149
 TC, TR

TC=cE

Economic
rent

TR=pY(E)

MC, AR,
MR

MR

Economic
rent
AC=MC=c

Abb. 60 Bioeconomic and efficient equilibrium

The difference between total sustained revenue TR and total cost TC is the so
called sustainable economic rent. The maximum economic rent is reached at the
level of effort of EMEY, where the difference between TR and TC is at its maximum
and marginal revenue equals marginal cost. In open access fisheries, the rent will
be dissipated over time. The fishery will reach a bioeconomic equilibrium at the
level EOA, at which total revenue equals total cost. In the long rum effort cannot
exceed EOA, because costs would exceed revenue and at least some fishing firm
would leave the fishing industry taking up alternative activities. A level below EOA
would induce fishing firms to enter the fishery attracted to revenue greater than
they can achieve elsewhere. Note that neither the open access yield nor the
maximum sustainable yield (MSY) is economic efficient.

150
In the very simple model of the Gordon-Schaefer approach market price for a unit
of landed fish is given and fix. If price is variable, one can derive the so called
backward bending supply curve of the open access fishery. In figure 1.3 the
backward bending supply curve is shown. The curves labelled D in (b) represents
different demand curves. It can be easily seen, that the amount of catch at the level
Y1 is a bioeconomic equilibrium corresponding to the demand curve D1 as well as
to the demand curve D3 . But at different costs of fishing. Since each point on the
backward-bending supply curve is a bioeconomic inefficient equilibrium, the
welfare lost well grow further more if price will rise along the backward-bending
2c
slope of the curve. Any market price for a unit of landed fish exceeding results
K
in biological overfishing.

P p

S S

p3

2c
D3
K p2
c p1
D1 D2
K
Y Y
MSY Y1 Y2

a) b)
Abb. 61 Backward-bending supply curve

11.3 The dynamic extension of the Gordon-Schaefer

model

The static Gordon-Schaefer model can easily be extended to a dynamic approach.

The dynamic version of the Gordon-Schaefer model is like the intention of Scott
more normative, asking: how should marine living resources be managed for the
societies benefit? Target is the maximization of the present value of the resources
use by a resource manager, who has to consider the regeneration function of the
resources as a binding restriction.

151


Formel (58) max ( X , E ) = ( p c( X ) ) Q e t dt

Q
0

s.t.

Formel (59) X = F ( X ) Q and 0 Qmin Q QMSY Qmax

Setting up the Hamiltonian and applying the maximum principle leads to the
steady-state solution:

c( X *) F ( X *)
Formel (60) F ( X *) =
p c( X *)
Equation (1.7) is an implicit equation for the resources stock X and has the unique
determined solution X = X * . The equation is central for the optimal management
of a fish stock. The steady-state catch must be controlled in such a way that the
"marginal productivity of the fish stock " equals the discount rate.

11.4 The Beverton-Holt Model

The biological framework of the logistic growth function in the Gordon-Schaefer

model is very simple. All biological informations represented by the parameters
intrinsic growth rate and the carrying capacity. Furthermore, one of the
fundamental problems of this type of model exists in the assumption of the
homogeneity of the resources stock. Since fishing gear have a varying selectivity
pattern for different size of fish and most stocks consist however of individuals of
different age and weight, the assumption of a homogenous fish stock is far away
from realism. The commercial value and the reproduction potential of resources
depend generally on the age or weight of the individual fish. Gear selectivity means
that all fish smaller than a certain size will escape, but all fish equal or bigger than
that mesh size are caught. In case that mesh size is close to the catch size of fish
that are old enough to spawn, depletion cannot occur.
A model using year-class features was developed for practical purposes in the
North Sea fishery by the British biologists R. J. Beverton and S. J. Holt. For certain
questions it is meaningful to use models in which the fish stock distinguish to such
individual criteria. However the model implementation turns out to be very
difficult due to insufficient data gathering possibilities. The model finds
nevertheless application in the fishery, for example on the North Sea plaice, the
Atlantic haddock and the Peruvian anchovies. Non suitably is this approach for
species, which spawn only towards the end of their life, like salmon.
For an optimal catch policy the determination of the age of the fish, when catched
and landed, and the amount of effort for a given fishing season is of importance.
Depending upon mesh size one receives different yield curves. The larger the
meshes, the more largely the maximum yield becomes, but it corresponds to a
higher fishing mortality rate. The envelope to all the individual yield curves is
called the eumetric yield curve. Since the fishing mortality is stock-independent
and regarding the assumption of sustainable yield in proportion to effort, only
points on the eumetric yield curve can be efficient. All realizable catches below the

152
eumetric yield curve are inefficient. To each mesh size there exists an associated
level of effort, which realized an efficient, but not necessarily optimal catch. The
optimal catch policy is determined by two factors. The first factor is the
determination of the fishing rate Y, which is in proportion to effort (Y = E). If effort
increases, the fish stock will decrease and the average weight of the fish stock
decreases too. The second factor is the determination of the size of the fish. The
more largely the mesh size, the more largely the landed fish will be. An increase in
the mesh size will at first reduce the yield but finally increase the biomass. The
optimal policy have to determine the optimal mesh size and the fishing rate / effort
simultaneously.

Y
Yeum

Y3

Y2
Y1
y=E
Abb. 62 The eumetric yield curve

With open access to a common pool resource two effects have to be considered. On
the one hand the effort is expanded in such a way that the economic rent will be
dissipated. This effect leads to the bioeconomic equilibrium, like in the Gordon-
Schaefer model. On the other hand it has to be expected that fishing firms will use
sufficiently small mesh sizes, in order to catch any available fish of commercial
value. Thus the case of open acces without any regulation implies a so-called
growth overfishing. The effort can achieve an equilibrium, in which the economic
rent dissipates. In this situation overfishing results from to much effort and non-
eumetric mesh sizes. A regulator, who wish to achiev an optimal allocation of the
resources, has to control both the effort E and the mesh size .
With open access the fishing industry stops in a bioeconomic equilibrium,
described by C in figure 1.4. In C the total cost equals total revenue of the fishing
industry, determining the corresponding mesh size 3 . This bioeconomic
equilibrium is not stable. As long as fishing firms are able to choose their mesh
size, they will have an incentive to reduce the size to raise their catch. A reduction
of the mesh sizes leads to raise in economic rents represented by the difference
between the TC line and the TR curve, like the distance AB with less effort E1 but
smaller mesh size 2 . A reduction in mesh sizes leads to higher catches and a

153
reduction in effort. With the mesh size 1 a bioeconomic equilibrium is achieved
in point B. However this is not efficient, since it is not on the eumetric yield curve.
With effort E1 the corresponding mesh size should be would be 2 . The optimal
allocation is given by point D with optimal effort E0 and mesh size 1 . Therefore
a regulator who wish to achieve an optimal outcome has to determine both: effort
and mesh size.

TR
TC TC

A C
Ym2 TR=pYeum

D
pYm3
B
Ym1 pYm2
pYm1

E
E0 E1 E2

Abb. 63 Equilibria in the Beverton-Holt model

Even the static Beverton-Holt model is related to the static Gordon-Schaefer

model, dynamic optimization in the Beverton-Holt model becomes very complex
and only simple versions are tractable, for extensions numerical methods are
commonly used, especially in fishery management models.

11.4.1 Multi-Species Approaches

In the single-species models intra and interspecific relations are considered only in
form of summarized constant parameters. For economic analyses it is also of
importance, in which way fish stocks are merged into a more complex ecological
system. Therefore it is necessary to consider the interaction among different
species in the economic management explicitly. For simplification and for
didactical reasons multi-species models are limited to interactions between two
species, which are basically reducible to three types:
Predator-prey relations with (mostly) mutual de- or increase or oscillations
of the stocks;
Symbiosis relations, which is in favour of both species;
Competition relations, in which due to inter-species competition both
species are influenced negatively.

154
Ecological interactions, which can be described by predator-prey relations, are
preferred in the economic modelling of optimal resource use. These approaches are
either normative asking: whether an optimal solution exists and whether it is stable.
Game theoretic approaches comparing the efficient outcome and the Nash-solution
are modelled too. These models are very stylized. Multi-species models together
with multicohort age-structured biomodels are used in numeric fisheries
management models. Even a game theoretic framework is incorporated, like in the
Barents Sea fishery model by Sumaila (1997).

11.5 Fisheries Management models

Actual management models as used in the fishery partly consider a whole range of
biological data, like age and size structure, sex differentiation, spatial as well as
multi-species relationship, gear selectivity, etc. Figure 2.1 shows a simple model
for the Islandic cod.

Minke Fin Humpback

Cod
Ricker or Beverton-Holt
-function, cannibalism,
weight, food
Capelin
stock cycles
(stochastic),
food

Shrimps
production -function,
food

Abb. 64 A simple model for the Islandic cod (Stefansson, 1998)

To enlarge this biological models incorporating fishing fleets, areas, fishing

seasons and other components of interest is a due to the huge amount of data
needed, is nearly impossible. A lot of components are needed, like a model for
revenues and costs for different fishing policy alternatives.
Fisheries management within the biological tradition seeks to affect the structure of
fish population by controlling the relative size of different species and year-classes
through regulation measures like territorial and seasonal restrictions, gear and
appliance restrictions, mesh size, size regulation for landed fish, fleet restriction,

155
etc Before the concept of individual transferable quotas is to be examined in more
detail, we will have a look at the regulators behaviour.

11.6 Regulators behaviour

In modelling the optimal use of living marine resources, no or little attention has
been paid to what regulators do in practice. Institutional economics may give some
hints how regulators may behave. Even the objective function regulaters are using
in fisheries management is not quite clear, whether thy maximizing the present
value of profits or maximizing the present utility of consumption. Wilen and
Homans (1998), showed that regulators are balancing stock safety goals against the
short-term costs that attaining these goals may place on the industry. Therefore,
regulators try to smooth the effect of instruments on the industry. However,
economists are in favour of the optimization problem imposed by Scott, rather of
management questions like how the fishing industry will be affected by any
regulation measurement. Economists so far have just argued that non-market
instruments will shift the total cost curve in such a way, that any economic rent will
be dissipated again, with less effort and a larger fish stock. Market instruments like
a tax on effort or on landed fish or ITQs would guarantee an efficient outcome and
a sustainable use of marine living resources. Nevertheless, non-market instruments
are very common in fisheries management. see the EU Common Fisheries Policy
(CFP), seems far away from success. Fish stocks are still overfished, economic rent
still dissipates. These instruments are neither economic efficient nor ensure
conservation. Like the economic models the fisheries management models neglect
both the motivation and behaviour of the regulator and the fishing firm reaction to
the regulation measures. Economists are in favour of economic efficient
instruments like taxes or transferable quotas. The letter is already implemented as
individual transferable quotas (ITQ) in many countries including Australia,
Canada, Iceland, New Zealand, Norway, the USA, and the Faroe Isles. ITQs are
seen as an instrument to overcome the problem of the tragedy of the commons,
by instituting property rights to the fishing stocks. The aim of the ITQ is to reduce
overfishing, downsize the overcapitalized fishing industry and to avoid detailed
regulation. The following section shows, that ITQs cannot overcome this problems.

11.7 Individual Transferable Quotas (ITQ)

ITQs are usually a fraction of the total allowable catch (TAC) set by the regulation
authority for a particular species.
Assumed, the TAC corresponds to the optimal steady-state fishing stock or
corresponds to the optimal path reaching the steady state stock, then ITQs will lead
to an optimal resource allocation. The economic rent then will be maximized,
because the individual fishing firm will include all user costs into their objective
function. But it is necessary that the fishery is perfectly monitored and enforced.
Since the extension of the Exclusive Economic Zone (EEZ) to 200 nautical miles,
nearly 90% to 95% of worldwide catch is under some kind of national jurisdiction,
the implementation of ITQ should be affordable. Besides its theoretical advantage

156
there are arise quite a lot impediments in the real life. A number of problems are
already discussed by Copes (1986). Some of the problems are presented and
suggestions how to overcome the impediments are discussed in the following
section.

Quota busting
Quota busting or smuggling arises when more fish are caught and landed than
the individual quota allows. The extent of compliance is at a large amount due to
monitoring and enforcement efforts. In coastal fisheries, in which vessels return to
their home port and land their catch there, quota busting is a problem which can be
neglected as long as there is only a small number of marketing channels.
Traditionally landed catch is marketed by local co-operatives besides local direct
marketing on a low level. If there is a lot of marketing channels the problem of
quota busting will become much more severe, especially if there are a lot of
different landing places.
In case the catch is landed outside the area controlled by the national or regional
regulator, quota busting will be much easier. To avoid quota busting the marketing
channels have to be regulated too.

High-Grading and Multi-Species fisheries

A fishing firm, confronted by an individual quota will wish to obtain the maximum
amount of net value from that quota. Since the ITQ does in general not regulate the
amount of fish that is harvested, but rather the amount that is landed and brought to
market. Fishing firms may want to fill the quota with the best quality of fish. Fish
of less quality results in a lower market price than fish of high quality, therefore the
fishing firm has an incentive to High grade the catch by discarding fish of lower
quality. Since discarded fish have a very high mortality rate, and since they are not
reported, the regulator gets wrong information on the fishing mortality leading to
an overexploitation of the resource. This problem arises in multi-species fisheries,
too. Typically a TAC is set for each specie in a multi-species fisheries. But it is not
sure, that catching the fish can be done separated. Therefore, not only the target
specie would be caught but also other species as by-catch. By-catch will often be
discarded, even if quotas are transferable. By-catch species might be of less value,
the hold should not be wasted for fish of lower value than the targeted species.
An instrument to avoid high-grading is to emit value-based ITQs, which gives the
allowance to land a certain value of each particular type of fish. Setting the Value-
TAC the regulator is confronted with two unknowns: The market price and the
amount of caught and landed fish. There is some evidence that the quota-induced
discarding problem might be reduced (Turner 1995). To avoid discarding in multi-
species fisheries, a value based ITQ, might be more appropriate.

Efficient allocation is not guaranteed

From a theoretical viewpoint the TAC would be optimal allocated by ITQ among
the fishing firms. In practise, ITQ may not be utilized due to some problems with
the fishing gear and no transfer to other fishing firms is possible due to time
restrictions. Therefore the TAC will not come into full effect. One might argue that
this effect will oppose quota busting, but it is not guaranteed, that one effect makes

157
up for the other. The amount of the shortfall in total catch cannot be determined in
advance.
In case of straddling or highly migratory fish stocks the problem of underutilization
of the TACs is much more serious because fish stocks may leave the quota area
earlier than expected, i.e. the season would be much shorter than anticipated.

Volatile stocks
For many species a TAC cannot not determined at the beginning of the fishing
season, because the are short living and the stock can be characterized by
instability in biomass. Many pelagic species like herring fall into this category.
Therefore only tentative TACs can be announced in advanced, encouraging fishing
firms to race for the fish.

Spatial distribution of effort

Fish species are not distributed equally within the fishing area but have different
stock densities on various grounds. Fishing firms will go to the profitable grounds
first, to achieve this, they will invest in fishing gear. Profit per unit of effort will
decline, the rent will be dissipated. As long as the individual quota is not filled, this
behaviour results in an open access fisheries like outcome, with a lower loss of
rent, but still with a loss.

Residual catch management

In fisheries where the catch is managed by an escapement target, ITQs are
inappropriate. An escapement target means, that not the catch is the target, but the
escapement and that the catch will be the residual. The rate of escapement is
determined in such a way, that it guarantees the sustainable use of the fish stock.
As an example for residual catch management the Northeast Pacific salmon
fisheries can be mentioned.

11.8 Is aquaculture an alternative?

Aquaculture is the farming of fish species in an attempt to generate profit and aid
in conservation of marine living resources. The fish are raised in large submersible
cages in the coastal seas. Therefore, nearly no effort in harvesting the catch is
needed, just lift the cage and the fish is already caught. Aquaculture has a long
tradition in fresh water fish farming. In the coastal seas fish farming starts with the
production of high priced in Southeast Asia in the early 80s. Norway and Scotland
started fish farming in the 70s by producing high priced salmon.
Aquaculture results in a much more constant and secure supply of this particular
species in comparison to the traditional method of fishing. Since aquaculture is
very efficient production method. Fish are raised in huge cages, harvesting is easy,
just lift the cage, and the fish are caught. The harvest of the open seas fish will be
reduced, due to the costs in effort. But this only holds, if farmed fish and the open
seas fish are seen as perfect substitutes. This is not always the case, as the demand

158
for salmon demonstrates, total demand for salmon is raising, but the demand for
the wild salmon is raising to.
But there are quite a lot of negative aspects, which should be mentioned:
Escaped fish compete with open seas fish, genetic mutation and weakening the
biodiversity of the oceans will occur.
External environmental effects occur directly by destroying the mongrove forest in
Southeast Asia for the implementation of fish (shrimp) farms. Other negative
external effect are the use of pesticide, antibiotics. Uneaten fish food and fish
excrements remain in the water, destroying marine life by reducing the oxygen
especially on the bottom.
The species which are commonly farmed are typically predators, they need other
fish as food. The fish food is mainly made by fish meal. As a rule of thumb, for a
kilo of salmon a kilo of fish meal have to be produced. Fish meal is produced from
small species like the capelin, but these species are typically prey species. If they
are caught intensively, food supply for predator species will be reduced.

11.9 Conclusion

Models including fishing firms and regulators behaviour, multi-species fisheries,

and even uncertainty are analytically intractable. In the case of fishery,
management simulation models are more appropriate. Complex simulation models
can evaluate different kinds of regulation measures and their impacts on the
dynamics of the population of different species. The recommendation for any
regulation authority is not an optimal solution, but may be yield in some rule-of-
thumb recommendations.
Especially individual transferable quotas cannot solve all the problems in fisheries
management, but in connection with a variety of some further measures they may
ensure a sustainable use and the conservation of some living marine resources. But
other aspects than only the biomass aspect of the seas should be taken into account
too, like ecological services, biodiversity and recreation possibilities. In case of
transboundary fish stocks or for fisheries in the open seas, a scheme of
transnational jurisdiction has to be implemented. Aquaculture, although supplying
the market with this particular specie, it is not an instrument to ensure the
sustainability of the marine system.

159
References

Beverton, R. J. H. and Holt, S. J. (1957): On the Dynamics of Exploited Fish

Populations. Ministry of Agriculture, Fisheries and Food, Fisheries Investigation
Series 2(19), London
Copes, P. (1986): A Critical Review of the Individual Quota as a Device in
Fisheries Management. Land Economics, 62 (3), 278-291.
Gordon, H. S. (1953): An Economic Approach to the Optimum Utilization of
Fisheries Resources. Journal of the Fisheries Research Board of Canda 10. S.442-
457.
Gordon, H. S. (1954): The Economic Theory of a Common Property Resource:
The Fishery. In: Journal of Political Economy 62, S.124-142.
Schaefer, M. B. (1954): Some Aspects of the Dynamics of Populations Important
to the Management of Commercial Marine Fisheries. Inter-American Tropical
Tuna Commission Bulletin 1, S.25-56.
Schaefer, M. B. (1957): Some Considerations of Population Dynamics and
Economics in Relation to the Management of Marine Fisheries. Journal of the
Fisheries Research Board of Canada 14, S. 669-681.
Scott, A. D. (1955): The Fishery: The Objectives of Sole Ownership. Journal of
Political Economy 63, S.116-124.
Stefansson, G, (1998): Statistical and other fisheries models.
http://www.hafro.is/hafro/Greinar/Adferdir/Model/nfmm2.html.
Sumaila, U. R. (1997): Strategic Dynamic Interaction: The Case of Barents Sea
Fisheries. Working Paper 1997/1, Chr. Michelsen Institute, Bergen, Norway.
Wilen, J. E. and Homans, F. R. (1998): What regulators do? Dynamic bshaviour of
resource managers in the North Pacific Halibut Fishery 1935-1978. Ecological
Economics, 24, 289-298.

160
12 Glossary

abatement costs
abatement is the reduction of emissions, so abatement costs are the costs of
reducing the degree or intensity of emissions.

biodiversity
The variability among living organism from all sources, including inter alia,
terrestrial, marine and other aquatic ecosystems, and the ecological complexes of
which these are part: this includes diversity within species, between species and of
ecosystems.

carbon sink
Forests, oceans and other ecosystems that absorb carbon, thereby removing it from
the atmosphere and offsetting CO2 emissions.

command-and-control (CAC) regulation

regulation that requires polluters to meet specific emission-reduction targets . Often
including the adoption of specific technologies to reduce emissions. Normally not
cost-effective, unless polluters marginal abatement costs MAC are taken into
account by designing the command-and-control regulation individually.

Contingent valuation
Valuation technique which asks people directly how much they are willing to
pay/to accept for improving/deteriorating environmental quality.

consumer surplus
The value of money of a good above the price consumers have to pay for it. Area
under the demand curve and above the price.

Critical level
Concentration limit beyond which a substance can cause dangerous effects to the
eco-system or to humans.

Deposit-refund system

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A deposit-refund system is the surcharge on the price of potentially polluting
products. When pollution is avoided by returning the products or their residuals, a
refund of the surcharge is granted.

Economic instruments
Economic instruments are fiscal and other economic incentives and disincentives to
incorporate environmental costs and benefits into the budgets of households and
enterprises. The objective is to encourage environmentally friendly and efficient
production and consumption through full-cost pricing. Economic instruments
include effluent taxes or charges on pollutants and waste, depositrefund systems
and tradable pollution permits.

effluent fee
an effluent fee is a fixed tax rate per unit (litre or kilogram) of emissions. They are
also referred to as emission charges or emission taxes.

Emission
Emission is the discharge of pollutants into the atmosphere from stationary sources
such as smokestacks, other vents, surface areas of commercial or industrial
facilities and mobile sources, for example, motor vehicles, locomotives and
aircraft.

emission charge
see effluent fee

Emission permits
The right to generate in the course of production activity a certain amount of
specific emissions, for example greenhouse gases. Emissions permits are a form of
intangible non-produced assets.

emission tax
see effluent fee

Environmental labelling
Environmental labelling provides an indication of the environmental impact
related characteristics of a product, typically on the package containing the
product, by private or public institutions.

Environmental quality

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Environmental quality is a state of environmental conditions in environmental
media, expressed in terms of indicators or indices related to environmental quality
standards.

externality
consequences of an economic activity influencing the welfare of people where
neither costs nor benefits are borne or received by the agent causing it;
Externalities may be either beneficial, positive or damaging, negative.

hedonic pricing
Indirect method to measure environmental value by observing how the price of a
good (house) varies with change in the level of its characteristics. The price
differences reveal the value of the characteristics (for example: air quality).

hot spot
area where there is a high concentration of pollution leading to greater pollution
damage than if the same total amount of pollution were more evenly distributed.
Hot spots of pollution can be found around industrial plants or areas.
liability law
A person or institution (firm) is responsible for the damage for damage to health to
another person or institution and is therefore responsible to pay compensation for
any damage incurred.

indirect use values

also called non-use or passive use values arise from motivations other than
personal use. Antonym: direct use or active values

polluter-pays principle
The polluter-pays principle is the principle according to which the polluter should
bear the cost of measures to reduce pollution according to the extent of either the
damage done to society or the exceeding of an acceptable level (standard) of
pollution.

public good
A good characterized by nonexclusivity and indivisibility

travel cost method

Indirect method to measure environmental value by observing travel cost a visitor
spent in getting to a recreational resource.

User-pays principle

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The user-pays principle is the variation of the polluter-pays principle that calls
upon the user of a natural resource to bear the cost of running down natural capital.

willingness to accept
The amount of compensation an individual is willing to take in exchange for giving
up some good or service. This may be obtained from stated or revealed preference
approaches.

willingness to pay
The amount an individual is willing to pay to acquire some good or service. This
may be obtained from stated or revealed preference approaches.

Most definitions are taken from the Glossary of Environment Statistics, Studies in
Methods, Series F, No. 67, United Nations, New York, 1997.

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