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 Economics of Natural Resources

1. INTRODUCTION
Traditional usage confines the term natural resources to naturally occurring
resources and environmental and ecological systems that are useful to mankind
or could be useful under feasible technological, economic, and social
circumstances. Examples of natural resources are forest land and its multiple
products and services (e.g. timber, wild-life habitat etc.), natural land areas
preserved for aesthetic, recreational, or scientific purposes (e.g. silent valley of
Kerala, wet lands of eastern Kolkata etc.); the fresh and salt water fisheries;
mineral resources that include mineral fuels and non-fuels (e.g. coal, aluminum
etc.); non-mineral energy sources of solar, tidal, wind, and geothermal systems;
water resources; and also the waste-assimilative capacity of the environment
and ecological systems. These examples make it clear that what we perceive as
natural resources depend on the conditions we have inherited from the past,
current or foreseen technologies, economic conditions, and tastes. For instance,
a century ago, not much was known about benefits of wetlands, and uranium
was not known.
Here we deal with the economics of natural resource use. In particular we
analyse how society should exploit a resource efficiently and the rate at which
a rational agents should exploit such resource through time. The rest of the
paper is organized as follows: In Section 2 we adopt a resource taxonomy
(classification system) that is used to distinguish various categories/measures
of resource availability. Section 3 deals with the question of how to allocate
exhaustible resources efficiently over time. It also discusses certain related
aspects of exhaustible resources. Section 3 analyses the basic issues of
economics of renewable resources taking fishery and forestry as examples.
Section 5 discusses certain aspects of water resource management and
concludes.
2. RESOURCE TAXONOMY
Three separate concepts are normally used to classify the stock of
exhaustible/depletable resource. They are (1) current resources, (2) potential
resources, and (3) resource endowment.
1
Current reserves are defined as known resources that can profitably be
extracted at current prices. Their magnitude can be expressed as a number. The
amount of potential reserves, on the other hand, depends upon the price people
are willing to pay for those resources – the higher the price, the larger the
amount of reserves potentially available. For example, techniques, more
expensive than conventional ones, generally allow greater amount of a resource
to be recovered. As the price per unit increases, the amount of a resource that
can be economically recovered also increases. Thus, potential reserves can be
defined as a function rather than a number.
The natural occurrence of resources in the earth‟s crust represents resource
endowment. It represents the upper limit on the availability of terrestrial
resources. Since the size of the resource endowment does not, in any way,
depend on the price, it is a geological rather than an economic concept.
These distinctions among the three concepts are important. Failing to take note
of them may lead to erroneous conclusions. We need to remember that data on
current reserves does not represent the maximum potential reserves. We also
need to remember that the entire resource endowment cannot be made
available as potential reserves at some price people will be willing to pay.
Certain mineral resources are prohibitively costly to extract. It is not likely that
any society, current or future, would be willing to pay the price necessary to
extract them. This, then, would imply that the maximum feasible size of the
potential reserves is likely to be smaller than the resource endowment. Box 1
gives us some ideas about the state of a exhaustible resource in India.

Box 1: Exploration and Production of Petroleum in India

India continues to be one of the least explored regions. of the 26
sedimentary basins, only 6 have so far been explored, accounting for only
30 per cent of the country‟s prognosticated reserves. India‟s balance
recoverable crude oil reserves are declining continuously after peaking at
806 million metric tons in 1992. This indicates the need for greater
exploration efforts.
Source: Parikh (1999)

2
Natural resources, as we have said before, include renewable resources such as
fish population and forests and non-renewable exhaustible resources such as oil
reserves and mineral deposits. Thus for another useful classification of natural
resources, we adopt the convention that classifies natural resources as
renewable and exhaustible depending on their rates of regeneration. Oil is
exhaustible because its formation requires millions of yearswhich is not an
economically meaningful time frame. Trees and fishes are renewable because
they can grow to maturity within a reasonably short span of time. Thus it is
possible, though not inevitable, that a flow of these resources could be
maintained over time.
It needs to be remembered, however, that for some renewable resources, the
continuation and volume of their flow depend crucially on humans.
Overharvesting reduces the stock of fish, which in turn reduces the rate of
natural regeneration of the fish population. This may even lead to extinction of
the otherwise renewable resource. For other renewable resources, such as solar
energy, the amount consumed by one generation does not reduce the amount
available to the generations that follow.
Managing natural resources of either kind has its own challenge. The challenge
for exhaustible resources involves allocating dwindling stocks among
generations. In contrast, the challenge for managing renewable resources
involves the maintenance of an efficient and sustainable flow over time.
At an analytical level, however, both the resource categories may be thought to
have a common foundation. The stock of natural resources (for example, the
population of fish in a lake or the number of tons of coal remaining in a coal
field) measures the state of a resource. Stocks of renewable resources like fish,
grow through regeneration; while exhaustible resources like coal are available
in fixed quantities. During a particular time period the stock depletes at the rate
of harvesting or extraction per period. These attributes of natural resources
have much in common with man-made capital. Just as investment increases
and depreciation reduces the stock of man-made capital, so growth through
regeneration increases and harvesting or extraction depletes the stock of natural
resources.

3
We will take up next the economics of exhaustible resources. Analytics of both
exhaustible and renewable resources involve some mathematics. However, we
will attempt to explain the basic ideas without developing the mathematics
(other than some simple algebra) that underlies them.
3. MANAGING EXHAUSTIBLE RESOURCES
Exhaustible resources will be depleted so long as the extraction rate is positive.
Are our exhaustible resources being depleted too rapidly? To answer questions
like this we need to know the optimal rate at which to extract/deplete
exhaustible resources. With that in view we will present here some simple and
intuitive results involved in the theory of depletion.
What are the conditions that must hold while depleting an exhaustible resource
over time, that is, along an optimal depletion path? The supply (and extraction)
behavior of a price-taking owner1 of an exhaustible resource such as oil differs
from that of an ordinary good or resource. An exhaustible resource is limited in
quantity and is not producible like an ordinary good. Ordinary goods produced
in the economy using available methods of production can be replicated. Since
exhaustible resources are created by geological processes with geological time
spans, they can be regarded as fixed in quantity, although the total quantity
available may not be known.
A price-taking firm supplying ordinary goods will adjust production in all
periods so that the incremental cost of production of an extra unit of output,
i.e., its marginal cost (mc) of production in each period equals price (p) in that
period. If the mc is less than p, the supplier can raise current profits by
increasing production. However, when the firm is the extractor of an
exhaustible resource, such behavior might require extraction of more stocks
than is available to the firm.
Cases like this, then, require some modifications of the standard theory. Since
an exhaustible resource is limited in quantity and is not producible, extraction
and sales of a unit today, involves an opportunity cost; the value that might
have been obtained for that time at some future date. This opportunity cost is
1
Competitive owner who sells his natural resource in a market where he does not have a large
enough market share to be able to influence market prices.
4
usually given the name user cost (uc). The presence of user cost is central to
the economics of exhaustible resources. User cost does not exist for
conventional reproducible goods since the consumption of an amount now
does not reduce the quantity that can be consumed in the future; additional
quantities can always be produced. However, a barrel of oil extracted today is a
barrel unavailable for extraction in the future. In deciding whether to extract
and sell an additional barrel today, the extractor must consider not only the cost
of pumping the barrel, but also the cost of foregoing the highest return that
could have been earned if the oil had instead been pumped and sold in the
future. Hence, it is necessary to have a more inclusive definition of marginal
cost and we call it augmented marginal cost (Salant, 1995). The augmented
marginal cost (amc) is, then, defined as the marginal cost of extraction (mc)
plus the user cost (uc).
When mc is redefined in this way, it is optimal for a competitive resource
owner (firm) to extract the resource in each period to the point where its amc
equals the market price (p). Instead of the usual efficiency condition, price (p)
= marginal extraction cost (mc), we have:
p = mc + uc.
This is the first condition of optimal depletion. As shown in Figure 1, it implies
that less of the resource will be extracted today than if it were a producible
ordinary good or a resource. Given the relation between demand and price p =
p(y), where p is the price and y is the quantity demanded and extracted, only y*
units (rather than y** where p = mc) will be extracted by a resource planner or
a price-taking firm seeking to allocate extraction efficiently over time. This
leaves a positive difference AB (the opportunity cost/user cost) between p and
mc.

5
 Figure 1:Optimum Extraction of an Exhaustible Resource.
Beneath the apparent simplicity of this rule lies a wealth of subtlely (Salant,
1995). The rule implies, for example, that the current extraction rate by a
private owner of a natural resource depends not only on the current price, as in
the standard theory, but also on expectation about future prices. These price
expectations determine the opportunity cost of additional current extraction. A
competitive supplier that expects future prices to be sufficiently low compared
with the current price may extract and sell intensively in the current period,
judging the opportunity cost of additional extraction to be small. But if future
prices are expected to be sufficiently high, the same current price may induce
no extraction whatsoever today.
For some further results let us, for simplicity, assume just two periods: the
resource owner either extracts and sells the resource today, in period 0, or
retains it in the ground until the next period 1. Let the price he can obtain for a
unit of the resource today be p0 and the price he expects to prevail for a unit in
the next period be p1. The cost per unit of extracting the resource and
delivering it to the buyer is C, which is not expected to vary between periods 0
and 1, that is C = mc remains constant.
Because the owner has a fixed stock (to be supplied from) of the resource, any
unit sold in period 0 will reduce the quantity that can be sold in period 1. If he
sells the unit in period 0 he will receive net revenue of p0–C but forgo revenue

6
of p1-C in the following period. The value in period 0 of the net revenue
foregone is its present value (p1-C)/(1 + r) where r is his discount rate2.
Hence his return from selling a unit today will be:
(p0 – C) – (p1 – C) / (1 + r)
(p1-C)/(1+r) is the opportunity cost of his decision to sell a unit today. It is the
user cost of his decision. It arises because he is faced with the alternative of
selling it in the following period. If
(po – C) > (p1 – C) / (1 + r)
he will be better off selling his resources in the current period. If, on the other
hand,
(po-C) < (p1-C) / (1 + r)
he will be better off by leaving it in the ground. His optimum amount of
current extraction is given where
po-C = (p1-C) / (1 + r) (1)
This implies that po = C + (p1 – C) / (1 + r) (1a)
Equation (1a) states our earlier result that the current price of the resource
when it is extracted optimally, should be equal to the mc plus the user cost (uc).
With reproducible resources there is no element of user cost since resources are
produced in each period to satisfy the demand in that period and there is no
carry over from period to period. Hence, as we have seen earlier, for a
reproducible resource the optimum output is given where po = C.

2
The present value (PV) of a stream of net benefits Bo …., BT received over a period of T years is
T

computed as PV (Bo ……. Bt) = B

t0
t
1  r  t
where  is the summation, r is the appropriate

interest rate, Bo is the amount of net benefits receivers immediately, and Bt is the amount of net
benefits received t years from now. The process of calculating the present value is called
discounting and the rate r is referred to as the discount rate. One rupee received in period t is
equivalent to 1/(1 + r)t1 rupees in period 0. At a discount rate of 10 per cent, a firm will be
equally well off if it earns Rs. 100 today (which can generate Rs. 10 of interest income) or if it
earns Rs. 110 one year from now.

7
 Transposing equation (1a) we have
(p1 – C) = (po – C) (1 + r) (2)
Equation (2) is the second condition of optimal depletion and is usually
described as the fundamental equation (due, originally, to Hotelling, 1931) of
exhaustible resource extraction. It says that along the optimum extraction path,
where the resource owner is indifferent as to the options of extracting or
leaving the resource in ground, the price of the resource, net of marginal
extraction costs, that is, the user cost has to rise at a rate equal to the discount
rate. A numerical example may help to illustrate this fundamental condition.
Suppose the interest rate is 10 per cent and the net price (p – mc), that is, user
cost per unit of the resource is Rs. 20. If the net price (user cost) is not
expected to grow by 10 per cent to Rs. 22 next year, it pays to extract more of
the resource in the current period, because the resulting income from sales will
earn 10 per cent interest if invested in interest bearing assets. If the net price is
expected to go above Rs. 22 that is, to grow faster than the rate of interest – the
producer will have no incentive at all to extract in the current period. This is
because any unit extracted today will (even after interest earning) be worth less
in a year than a unit extracted and sold a year from now.
If mc of extraction is small relative to the price of the resource, equation (2)
approximates to
p1/po = 1 + r or p1 = po (1 + r).
Thus along the optimum path resource prices grow at the discount rate. The
higher the discount rate the faster the rise of resource price along the optimum
path. A higher discount rate reduces the user cost of the resource and causes
mine owners to deplete their resource at a faster rate. In reality, of course,
extraction costs are never zero. Whenever they are positive, a price increase
equal to the interest rate would cause the net price to rise by more than the
interest rate. For example, suppose the price per unit of a resource is Rs. 30 and
the net price is Rs. 25. A 10 per cent price rise (in the rate of interest) would
boost the net price from Rs. 25 to Rs. 28, or by more than 10 per cent. This
difference would give every extractor an incentive to postpone extraction

8
rather than satisfy current demand. If such imbalances are to be avoided, the
price in successive years must rise by less than the interest rate.
We will see that this analysis may illuminate many questions of practical
policy. Let us consider for illustration, the following questions (Salant, 1995):
 Suppose a state-owned or controlled enterprise say Coal India Limited
(CIL) is entrusted with selling an exhaustible natural resource (in this
example coal) on the world market. For a small country3 can it be right
to extract it to the point where the mc of extraction equals the world
market price? Is it ever prudent to refrain from extracting a resource,
even though it is profitable to begin with that is, current price exceeds
the mc of extracting the first unit?
 Credit may be more tightly rationed (and interest rates higher) in one
country than in another. How does this affect the former country‟s
relative rate of resource extraction?
 Suppose a government decides to restrict the extraction of a resource
that is privately owned and extracted because the resource is
considered highly valuable (such as gold in India) or because the
extraction process generates pollution (such as gold mining which uses
mercury or arsenic). Is it right in such cases to give the extractor a
grace period before the restrictions are effectively imposed to
overcome the dislocations that such policies will cause?
Each of the questions raised above ceases to be puzzling once attention is
properly refocused on the opportunity cost of current extraction and how that
cost changes when a new policy is anticipated.
Expanding short-run coal production based on the equality of mc of extraction
and market price is excessive because it fails to account for the future net
return (profit) foregone, when an additional ton of coal is extracted. Moreover,
if this opportunity cost is sufficiently high, no amount of the resource should

3
A small country is one that sells on the world markets but that does not have a large enough
market share to be able to influence world prices (a price-taker).
9
be extracted today even though the current price exceeds the current mc of
extracting the first unit.
As regards the second problem, when the real interest rate rises, the uc of
extracting another ton declines because the future profit (from the ton that must
be foregone) is worth less today (that is discounted profit is low today). Hence,
even if mc does not shift, the augmented mc (amc) in early periods will fall. As
a result, the same sequence of prices would generate an initial expansion in
extraction. This outcome can be used to explain differences in the behavior of
two countries selling the same natural resource on the world market. Assume
that both countries have approximately the same underground reserves and
costs of extraction. If credit is rationed more tightly in one country, that
country should extract more rapidly in the short-term in order to maximize
national wealth.
In the third problem where (say) it is proposed to shut down a highly valued
or/and polluting gold mine but the mine operator is permitted a grace period to
mitigate the dislocations caused by the closure, during the grace period
premature closing lowers the uc of an additional unit. Consequently, the amc in
each period before the date of closing is lower than it was before the policy
was announced. If the sequence of world price is unchanged, the mine operator
will find it profitable to intensify mining throughout the grace period.
3.1 Towards a Substitute (Backstop)
Our discussion so far considered optimal depletion of an exhaustible resource
when we implicitly ruled out availability of any substitutes or „backstop‟ as it
is sometimes called, of the resource concerned. However, it may so happen that
a substitute resource, possibly a renewable resource, is available at a constant
marginal cost. This scenario could pose the problem of optimal depletion of
say oil or natural gas with a solar substitute. What would be the optimal
depletion rules in these circumstances?
We note that the amc for the exhaustible resource cannot exceed the mc of the
substitute. The society could always opt for the use of a renewable resource
instead, whenever it appears cheaper to do so. Thus, although the maximum
willingness to pay (the „choke price‟) sets the upper limit on amc and for that
10
matter on p when no substitute is available, the mc of extraction of the
substitute sets the upper limit when a substitute resource is available at amc
that is lower than the choke price.
3.2 Exploration and Technological Progress
In principle, extraction costs may rise over time as lower-cost reserves are
depleted and higher-cost reserves remain to be exploited. The search for new
resources involves costs. As more easily accessible resources are exhausted,
we must move into less accessible areas, such as the bottom of the ocean or
high slopes of the mountain. This suggests that the marginal cost of
exploration, which is the marginal cost of finding an additional unit of the
resource, should be expected to rise over time, just as marginal cost of
extraction does.
Rising augmented marginal cost of a resource induces society to exploration
activities. Some of this exploration would be successful. If the mc of extraction
of the newly found resources is sufficiently low, this could lower, or at least
moderate, the increase in amc and price.
Technological progress, in the present context would be manifested as
reductions in the cost of extraction. However, with a finite amount of a
particular exhaustible resource, the fall in amc would not last indefinitely,
because ultimately it would have to rise. This period of transition could last
quite a long time though.
3.3 Resource Extraction and Environmental Cost
Extraction of a natural resource may impose an environmental cost on society.
In situations like this property-rights are not usually well-defined and hence
this cost is not internalized by the extractors. The aesthetic costs of strip
mining, the occupational health hazards associated with coal mining, and the
acids leached into streams from mine operations are all examples of associated
environmental costs. The cost of extraction and sale (including user cost) is
borne by the resource owner and taken account of (internalized) in the
calculation of how much of the resource to extract. The environmental damage,
however, is an external cost and is not borne by the owner and as such it will

11
not be part of the extraction decision. It is important to know how the market
allocation, based on only the former cost would differ from the optimal
allocation (depletion), which is based on both.
The inclusion of environmental costs results in higher resource prices, which
tend to lower demand. All other things being equal, it would allow the resource
to last longer. On the other hand when environmental side-effects are ignored
by the resource extracting firm, the price of the exhaustible resource would be
too low, demand too high, and the resource would be extracted too rapidly over
time.
3.4 Resource Scarcity
Are resources getting scarce? We will consider two economic measures of
resource scarcity, namely cost and price to confront the question raised.
Nineteenth century economist David Ricardo views the increasing costs
associated with depletion as a limit to growth. In principle, extraction costs
may rise over time as lower-cost reserves are depleted and higher-cost reserves
remain to be exploited. Certainly resources have been extensively depleted
over the last century and more. How have costs behaved?
The predictions of Ricardian scarcity were examined empirically for the USA
in a famous study by Barnett (1979). The authors considered two versions of
the scarcity hypothesis: a strong version, that unit costs of extractive
(exhaustible material) industries should rise through time; and a weak version,
that costs in extractive industries should rise relative to non-extractive
industries. The latter version recognizes the impact of technical progress in
lowering costs of production in modern economies. For all true extractive
industries, costs over the long term declined relative to the costs in non-
extractive industries.
These studies also examined the proposition, derived in the earlier sections,
that because of the influence of user cost, prices of exhaustible resources
should rise relative to those of reproducible resources. This proposition is also
rejected by the evidence.

12
 There are four basic reasons for the failure of the scarcity hypothesis
(Bowers, 1997).
1. As higher grade resources are exhausted, lower grade resources are
found in greater abundance. Furthermore, the difference in grades
diminishes as the known stock expands.
2. As a particular resource becomes scarce, price rises are offset by
switches in demand to substitutes (backstop). That is, scarcity is offset
by decline in demand.
3. Increases in prices stimulate exploration for new deposits and induce
increased recycling.
4. Technical progress influences supply by reducing extraction costs and
by making possible the exploitation of previously uneconomic
deposits. It also reduces demand by encouraging efficiency in resource
use.
4. MANAGING RENEWABLE RESOURCES
The line dividing exhaustible resources and renewable resources is not always
clearly drawn. Just as exhaustible resources, in a sense, can be renewed
through exploration and technology, renewable resources can be exhausted. In
fact, much of the current concern about resource exhaustion involves
renewable resources (Fisher, 1981). However, renewable resources are
different from exhaustible resources because of the fact that they are naturally
regenerated on time frame that is relevant to human exploitation. Catching a
fish or cutting a tree does reduce the population of fish or tree in any period.
But unless the population has already been reduced to the point of the critical
threshold, natural growth will replenish the loss of biomass due to the harvest
within a relatively short period. So, although it is true that a renewable resource
can exhausted, it need not be.
Mankind shares the planet earth with many other living species. When
biological species become commercially valuable they are subjected to two
opposing human objectives. On one hand, the value of the species to humans
provides a reason for human concern about its future. On the other hand,

13
commercially exploitable biological resources can also be pushed to the brink
of extinction if not managed sensibly.
In case of biological resources the size of the resource stock (population) is
determined jointly by biological factors and by actions taken by society. The
size of the population, in turn, determines the availability of resources for
future. As the flow of these resources over time is not purely a natural
phenomenon, a crucial issue is the optimum (efficient) rate of resource use
over time and over generations. A related question is: can the market be relied
upon to achieve and sustain this rate? Using the fisheries as an example of a
renewable resource we will address these issues here.
4.1 Biological Dimension: Growth Curves
Unlike exhaustible resources, renewable resources can be reproduced. Thus,
even though available stocks are affected by human intervention via their
levels of exploitation, the economics of renewable resources depends,
crucially, on assumptions about their population dynamics.
Figures 2 and 3 show the population dynamics of a hypothetical renewable
resource, which we assume to be a single fish species. The stock of fish (or
biomass) is supposed to follow growth through time as shown in Figure 2. This
shows cumulative growth, or the size of the stock, as a function of time. At low
levels of stock the fish multiply, but as they begin to compete for food their
rate of growth slows down and eventually the stock converges on some
maximum level Xc, the ecosystem‟s carrying capacity for that species (in the
absence of human intervention). The cumulative curve, thus, takes the general
logistic shape with at first successively larger increments, then successively
smaller ones. Note that the curve, as we have drawn, begins at Xmin – the
critical minimum level of population. If the size goes below this level the
species is driven to extinction (X0).
It is useful for our purposes to look at the information contained in Figure 2 in
a somewhat different way. Figure 3 shows the growth in the resource stock on
the vertical axis and the level of stock (X) on the horizontal axis. The solid
curve relates this growth of the species, measured as the net annual increment
to the population or weights thereof (births minus death), to the stock level.
14
Left to nature and in the absence of human predation, Xc is the population level
that willprevail. Xc is known as natural equilibrium because at Xc stock is just
replacing itself. Reductions in the stock because of mortality or predator
species or (in the case of fish) out-migration would be exactly offset by
increase in the stock because of births, growth of the resource (weight) in the
remaining stock, and in-migration (of fish).
This natural equilibrium would persist because it is stable. A stable equilibrium
is one in which movements away from this equilibrium stock level set forces in
motion to restore it. If, for example, the stock temporarily reduces below Xc
then it will recover because for all stock levels below Xc growth is positive.
Thus if the stock is reduced to X1, it will increase in the first year by G(X1). In
the next year the population level of X1 + G(X1) will grow by less than G(X1),
but the growth will still be positive and the process will continue until the stock
is back to Xc. If, on the other hand, the stock temporarily exceeds Xc, it would
be exceeding the capacity of its habitat (carrying capacity). As a result,
mortality or out-migration would increase until the stock settles down within
the confines of the carrying capacity of its habitat at Xc.

Figure 2: Logistic Growth Curve of a Renewable Resource where Stock

Size is a Function of Time

15
 Figure 3: Relationship between Resource Stock and Growth
Xmin, in the diagram, is known as the minimum viable population and
represents the level of population below which growth in population is
negative (i.e., deaths and out-migration exceed births and in-migration). The
reader can check that in contrast to Xc, this equilibrium is unstable. Here, once
the stock moves away from Xmin no forces act to bring back the resource stock
to a viable level.
With human intervention when catch (yield) level equals the growth of the
stock, it is known as sustainable yield. Here the stock size, the growth rate and,
hence, the catch all remain constant. Thus, in terms of Figure 3, G(X1) is the
sustainable yield for resource stock X1.
Figure 3 helps to identify a concept widely used (particularly by biologists).
This is the maximum sustainable take (MSY), which occurs when the growth of
the resource is at a maximum. In Figure 3 it is G(Xm) corresponding to the
MSY stock Xm. The apparent attraction of MSY should be obvious: if we
harvest the renewable resource in such a way that we take MSY from the stock,
it will regenerate itself and we can get MSY again in the next time period, and
so on. If it takes one year to regenerate, MSY can be harvested each year. If it
takes ten years, we must harvest MSY every tenth year only. MSY is the most
we can harvest from the resource and maintain its sustainability without
reducing its long term stock. We get the maximum from it each period. Herein

16
lies attraction in the idea of setting our rate of harvest equal to MSY4. However,
we shall see shortly that, MSY is unlikely to be an economically optimal policy.
4.2 Efficiency and Sustainable Yield
Allocation to be efficient has to equate marginal costs of harvest with marginal
benefit (that is, maximize net benefits) and hence must include the costs as
well as the benefits associated with harvests. For our present purpose we ignore
discounting and define the static-efficient sustainable yield. It is the catch
(harvest) level that, if maintained perpetually, would produce the largest annual
net benefits. Dynamic-efficient sustainable yield will incorporate discounting.
Initially we concentrate on static concepts and properties.
Our analysis, for simplicity will assume that: (1) The resource (fish) price is
constant; (2) the marginal cost of fishing effort (to be explained subsequently)
is constant; and (3) the amount of harvest (Y) per unit of effort E expended is
proportional to the size of the resource stock (that is, the smaller the fish
population, in our present example, the fewer fish caught per unit of effort).
We now introduce the level of exploitation or harvest or yield of the resource.
Following assumption (3) above, we write
Y = EX (3)
Then, the rate of harvest can be shown on Figure 3. To keep the diagram
simple, we assume that Xmin = Xo. The choice of E will determine the
equilibrium harvest Y and the stock level X, that is, where EX is equal to the
growth of the resource and this is shown in Figure 4 where E = E1. This gives
the harvest Y* and the stock X*. Any harvest level above Y* along the line E1X
will mean that harvest is greater than the sustainable yield Y* and the stock will
decline to X*. A harvest level below Y* along E1X will be less than the yield
through natural regeneration (growth), and the stock will grow to X* again.
It is easy to see that Y*, though sustainable, is not MSY. However, by
manipulating E we could set Y equal to EmX at Ym, the MSY. Introducing the

4
It is to be noted that catches (harvests) larger than growth would be possible in the short-term,
but these could not be sustained. They will lead to reduced stock size and, eventually, if the stock
were drawn down to a level less than Xmin, to the extinction of the species.
17
effort level, thus, helps us to determine the harvest and stock level. But it does
not allow us to indicate the efficient sustainable yield. For that we need to
introduce costs and benefits (revenue) into the picture.

Figure 4: Effect-Growth Equilibriums

To introduce costs and revenues we transform figure 4 into Figure 5 showing
the relationship between the harvest (yield) and the level of effort, that is,
moving from (X, Y) plane to (E, Y) plane.
Figure 5 shows various equilibrium levels of yield (like Y*, Ym, etc.)
corresponding to various levels of effort (like E1, Em etc.), where Em > E1
and so on. A little reflection will show that every effort level on this figure
corresponds a stock level in Figure 4 and Eo corresponds to Xc, and Emax to
Xo. Note that increasing fishing effort (a movement from left to right in Figure
5) would, in Figure 4, result in smaller resource stock and would be recorded
as a movement from right to left.

18
 Figure 5: Effort-Yield Function
Now, the effort-yield curve depicted in Figure 5 can be translated into costs
and revenue. In Figure 6, revenues (benefits) and costs are shown as functions
of harvesting (fishing) effort. Because the price (p) of the harvested resource
(fish) is assumed to be constant, total revenue (R) from harvest (Y) is
R = pY,
and the shape of the revenue function has the same shape as that of the effort-
yield function of Figure 5.
As sustainable levels of effort are increased, eventually a point is reached (Em
in Figure 6) where further effort reduces the sustainable catch (yield) and
revenue for all years. That point corresponds to the MSY (Ym in Figure 5).
The net benefit is shown in Figure 6 as the vertical difference between the
benefit R = pY and costs, C = cE (the constant marginal cost of effort times the
units of effort expended). The efficient (optimum) level of effort is Ee, where
the vertical distance between benefits and costs is maximized. In other words,
Ee is an efficient level of effort, because it is where the marginal benefit (slope
of the total benefit curve) is equal to the marginal cost (the constant slope c of
the total cost curve). Once the efficient level of effort is determined we can
determine the efficient level of yield from Figure 5.

19
 Figure 6: The Efficient (Optimum) Sustainable Yield for a Renewable
Resource (Fishery)
Is, then, the MSY efficient? The MSY is efficient (in a timeless static world)
only if the marginal cost of effort is zero. At the efficient level of effort this
(zero) marginal cost has to be equal to (zero) marginal benefit and marginal
benefit is zero at the MSY level only. Because this is not generally true, the
efficient level of effort (Ee) is less than that necessary to harvest MSY (Em).
Hence, the static efficient level of effort leads to a larger resource (fish) stock
than does the MSY yield level of effort and MSY does not appear to be a
socially desirable objective to strive for.
4.3 Market, Free (Open) Access and Common Property Resources
Having identified an efficient allocation of a renewable resource (fishery), we
can now consider a competitive market allocation and compare these two
allocations. A competitive sole owner is supposed to have well-defined
property rights to the resource. A sole owner would want to maximize his
profit. This will occur (ignoring discounting again) at an effort level where
marginal revenue equals marginal costs. Clearly, this is effort level Ee, the
static-efficient sustainable yield. This will provide positive profits equal to the
difference between R(Ee) and C(Ee). In the absence of any externality,
maximizing net profits and maximizing net social benefits may be assumed to
be the same thing, and hence lead to the same result.
20
While it is not difficult to think of privately owned fishing rights in lakes,
private owners are not normal in ocean fisheries. Ocean fisheries may typically
be international common-property; resources, no single fisherman exercises
control over. Because no sole property rights to the fish belt are conferred to
any owner, no single fisherman can restrict others from exploiting the resource.
This characterizes free (open)-access resources.
What could be the consequences when access to the resource (fishery or
forestry) is completely unrestricted? Free-access resources generate two kinds
of externalities (Titenberg, 2001): (1) a contemporaneous externality, which is
borne by the current generation. It involves congestion due to over-
commitment of resources to fishing – too many boats, too many fishermen, too
much effort. As a consequence, current fishermen earn a substantially lower
rate of return on their effort5. (2) An inter-generational externality, which is
borne by the future generations. It occurs because over-fishing reduces the
stock of fish, which in turn lowers future profits from fishing (once, in the
process, effort level exceeds that associated with the MSY).
When access to the fishery is free, an incentive to expend effort by each
fisherman beyond Ee reduces profit to the fishery as a whole. Every one
imposes a burden on everyone else. At the efficient level, each fisherman
(boat) will receive a profit equal to its share of the scarcity rent. However, this
rent serves as a stimulus for new fishermen to enter, driving up costs and
eliminating the rent. Hence, open access results in overexploitation of
resources.
In a free-access resource, as stated above, the individual fisherman has an
incentive to expend further effort, until profits are drawn down to zero. This
occurs at effort level Ef in Figure 6, where net benefits are zero (R = C).
Contemporaneous externality manifests in too much effort being expended to
catch too few fish, and cost (C) is substantially higher than it would be in an
efficient allocation. In fact, many fisheries and forests in different parts of
India and elsewhere are currently plagued by these kinds of problems.

5
Some areas of deltaic West Bengal and coastal Kerala are experiencing this phenomenon.
21
A resource owner with exclusive property rights would balance the use value
against the asset value of the resource (that is, would consider future flow of
returns also). When access to the resource is unrestricted, exclusivity is lost. It
is then rational for the individual fisherman to ignore the asset value, as he can
never appropriate it. This process will dissipate all the scarcity rent.
However, free-access harvesting may or may not lead to the extinction of the
species. It depends on the nature of the species and the benefits and costs of
harvesting below the minimum viable stock (Xmin in Figure 2 or 3). The
condition under which extinction will occur are: (a) that effort is costless –
effort is at Emax in Figure 5 and the stock goes to zero; or (b) harvesting takes
place at levels above the natural rate of regeneration, that is, the harvest is non-
sustainable. The risk of resource extinction is high if there is a critical
minimum size of the population (Xmin).
Are free-access resources and common-property resources synonymous
concepts? Do they imply identical equilibra? The answer is generally no. We
have seen that free-access means that no one owns the resource and access is
open to all and unrestricted. A common-property resource, however, is one that
is owned by a defined group of people – say a community. It is possible that
within this group members may have free-access to the resource. But it is very
likely that the group will develop rules and norms of use, restricting the use
that any one individual is allowed to make of the resource. These rules are
widespread where common property exists; tribal control of woodlands in
Arunachal, community controlled irrigation systems in many parts of India and
so on. The reason that such rules emerge is the cognizance of the fact that
unrestricted use by each individual is more likely to lead to resource extinction,
adversely affecting the welfare of everyone and perhaps imposing an
irreversible damage (cost) on future generations. In terms of Figure 6 we might
expect a common-property solution to be generally between the profit-
maximizing solution and the free-access solution. However, common-property
solutions can break down if, for instance, the defined group gets larger and
larger because of population growth and in-migration. It may then pay any one
individual to defect, breaking ranks and maximize individual benefit at the

22
expense of the resource and the community‟s overall interests (Pearce and
Turner, 1990).
4.4 Another Renewable Resource: Forests
Forests provide multiple benefits (goods and service) to humans. Forests are
the source of timber which serves a variety of human needs (including fuel
needs of people of the less developed world). Forests protect us from floods
and soil erosion, cleanse the air, and act as the natural habitat of wildlife. They
play a crucial role in the ecology of watersheds that supply much of our useful
water.
Although forests share many attributes with other renewable resources, they
also exhibit some unique features. Trees are commercially valuable when they
are cut and sold. However if not cut, like a capital asset, standing forests also
provide a stream of non-timber environmental services (as mentioned in the
preceding paragraph). Each year, the forest manager has to decide about when
to cut (harvest) a particular forest stand. Unlike many other renewable
resources, the time period between initial investment (planting) and recovery of
that investment (harvesting) may be quite long. Intervals of 25 years or more
are common in forestry. Furthermore, most of the environmental benefits
provided by the forest are positive externalities which normally cannot be
captured by the resource managers. This leads to inefficient management.
Economics can be combined with forest ecology to arrive at an efficient
management of this important natural resource. The standardThe starting point
is to model the efficient decision to cut an even-aged homogeneous single
stand (or cluster of trees). Here we assume that the forest provides only
commercial value of timber. This model could then be used to indicate how the
multiple values of the forest resource should influence the harvesting decision.
4.5 Tree Growth and Harvest
Data, based on measurement of volume, suggest that when even-aged trees are
very young growth is rather slow in volume terms, though the tree may
increase sufficiently in height. Then a period of sustained rapid growth follows.
Ultimately, with the aging process growth slows down, stops or even reverses.

23
When should such a stand be cut (harvested)? Foresters adopt a biological
approach to answer this question. They suggest a measure known as mean
annual increment (MAI). The MAI is obtained by dividing the cumulative
volume of the stand at the end of each decade by the cumulative number of
years the stand has been growing up to that decade.
The biological decision rule then is: cut (harvest) the stand at the age when the
MAI is maximized.
4.6 Economics of Forest Harvesting
To an economist, however, the above rule would appear somewhat arbitrary.
This rule ignores the factors that seem to play a crucial role in an efficient
harvesting decision. Some of these factors are, for example, the value of the
timber, the time value of money, the costs of planting and harvesting. An
economic model of the harvesting decision would, however, incorporate the
basic biology of tree growth as shown in Figures 2 and 3 in Section 4.
Economic efficiency would imply that the optimal time to harvest a stand
would be that age that maximizes the present value of the net benefit from
wood. .
In this framework, it can be shown that discounting (incorporated in time value
of money) shortens the age when the stand is harvested. The use of zero
discount rate implies that the opportunity cost of capital is zero; therefore, it
pays to leave the money invested in trees as long as some growth is occurring
and the value of timber is increasing in the process. With a positive discount
rate, however, the trees will be harvested as soon as more will be earned from
the money from the sale invested in a financial asset at rate r. Is economic
efficiency compatible with sustainable forestry? According to one approach,
sustainable forestry would imply harvesting limited to the growth of the forest,
leaving the volume of wood unchanged over some specified period of time.
Efficiency is not necessarily compatible with this definition of sustainable
forestry. Efficiency requires maximizing the present value. Maximizing the
present value, in turn involves, as shown above, an implicit comparison
between the increase in value from delaying harvest (basically because of the
growth in volume) and the increase in value from harvesting the timber and

24
investing the sale-proceeds to earn r. If the growth rate in volume is small (as
with slow-growing species), maximizing the present value may imply harvest
volumes higher than the net growth of the forest.
It is interesting to note that the search for sustainable forestry that is also
economically efficient has led to the emergence of rapidly growing tree species
and plantation forestry (for example, eucalyptus). These species raise the
attractiveness of replanting, because the invested money is tied up for a shorter
period of time. These species are raised in plantations.
Plantation forestry, however, has raised many questions and has become
controversial. It involves a single species of tree, endangering biodiversity so
essential for many purposes including wildlife habitat. It also requires large
chemical inputs and water, endangering growth of other species around. In
Karnataka, a few years back, a popular movement developed against planting
eucalyptus.
It is instructive to note that thus far we have abstracted from the amenity values
of a forest while determining optimal rotation length. If standing trees provide
amenity services in proportion to their volume, it can be shown that efficient
rotation will be longer (Snyder and Bhattacharya, 1990). However, when
amenity values are large and cannot be captured by the forest owner, the
private rotation decision may fail to take account of these values, leading to
inefficiently short rotation periods.
In India, soon after independence, in the first flush of industrial growth, vast
stretches of bamboo forests were leased to paper and pulp mills. The
agreements required the mills to pay a royalty to the government for the
quantities of bamboo extracted. This royalty was fixed at a highly subsidized
rate. Generous subsidies were also offered to forest-based industries for forest
clearance and harvest. All these prompted destruction of the forest resource
base. Lease of forest lands without creation of any stake in the future
productivity of these lands has adversely affected the regeneration potential of
these areas. Such policies have not only deprived the government of revenue,
but also encouraged unsustainable, indiscriminate exploitation of the country‟s
forest wealth.

25
Dense forests once covered India. As of 2010, the Food and Agriculture
Organization of the United Nations estimates India‟s forest cover to be about
68 million hectares, or about 20 percent of the country‟s area. In qualitative
terms, however, the dense forest in almost all the major Indian states has been
reduced. Forest degradation is a matter of serious concern. India is the world‟s
largest consumer of fuelwood. India‟s consumption of fuelwood is about five
times higher than what can be sustainably removed from forests.
5. ECONOMICS OF WATER RESOURCE
Water is one of the essential elements of life. We humans depend not only on
an intake of water to replace the continual loss of body fluids but also on food
sources that themselves need water to survive. This resource deserves special
attention.
The earth‟s renewable supply of water is governed by the hydrologic cycle, a
system of continuous water circulation. Enormous quantities of water are
cycled each year through this system, though only a fraction of circulated water
is available each year for human use.
Available supplies are derived from two rather different sources – surface
water and groundwater. As the name implies, surface water consists of the
fresh water in rivers, lakes, and reservoirs that collects and flows on the earth‟s
surface. By contrast, groundwater collects in porous layers of underground
rock known as aquifers. Though some groundwater is renewed by percolation
of rain or melted snow, most has been accumulated over geologic time and,
because of its location, cannot be recharged once it is depleted.
In many parts of the world, water scarcity is already upon us, and that of other
areas, including several parts of India, can be expected to experience water
scarcity in the next few decades.
The problem with groundwater is even more severe. Groundwater levels have
been declining in some areas of the country as a result of intensive pumping,
and significant depletion of groundwater supplies has occurred in several
regions. Around 29 per cent of ground water blocks in India are semi-critical,
critical or overexploited and the situation is deteriorating rapidly. By 2025, an
estimated 60 per cent of ground water blocks will be in a critical condition.
Climate change will further strain ground water resources.
26
India is the largest user of ground water in the world, with an estimated use of
230 cubic km of ground water every year – more than a quarter of the global
level. Now, ground water supports around 60 per cent of irrigated agriculture
and more than 80 per cent of rural and urban water supplies.
Though the discussion thus far has focused on the quantity of water, that is not
the only problem. Quality is also a problem. Much of the available water is
polluted with chemicals, radioactive materials, salt, or bacteria. It is important
to keep in mind that water scarcity has an important qualitative dimension that
further limits the supply of potable water.
This brief survey of the evidence suggests that in certain parts of India
groundwater supplies are being depleted to the potential detriment of future
users. Supplies, which for all practical purposes will never be replenished, are
being “minded” to satisfy current needs. Once used, they are gone. Is this
allocation efficient, or are there demonstrable sources of inefficiency? In order
to answer this question we must be quite clear about what is meant by an
efficient allocation of surface water and groundwater.
5.1 The Efficient Allocation of Scarce Water
What efficiency means for the allocation of water depends crucially on whether
surface water or groundwater is being tapped. In the absence of storage, the
problem with surface water is to allocate a renewable supply among competing
users. Intergenerational effects are less important, as future supplies depend on
natural phenomena (e.g., precipitation) rather than on current withdrawal
practices. For groundwater, on the other hand, withdrawing water now does
affect the resources available to future generations. In this case, the allocation
over time is a crucial aspect of the analysis. Because it represents a somewhat
simpler analytical case, we shall start by considering the efficient allocation of
surface water.
Surface Water
An efficient allocation of surface water (1) must strike a balance among a host
of competing users, and (2) must supply an acceptable means of handling the
year-to-year variability in surface water flow. The former issue is acute,
because so many different potential users have legitimate competing claims:
27
Some (e.g., municipal drinking water suppliers or farmers) withdraw the water
for consumption; others (e.g., swimmers or boaters) use but do not consume
the water. The latter challenge arises because surface water supplies are not
constant from year to year or month to month. Because precipitation, runoff,
and evaporation all change from year to year, less water will be available to be
allocated in some years than in others. Not only must a system for allocating
the average amount of water be in place, above-average and below-average
flows must also be anticipated and allocated.
With respect to the first problem, the dictates of efficiency are quite clear – the
water should be allocated so that the marginal net benefit is equalized for all
uses. If marginal net benefits have not been equalized, it is always possible
to increase net benefits by transferring water from those uses with low net
marginal benefits to those with higher net marginal benefits. By transferring
water to the users who value the marginal water more, the net benefits of the
water use are increased; those losing water are giving up less than those
receiving the additional water are gaining. When the marginal net benefits are
equalized, no such transfer is possible without lowering net benefits.
Groundwater
When withdrawals exceed recharge from a particular aquifer, the resource will
be mined over time until supplies are exhausted or until the marginal cost of
pumping additional water become prohibitive. The marginal extraction cost
(the cost of pumping the last unit to the surface) would rise over time as the
water table drops. Pumping would stop either (1) when the water table run dry
or (2) when the marginal cost of pumping was either greater than the marginal
benefit of the water or greater than the marginal cost of acquiring water from
some other source.
Abundant surface water in proximity to the location of the groundwater could
serve as a substitute for groundwater, effectively setting an upper bound on the
marginal cost of extraction. The user would not pay more to extract a unit of
groundwater than it would cost to acquire surface water. Unfortunately, in
many parts of the country where groundwater overdrafts are particulars severe,
the competition for surface water is already keen; a cheap source of surface
water doesn‟t exist.
28
In efficient groundwater markets, the water price would rise over time. The rise
would continue until the point of exhaustion, the point at which the marginal
pumping cost become prohibitive or the marginal cost of pumping becomes
equal to the next-least-expensive source of water. At that point the marginal
pumping cost and the price would be equal.
5.2 Common Property Problems.
The allocation of groundwater must confront one additional problem. When
many users tap the same aquifer, that aquifer becomes a common-property
resource. Tapping a common-property resource will tend to deplete it too
rapidly; users lose the incentive to conserve. The marginal scarcity rent will be
ignored.
The incentive to conserve a groundwater resource in an efficient market is
created by the desire to prevent pumping costs from rising too rapidly and the
desire to capitalize on the higher prices that could reasonably be expected in
the future. With common-property resources, neither of these desires translates
into conservation, for the simple reason that water conserved by one party may
simply be used by someone else because the conserve has no exclusive right to
the water that is saved. Water saved by one party to take advantage of higher
prices can easily be pumped out by another user before the higher prices ever
materialize.
For common-property resources, pumping costs would rise too rapidly, initial
prices would be too low, and too much water would be consumed by the
earliest users. The burden of this waste would not be shared uniformly.
Because the typical aquifer is bowl-shaped, users on the periphery of the
aquifer tend to be particularly hard hit. When the water level declines, the
edges go dry first, whereas the center can continue to supply water for
substantially longer periods. Future users would also be hard hit relative to
current users.
In conclusion we may say that we touched upon here some of the basics of the
economics of natural resources using some representative resources. However,
we need to remember that this is just a very brief introduction of a much larger
issue.
29
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Observer, February, pp.93-111.
Snyder, D. and R.N. Bhattacharya, (1990), „A More General Dynamic
Economic Model of the Optimum Rotation of Multiple-use Forests‟,
Journal of Environmental Economics and Management, 18, pp. 168-
75.
Titenberg, T. (2001), Environmental Economics and Policy, 2nd ed., USA:
Addison-Wesley.

30
Centre of Excellence in Environmental Economics

The Ministry of Environment and Forest, Government of India has

designated Madras School of Economics as a Centre of Excellence in the
area of Environmental Economics. The Centre carries out research work
on: Development of Economic Instruments, Trade and Environment, and
Cost-Benefit Analysis. The Centre is primarily engaged in research
projects, training programme and providing policy assistance to the
Ministry on various topics. The Centre is also responsible for the
development and maintenance of a website (http://coe.mse.ac.in), and for
the dissemination of concept papers on Environmental Economics.

Madras School of Economics

Madras School of Economics was founded in 1993 as a private post-

graduate institution for teaching and research in economics. MSE offers a
two-year Master's program in Economics, Financial Economics, Applied
Quantitative Finance, Actuarial Economics and Environmental Economics
affiliated to the Central University of Tamil Nadu, and a Ph.D. programme
affiliated to Madras University. MSE has undertaken a large number of
research projects since its inception, including the World Bank sponsored
Capacity Building Programme in Environmental Economics. The World
Bank project involved research, training, curriculum, and overseas
fellowship components which were coordinated by MSE. Subsequently, the
Ministry of Environment and Forests approved the proposal to set up a
Centre of Excellence in Environmental Economics at MSE. MSE has also
served as an ENVIS Centre in Environmental Economics under the
Environment Information System (ENVIS) of the Ministry of Environment
and Forests, Government of India. A dedicated program on Trade and
Environment, with support from the Ministry of Environment and Forests,
Government of India, has been initiated at MSE.
 AN OVERVIEW OF ENVIRONMENTAL ECONOMICS

INTRODUCTION:

Environmental Economics has emerged as an important branch of study over the

last few decades or so. Many environmental goods were earlier thought to be
abundantly available free gifts of nature and hence, outside the scope of Economics.
(Economics is concerned with the use of limited resources at the disposal of
individuals and the society to meet the unlimited human wants, and hence scarcity is
typically at the heart of economic problems.) However, with the passage of time
people started realizing that many of such goods have been increasingly becoming
scarce. Accordingly, their use and allocation have increasingly attracted attention of
the economists.

Within economics, environmental economics has emerged as a separate branch

because the usual system in which the allocation of most of the economic goods
take place does not work for environmental goods. In a market economy framework
allocation of resources or as to how much of various ordinary economic goods and
services such as rice, bikes, pens, computers etc. to be produced gets decided
through the working of the price system. If, for instance, there is excess of supply of
a particular good over its demand by the people then price will fall. On the other
hand, in the opposite case of excess demand of a commodity over its supply the
price will increase. This process of adjustment in prices will continue till the quantity
supplied of the commodity concerned is exactly equal to its quantity demanded by
the people. Except under certain exceptions, this system works more or less
efficiently in a competitive economy. However, in case of environmental goods and
services the price system fails to ensure their judicious use in the society. Many
environmental goods despite being scarce do not command price because of certain
factors to be discussed later. Even when price exists for them, the price fails to
adequately reflect its proper value. Thus, the various issues related to the use of
environmental goods and services by the society require specific treatment which is
done in the branch of environmental economics.

Some of the main components of Environmental Economics are

 Inter-linkage between the Economy and the Environment
 Sources of Market Failure
 Pollution Control Policies
 Economics of Natural Resources
 Valuation of Environmental Amenity
 Development-Environment Interrelationship
 Sustainable Development
 Economic Aspects of Global Environmental Issues

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The following is a brief outline of the contents of these components

INTER-LINKAGES BETWEEN THE ECONOMY AND THE ENVIRONMENT:

Most text books on Environmental Economics begin with a chapter dealing with the
inter-linkages between the economy and the environment. Indeed, an understanding
of such inter-linkages is useful for a better insight to the more complex issues of
Environmental Economics.

The service of the environment to the economy is multidimensional. First of all, it

provides resources (materials and energy) as inputs for production of consumable
goods and services. The environment also supplies recreational amenity for the use
of human beings. More vitally the environment provides the ecosystem for
continuation of human and other life forms in the earth. Apart from this, the wastes
generated in the process of human economic activities are largely absorbed and
assimilated by the environment. It is, however, important to recognize that these
different services of the environment to the economy are interlinked and there are
important trade-offs between one role and the other. For instance, too much
dumping of wastes into the environment impairs the capacity of its life support
system. Similarly, increased extraction of environmental resources as inputs for
economic activities can damage its recreational value. Accordingly, the optimal
balancing of the different roles of the environment in the economy is the core issue
underlying the subject of environmental economics.

MARKET FAILURE AND ITS COMMON SOURCES:

Market failure refers to a situation where the market mechanism (or price system)
fails to ensure an efficient allocation of resources. Two main reasons why price
system does not work properly in case of environmental goods are what economists
call ‘externality’ and ‘non-excludability’.

Externalities are the effects of production or consumption by one on production

and/or consumption opportunity of another which is not captured in prices in market
transaction. For illustration, let us take the case of paper production. The production
process involves use of various resources such as labour raw material, machinery
etc. Owners of these resources are compensated by paying prices and hence the
value of these resources enters the cost calculation of the producer. However the
pollution generated in the production process, may cause losses to the society in a
number of ways. These losses actually form a part of cost of producing paper. But
so long as the producer does not have to compensate these losses, they cannot
enter the process of determination of price of paper. Hence paper will be under
priced resulting in its too much demand for paper and concomitantly too much
pollution inflicted on the society. Thus the market fails to provide for social
optimality.

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 ‘Non-excludability’ is a situation where it is impossible or highly costly to exclude
any one from using a particular good or service. Since people can use such goods
and services without paying any price, no price can ordinarily be charged for them
even though they are not abundantly available. Most environmental services have
this non-excludability feature. For instance the waste disposal capacity of the
environment is not unlimited. Yet the market cannot set a price for this service as it
is ordinarily possible for people to use it without paying for it.

Addressing market failure in environmental goods is a major concern in

Environmental Economics.

POLLUTION CONTROL POLICIES:

The illustration of paper manufacturing in the previous section clearly shows that
market forces will not automatically lead to socially optimal level of output and
pollution. (It is to be noted that zero pollution may not be consistent with socially
optimal level because any type of economic activity involves some amount of
pollution). Hence, one area of environmental economics focuses on the methods of
controlling pollution. Such methods of controlling pollution can be broadly divided
into two categories, viz., command and control and incentive based measures.

In case of command and control the regulator specifies certain steps and commands
the polluters to follow them and act accordingly in order to control pollution. For
example, the regulator may instruct the polluters to use particular pollution control
equipment. An important advantage of this method is that it can assure with certainty
as to how much pollution will result from the regulations, provided the polluters follow
the guidelines of the authority. Moreover, monitoring of compliance with a regulation
is simple. However, the major problem of this tool is that it is difficult and very costly
to enforce it mainly due to informational constraints. Another significant problem with
the command and control is that since the polluters have to comply with the
regulation; they do not have the incentive to look for a better way of controlling
pollution.

The incentive based measures relies on providing incentives in terms of rewards for
the polluters to do what is perceived to be in the interest of the people. The incentive
based measures or economic incentives in short, are basically of three types, viz.,
fees, liability and marketable permits. Pollution fees involve imposition of taxes per
unit of pollution emitted. This is also referred to as Pigovian tax, named after the
famous economist A.C. Pigou. When the polluter is required to pay for every unit of
pollution emitted naturally it is in his interest to reduce emissions. The pollution fees
may take the form of tax on a commodity generating pollution either through its
production, consumption or through use of polluting inputs. (For more illustration see
Carbon Tax.)

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Carbon Tax:

A carbon tax is a charge levied on the fossil fuel which may vary within different
types of fuels depending on their relative carbon content. It can be collected in
several ways: as a tax on domestic fossil fuel output, as a tax on import of fuel
output, as a tax on primary energy inputs etc. If the tax is higher than the cost of
abating the additional unit of carbon (also known as Marginal Abatement Cost), the
polluter would like to reduce the emission of carbon. On the other hand, if the tax is
lower than Marginal Abatement Cost then he would like to emit and pay the tax.
Thus, it is clear that the best solution for a polluter is to pollute up to that level where
Marginal Abatement Cost is (MAC) equal to the tax. If all the polluters across
sources behave in the same fashion, a situation will be attained where Marginal
Abatement Cost of all sources is equal to the tax. This is the ideal or cost effective
situation from society’s point of view. This is the ideal or efficient solution because if
this situation is attained then it is ensured that a specific emission reduction target is
achieved with the minimum possible cost. This point can further be elaborated. Let
us assume there are only two sources of carbon emissions. If the MAC of one
source is higher than the other, then society can always save money by reallocating
emission control responsibility away from the higher-MAC source and towards the
lower-MAC source. Thus same amount of emission reduction can be achieved but at
a lower cost. Once the MAC across sources becomes equal the scope of further
reallocation of the emission control responsibility is no longer there. At that point
whatever cost is incurred that is the minimum cost required to be spent to attain that
particular level of emission reduction. Thus, it can be stated that the carbon-tax has
the in-built-mechanism to attain the efficient solution.

A tax may result in several responses: different sources might reduce their tax
liability by reducing emission, fossil fuel users will increase the energy efficiency, use
less carbon intensive fuels and consume goods and services produced in carbon-
saving ways. The major problem with tax, however, is that it is uncertain whether an
emission reduction target will be attained or not.

An alternative to the Pigovian tax as suggested by D. H. Dales may be tradable or

marketable pollution permits. The tradable pollution permits allows the polluters to
buy and sell the ‘right to pollute’. Let us take the example of air pollution. First the
optimal level of pollution in a locality is determined and then this is divided into a
number of permits and distributed among the polluting firms. Thus every firm enjoys
the right to pollute according to their permits. Now cost of abetment is likely to differ
across firms. While some firms can cut back pollution at a relatively small additional
cost, for some others cutting down pollution level may be a much higher cost affair.
Since pollution permits are tradable, the firms with low abatement costs will have the
incentive to cut down pollution level and profit by selling surplus pollution permits in
the market. The firms with high abetment cost would like to buy additional permits as
that will spare them the high cost obligation of reducing pollution. In other words
pollution will be reduced sharply in units where the cost of abatement is low and

4
permits will be concentrated in units where abetment cost is high. Thus, through
buying and selling of the permits aggregate pollution will be kept within the
prescribed level with minimum collective (social) cost of the firms. Markets for
trading in carbon permits are already in operation. Carbon trade is slated to acquire
a significant volume in India too.

The third type of incentive based measure is liability. Strong liability law is can help
to minimize the risks of environmental disasters. Carelessness in storage,
transportation and disposal of hazardous chemical or radioactive waste or other
polluting agents can result in their leakage to the environment causing extensive
damage to life and ecosystems. When agents dealing with use, storage and
transportation such material are made severely liable for punishment and/or
compensation for any such leakage, it creates the incentive to be careful to avoid
such leakage. The incentive in turn reduces the probability of occurrence of
environmental disasters like the Bhopal Tragedy.

ECONOMICS OF NATURAL RESOURCES:

Natural resources refer to the resources in the form of various goods and services
provided by nature. For example, air, water, mineral, timber, solar energy and so on.
Economics of natural resources is concerned with the principles regarding use,
regulation and preservation of different types of natural resources.

Natural resources may be broadly categorized into two types, viz., renewable and
non-renewable resources. The renewable resources are those which get
regenerated through a biological process. Fisheries and forests are examples of
renewable resources. On the other hand, non-renewable resources are not
regenerated within a time horizon relevant to economic calculations of the human
society. Minerals like coal, iron ore and hydro-carbon are prime examples. (The
renewable resources like trees in a forest and the fish stock in a water body can
regenerate within a reasonably short period of time whereas the resources like coal
take million of years for their formation.)

Since the non-renewable resources are exhaustible in use, their stock is bound to
deplete with the passage of time and growing demand for them. Therefore, the main
issue regarding the management of such resources should focus on their optimal
extraction and depletion over time. The management of non-renewable resources is
concerned with the optimal allocation of resources between present and future. Here
price system can play an important role. The price of such a resource increases with
increase in its scarcity, which provides an incentive for economization in use and
also for looking for substitutes. For example, the scarcity and higher price of non-
renewable energy resources such as mineral oil, coal etc. has encouraged people to
focus on other substitutes like solar energy and nuclear energy as alternative energy
sources. Moreover, the existence of monopolies and cartels may also slow down the
rate of depletion of non-renewable resources. For example, the Organization of

5
Petroleum Exporting Countries (OPEC) may reduce the supply of oil in the market
leading to increase in the price and thereby reduce the depletion of crude oil.

The case of renewable resources is quite different from that of the non-renewable
ones as the former may be prevented from its exhaustion unlike the later. However,
their indiscriminate extraction should be avoided. For instance, over harvesting
reduces the stock of fish, which in turn reduces the natural regeneration of fish
population. Sometimes, it may even lead to the extinction of otherwise renewable
resources as is now with the case of many endangered species. Hence, we should
go for sustainable exploitation along with necessary steps to facilitate their
regeneration so that the stock of the resources remains un-replenished.

Economic analysis has shown that if rights over the resources are firmly and clearly
defined then market forces can ensure sustainable use of the renewable resources.
However, the main problem arises when property right is not well defined and it
becomes an open access common resource. Open access resource signifies a
situation where there are no enforceable property rights over the use of the resource
and it is open to exploitation by all members of a group. It may lead to ‘tragedy of
commons’.

The Tragedy of Commons:

Let us take an example of a common grazing land in a village which is open to all
the villagers. Each villager in the pursuit of maximizing individual gain adds more
and more cattle to the grazing field. He gets the full benefits of adding one more
animal to the field. His personal gain from adding one more animal exceeds his
personal loss from the damage done to the field (since the loss done by one more
animal is to be shared by all as opposed to the gain which accrues fully to him). All
villagers think the same way and act accordingly to maximize personal gains.
Eventually the total number of cattle exceeds the carrying capacity of the grazing
land and everybody loses from the damage of the land. Thus, in the absence of
appropriate regulation, overexploitation of resources leads to their destruction. Such
tragedy may also occur in case of common fishery in the villages.

Since the problem originates from laxity in defining and enforcement of property right
over the commons, the usual solution suggested is assignment of property rights
either in the form of private property rights or through establishing common property
rights regime, which lays down rules to limit entitlement of individual members to
common resources of the community

‘Prisoner’s Dilemma’:
A popular analysis of the ‘Tragedy of Commons’ takes the form of a game known as
the ‘prisoner’s dilemma’. To explain this concept let us assume that two persons,
Haren and Bittu have been arrested on the charges of theft. They have been kept
separate so that no communication is possible between them. The options in front of
them are: if one confesses but the other does not, the former will be set free while

6
the later will receive punishment of 5 years in jail; if both confess then they will get a
modest punishment, say of 2 years; and if neither confesses his crime they will be
freed after 3 months due to lack of evidence. This is depicted in Table 1. Now Haren
thinks that if Bittu does not confess his best option is to confess and secondly if Bittu
does not confess, then again his best option would be to confess. Because if he
does not confess and Bittu confesses, he will get a severe punishment of five years
and there is no way for him to know what the decision of the later would be . On the
other hand, Bittu thinks the same way and decides to confess. Thus the likely
outcome is that both will confess and get a punishment of 2 years each. However, it
is interesting to note that if both could come to contact and cooperate then they
could have got only 3 moths punishment simply by denying the charges against
them. But since they have been kept separate cooperation is not possible. The
essence of ‘prisoner’s dilemma’ is that lack of cooperation among the parties
deprives them of the best of all the outcomes.

Table 1: The ‘Prisoner’s Dilemma’

Haren
Bittu
Confess Don’t confess

Confess 2 years, 2 years free, 5 years

Don’t confess 5 years, free 3 months,

3months

Thus, ‘prisoner’s dilemma’ refers to a situation where each participant receives a

comparatively lower return as a result of non-cooperation than what they would have
received if there were cooperation between them.

The same sort of ‘prisoner’s dilemma’ can be observed in case of the commons. Let
us now take the example of common grazing land used while discussing ‘tragedy of
commons’. It was found that the desperate use by all the herdsmen lead to
degradation of grazing land. For the sake of simplicity let us assume that there are
only two herdsmen Haren and Bittu. The different options open to each one of them
are shown in Table 2. As clear from the table when one cooperates in the judicious
use of the land but the other does not, the later is the gainer in terms of returns from
his livestock as he will be putting more and more cattle on the land. If neither of them
cooperates and uses the grazing land indiscriminately then each gets a low return of
20. The best action, however, would have been to cooperate and appropriate a
larger return of 50 each. But their individual rational choices lead to non-cooperation.

Table 2: Common Grazing Land and ‘Prisoner’s Dilemma’

Haren

7
 Bittu Cooperate Don’t cooperate

Cooperate 50,50 10,30

Don’t cooperate 30,10 20,20

However, this undesirable solution may be avoided in a ‘repeated game’ framework.

Suppose the players, Haren and Bittu in our example, go through the dilemma
repeatedly. Once repeatations come into calculation, the players are likely to realize
the mutual gain from cooperation, and their choice of action may be different from
what that will be in a one-off game. There are ample empirical instances when
members of a community get together to form rules to self regulate the use of their
commons and thereby manage to avoid the ‘tragedy of commons’.

VALUATION OF ENVIRONMENTAL AMENITY:

Why is the valuation of environmental amenity needed? The answer depends on the
values that the society puts on the environmental amenities. Since the society puts
value on such amenities, it is desirable that they should be preserved and
conserved. As preservation and conservation involve costs, hence decision has to
be taken regarding the amount that is socially justified. The valuation tools have now
been extended to heritage sites and monuments also. Before going to discuss the
valuation techniques it is necessary to highlight upon the values the society puts on
environmental goods.

The environment provides different types of goods and services. The values that the
society puts on such goods and services are broadly categorized into use value and
non-use value.

Use value arises when one derives benefits from an environmental good or service
by directly participating in its use. For example, the environment provides raw
materials and other resources which are used directly in the production and
consumption activities. Another example of this is sightseeing where an individual is
directly engaged in viewing the beautiful scenery.

On the other hand, in case of non-use value an individual derives satisfaction

without directly using the goods or services. One may feel happy simply by knowing
that the one-horned rhino is found in Kaziranga National Park in the state of Assam.
The non-use value may, however, be of different types, viz., option value, existence
value and bequest value. An option value is the value placed on the option for using
a good in future. An example of option value is preservation of biodiversity.
Preservation of some of the endangered species may be desired as many people
may wish to have enjoyment from seeing them in future. Existence value refers to
the value attached to knowing something exists. An example is the one-horned rhino
mentioned earlier. Bequest value arises when one intends to pass a good or service
on to the future generation.
8
Non-market Valuation Techniques:

The value or price of the ordinary goods that we use in our day–to-day life such as
pen, rice, computer, clothes etc. are determined through the market on the basis of
their demand and supply as mentioned earlier. The problem, however, arises in case
of environmental goods most of which do not command any price notwithstanding
their great importance and scarcity. Therefore, the usual valuation techniques based
on the market forces cannot be applied for such goods or services. In simple words,
market does not exist for such goods. Hence, for valuation purposes certain
techniques popularly known as ‘non-market valuation techniques’ are used in this
regard. This is perhaps one of the biggest contributions of environmental economics.
The two major groups of non-market valuation techniques are - Stated Preference
Method and Revealed Preference Method. They are briefly discussed below.

Stated Preference Method:

In this method people are asked to state their preference in terms of willingness to
pay (WTP) or willingness to accept (WTA) for certain hypothetical changes in the
environmental quality. For example, they may be asked what they would be willing to
pay for an improvement in the air quality or what they would be willing to accept as
compensation for any deterioration in the air quality, if there were a market for it.
Since market doest not exist for air quality, say for instance, this method is based on
the existence of a hypothetical market. One popular form that has been extensively
used in the empirical researches is the contingent valuation method. In the
contingent valuation method the respondents constituting a sample of population are
asked to state what they would be willing to pay (or accept) for a hypothetical
increase (or decrease) in the environmental quality. However, the major limitation of
this method is that the respondents may overstate their willingness to pay if they
believe that they will not actually be required to pay whereas they may have a
tendency to understate their willingness to pay if they think that their response may
influence how much they would actually be charged.

Revealed Preference Method:

In this method attempt is made to estimate the value that people place on
environmental goods from their observed behaviour in terms of expenditure on a
closely related ordinary good. Unlike the stated preference method in the revealed
preference method we make use of people’s actual behaviour rather than their
intentions (in terms of WTP of WTA). There are two approaches to this method:
hedonic pricing method and travel cost method.
The hedonic pricing method starts with the assumption that variations in the
presence (or absence) of environmental qualities cause differences in the prices of
ordinary goods and this information can be used to infer the value of the
environmental qualities concerned. This approach is generally used in case of
housing markets. For example, a house contains different attributes like number of
rooms, age of the house, open space outside of it, its location form the main town

9
etc. and also environmental characteristics like air quality, noise level, sunlight,
scenic views and so on. Now, other things being equal, a house with a better air
quality or in a quieter environment may fetch a higher price (or rent) than a similar
house with a relatively poorer air quality or noisier part of the city. The hedonic
pricing method seeks to infer the implicit value of the environmental attributes (like
air quality in the above example) from the amount people are willing to pay for the
ordinary goods like houses.
The travel cost method is associated with the valuation of environmental goods such
as outdoor recreational sites. The method uses travel cost (time cost as well as
money cost) as a proxy for the value of visiting such sites. A statistical relationship
between observed visits and cost of visiting is derived and this relationship may be
used to infer the value that the visitors enjoy.

DEVELOPMENT-ENVIRONMENT INTERRELATIONSHIP:

Development and Environment Trade-off?

The relation between the development process of a country and its environmental
quality has attracted the attention of a number of economists. Some of them have
found that environmental pollution has a relation with the development process
which is of the shape of an inverted U. That is, the pollution levels first tend to
increase as development process takes off. But as the process crosses a certain
threshold and attains a fairly high level the pollution levels tend to decline with
further advancement of development. The explanation for such relationship is given
in the following lines. At low level of development economic activities, by and large,
are subsistence in nature. Hence, the quantity and intensity of resource use being
limited and wastes being mostly biodegradable, environmental degradation remains
low. But as economic development accelerates agriculture gets intensified, resource
extractions acquire larger scale and industrialization takes off. As a result, resource
exploitation and waste generation increase in quantity and toxicity. At higher levels
of development, however, the structure of the economy becomes more service
oriented, environmental awareness increases and demand for cleaner environment
expands with rising income levels. Consequently, environmental regulations are
enforced and better technology and higher expenditures are applied for limiting
pollutions. Such factors contribute to leveling of and gradual decline of
environmental degradation.

Empirical evidence in support of such an inverted U-shaped relationship is not fully

conclusive. Even if such a relationship exists, leaving environmental degradation
unattended in the development process with the hope of the process itself taking
care of the environment at a later stage is not an advisable approach. For, once
environmental degradation crosses some threshold the damages may become
irreversible. Hence, environmental economists call for the sustainable development
(to be discussed later) approach rather than leaving development process to take
care of environmental degradation merely through its inherent dynamics.

10
Poverty and Environmental Degradation:
All over the world poor people usually live near the dirty factories or waste dumps or
other degraded locations which the better off choose to avoid. Accordingly the poor
people, almost always, bear the burnt of environmental degradation. Most of the
people who die from air and water pollution every year are poor.

Poverty and environmental degradation are often caught in a mutually reinforcing

downward spiral. The poor are usually more critically dependent on common
resources such as forests and water bodies for their day to day living than those who
possess greater private wealth. Because of the pressure of growing population and
in absence of other resources to fall back upon in difficult times, poor people are
forced to exploit such resources more extensively than before. This puts further
pressure on the environment. Environmental degradation, in turn, makes their living
conditions even more precarious forcing them squeeze the already degraded
environmental resources. If the spiral is to be arrested, purely environment oriented
policy obviously will not be adequate. Addressing poverty will be equally important.

Indeed, for appropriate policy formulation it is necessary to examine the causality

between poverty and environmental degradation. Addressing poverty supported by a
programme of environmental restoration should be adequate only if the downward
spiral is triggered off by poverty. However, the poor usually do not possess the
means and power to damage the environment to the point that will unleash the
spiral. On the contrary, there are ample evidence to show that greed and rent
seeking by the rich and the powerful initiate the degradation of the environment and
common resources in a scale that endanger the livelihood of the commons-
dependent poor pushing them degrade the very resources on which they are
critically dependent. Under such a situation merely addressing poverty can at best
have only some temporary impact. More permanent solution will require correcting
market and institutional failures that allowed plundering of environmental resources.

SUSTAINABLE DEVELOPMENT:

Definition and Interpretation:

Energy crisis of 1970s and some other events in the same period heighten concern
about depleting natural resources and degrading environment all over the globe.
Some thinkers even call for slowing down of economic growth so as to
avoid/postpone environmental and natural resource crisis. On the other hand,
existence of wide spread poverty and deprivation in the less developed countries
necessitated enhanced level of economic activities in these countries so as to
eliminate poverty and underdevelopment expeditiously. To find out a way of
reconciling the apparently conflicting goals of speeding development process on one
hand and conserving resources and environment on the other, the United Nations
instituted the World Commission on Environment and Development under the
chairmanship of Mr. Bruntland, the then prime minister of Norway. The commission

11
in its report ‘Our Common Future’ published in 1983, articulated sustainable
development as “Development that meets the needs of the present without
compromising the ability of future generations to meet their own needs”.

While the concept of ‘sustainable development’ as given by the Bruntland

Commission sounds appealing at the first instance, an attempt at putting the idea in
practice is confronted with ambiguity. The ambiguities arise from the fact that the
definition is based on needs of present and future generations. The need of the
future generation is particularly difficult to foresee and hence it is difficult to
comprehend the course of action that will pass sustainability criterion. For practical
application of the idea, a more distinct interpretation of it becomes necessary.

Economists led by Nobel laureate Robert M. Solow finds that the idea of
sustainability resonates with Economists’ conceptualization of INCOME, i.e.,
maximum consumption one can have in a period while remaining as well off in the
end as in the beginning of the period. In that light sustainability has been interpreted
as an obligation to conduct ourselves so that we leave to the future the option or
capacity to be as well off as we are. The emphasis is on keeping the stock of asset
undiminished so that the flow of production of goods and services for consumption is
maintained. Accordingly, sustainability requires that the stock of capital-
manufactured, human and natural, is left undiminished. This in turn needs restricting
consumption to save resources for asset creation and conservation and protection of
the environment.

Environmentally Adjusted National Income:

Conventionally while computing national income the wear and tear of manufactured
capital is deducted from the gross value of annual production. This is necessary to
provide for replacement of depreciation of the capital stock so that the production
capacity of the economy is maintained. However, till recently, national income
accountants were oblivious of the fact that even the stock of natural capital and the
quality of environment also takes a beating in the process of production and
consumption in the economy. Environmental economists have driven home the point
that provision should be made for the depletion of natural resources and damage
caused to the environment also from the gross value of a country’s production to
obtain its income. Accordingly they define ‘genuine income’ of a country as its Gross
National Product less (a) depreciation of man made manufactured capital, (b)
depletion of the stock of natural capital and (c) the value of damage caused to the
environment in course of producing and using that GNP. Countries where total
consumption is within the limit of such environmentally adjusted income can be
regarded as adhering to a broad sustainability norm.

12
ECONOMIC ASPECTS OF GLOBAL ENVIRONMENTAL ISSUES:

These issues can be broadly divided into two categories. One set of issues arises
from the consequences of differences in environmental regulations across countries.
The other set of issues is concerned with management of global environmental
public good.

Trade and Environment:

International trade helps a country to specialize in the production of those
commodities in which it has comparatively a lower cost (i.e., comparative cost
advantage) as compared to other countries and import those commodities from
others in which it has a comparative cost disadvantage. The relative endowments of
different types of natural resources, among other things, play an important role in
determining the pattern (i.e., composition of the goods and services to be traded)
and volume of trade. On the other hand, the pattern and volume of trade, through
changes in the spatial distribution of production and consumption, affects the
environment nationally and globally. This issue assumes greater significance
particularly in the context of the move towards liberalization and globalization by
almost all the countries.

As suggested by the standard theories, the two sources of international trade

determining the comparative cost advantage of different countries are differences in
the labour productivity and relative availability of factors of production including the
natural resources. However, apart from these two sources the differential
environmental standards or regulations across countries may also affect the pattern
and spatial distribution of trade, and thereby the environment. International trade
facilitates greater production and consumption, which in turn lead to different types
of environmental problems like loss of forests and bio-diversity, pollution of water
and air etc. These are important costs that the society has to bear, but remain
uncovered in the cost calculations of the individual producers. As mentioned earlier
(under section on ‘Market Failure and its Common Sources’) in such cases of
negative externalities private costs underestimate social cost and hence, the price
set is lower than the costs that the society bears as a whole. Consequently, more
output is produced than the socially optimal level. The appropriate regulations may,
however, prove useful to make the polluters curtail output to the socially optimal
level when they are compelled to bear the cost of such pollution.

The above point needs a little bit elaboration. Let us take two countries --- one
developed and the other developing. The environmental regulations are generally
stricter in the former as compared to the later. Suppose the two countries are
identical with respect to factor endowments, prices of factors and technology; except
the differences in their environmental regulations. In the developed countries the
stringent regulations force the producer to set prices at the level of social costs. On
the other hand, the absence of such environmental regulations in the developing
countries enables their producers to sell the products at a low price (which is equal
to private cost rather than the social cost). Thus, the developing countries appear to

13
enjoy a comparative advantage, though this is not a genuine comparative
advantage.

Thus the developed countries are forced to go for producing and exporting those
commodities and use those methods of production which are less polluting in nature;
otherwise they will have to bear the cost done to the environment because of
stringent environmental regulations. On the other hand, due to apparent comparative
advantage the developing countries would specialize and export the environmentally
intensive goods which are more polluting in nature. Secondly, they cannot afford to
produce less polluting goods as it requires investment on ‘clean technology’. If this is
the reality then international trade between the developed and developing countries
will turn the later into ‘pollution havens’ where all the ‘dirty industries’ or heavily
polluting industries would get concentrated.

Empirical evidence however provides little support for the ‘pollution haven’
hypothesis. Obvious explanation for why the phenomenon has not manifested in any
significant scale is that there are costs of relocating an industry which often outweigh
the advantage of less stringent environmental regulation.

Global Public Goods and Bads:

Public goods are those which are non-rival and non-excludable in nature. Non-rivalry
means the use of the good by one person does not make it less available to others.
Non-excludability means it is impossible or highly costly to exclude any one from
having the benefits of the good or service concerned. Similarly, public bads affect all
the people in a locality adversely and no one can be excluded from its effects. These
public goods and bads may be local as well as global. One example of global public
good is ozone layer. The good effects of the ozone layer is not exclusive to any
country irrespective of whether the country has or has not taken steps to conserve it.
Similarly an example of global public bad is a green house gas, since a country
cannot exclude itself from its adverse impact.

Because of the non-excludable feature of global public goods and bads individual
countries on their own may not have enough incentives to take necessary measures
for conserving the goods and limiting the bads. Indeed, a country might try to free-
ride on other countries hoping that others would, in any case, take necessary
actions. However, if each country thinks in this line enough actions will not be taken
and the ‘tragedy of commons’ will repeat itself. Thus for dealing with such global
environmental goods and bads, cooperation among countries around the globe is
essential. The realization of the need for such cooperation is the foundation for
discussions and negotiations of different international protocols such as the Kyoto
Protocol, the Montreal Protocol etc. on global environmental issues.

LINKS
Command and Control:

14
The command and control measure is one of the dominant forms of environmental
regulation in the world today. The essence of the method is that the regulator
commands the specific steps that the individual polluters have to take to solve a
particular problem which he decides upon after collecting the necessary information.
The best analogy for command control is the system of central planning that existed
in the former Soviet Union to manage its economy. The method may take several
forms. One way of conveying the command and control may be by example. The
authority may set off an act which fixes the minimum pollution control performance of
an individual polluter. This may require the authority to study each and every
category of polluters and fix separately the minimum requirement of different
categories of them. The regulator might, in some cases, specify the use of particular
pollution control equipment. Command and control may in fact be combined with
significant fines and penalties associated with non-compliance. However, such
incentives to comply with a command and control regulation should not be confused
with an economic incentive to abate pollution. There are two key features that
differentiate command and control from economic incentives: 1) choice regarding the
means to meet an environmental target is restricted in command and control
measure and 2) Command and control lacks a mechanism to equalize the marginal
control costs across polluters whereas the economic incentives have it. One major
advantage of this approach is whereas it is unclear how a polluter might respond to
an economic incentive, command and control gives greater certainty on how much
pollution will result from regulations. Another advantage of command and control is
that the monitoring of compliance with a regulation is simple. If the authority
commands the use a specific type of pollution control equipment, monitoring
involves simply verifying if that equipment has been used. There are, however,
certain disadvantages of command and control. Informational requirements are very
high for command and control method. Hence, such a regulatory system can be very
costly to administer. Moreover, there is potential for fundamental information
problems. Very often, the regulator needs to rely on information regarding either the
level of pollution or the cost of control provided by the polluters who may distort the
information. A very significant problem with the command and control is since the
polluter must have to comply with the regulation; he does not have the incentive to
find out a better way of controlling pollution. The biggest problem, however, is the
difficulty in implementing the equimarginal principle which has already been
mentioned while referring to the differences between the command and control and
the economic incentives. The final problem of command and control is that the
polluter pays only for pollution control and not for the damaged caused by the
pollution that is being still emitted even after the regulation is in place.

Common Property Resource (CPR):

A property or resource owned collectively by a group or community is called a

common property resource. Some of the familiar common property resources are
village grazing ground, common fishery, forest etc. All the common property
resources in general have two characteristics: 1) everyone in the group has right on

15
the use of the property but no one has excusive right on it and 2) use of the resource
by one member makes it less available for another member. Within the group, some
sort of rules and regulations are developed so as to share the property. The group
can put restriction on the use of the property by the outsiders. Due to the second
characteristic, each member of the group usually has an incentive to exploit the
resource before somebody else uses it resulting ultimately in over-exploitation of it.
This is the reason why the community very often finds difficulty in devising a way of
sharing the benefits from the common property.

Contingent Valuation Method (CVM):

CVM involves surveying a group of people and asking them to state directly their
willingness to pay (WTP) or willingness to accept compensation (WTAC) for a
specific level of environmental up gradation or degradation. People should be
informed before they state their WTP/ WTAC as to why they will have to pay or how
they will pay so that they can make an informed judgment. The mode of payment
should appear to be practical. For example- people should be asked to pay an entry
fee rather than a general tax for the up gradation of a park. The surveyor can give
different options to the respondent through which he/she can express his/her
willingness. It may be an open ended question where the respondent can say any
amount; may be a dichotomous choice or may be any other version. Once the
responses about WTP/WTAC are collected, mean WTP/WTAC of the group can be
calculated. It may be possible that somebody states zero WTP. This may happen if
the good for which one is asked to pay is completely irrelevant for the person. On
the other hand, somebody’s WTAC for some good may be zero if nothing can
compensate for the destruction of the good. These kinds of responses are to be
separated from the positive responses before calculating the sample mean
WTP/WTAC. The next stage involves tracing the effect of other factors like
education, income etc of the study group on WTP/WTAC. For example, other things
being equal, people having higher level of income may be willing to pay more. The
final stage of CVM is to obtain the social valuation of the environmental change from
the sample mean WTP/WTAC.

Major advantages of this method are: 1) it can be applied for a wide range of
situations, 2) the questionnaires can be designed in such a way that the researcher
can gain some insights into why people value the environmental good and how the
valuation changes if the uncertainty surrounding the supply of the environmental
good changes. The method, however, is criticized on the following grounds: 1) CVM
works with what people state, but what they actually do may be different from what
they say. For example, if they feel that their responses may influence what they
actually get charged to pay, respondents will understate their WTP. On the other
hand, if they feel that their responses might influence the possibility of the supply of
the good and not what they will have to pay, they will overstate their WTP. 2) All the
WTP responses may not be effective. Usually respondents do not keep a part of
their budget or income separately for the environmental goods. Hence there is
possibility that the total amounts that they state as are willing to pay may be more

16
than what they actually keep for such environmental good in a mental accounting
process. Thus, all the WTP responses can not be effective. To guard against this
problem, CVM surveys these days also ask which expenditure will be reduced to
make money available for the payment for environmental change. 3) Another
weakness of CVM is that the responses of the respondents depend heavily on the
information provided to them. There fore determining the right amount of information
to be provided is a major issue in CVM. 4) Whether to work with the responses of
the ill-informed respondents or to let the experts work alone, especially in the context
of making policy is another debating issue in CVM.

Hedonic Pricing Method:

The essence of the hedonic pricing method (HPM) is that the valuation of an
environmental good is done in the market for an associated private good (usually
houses). It is assumed that people value the private good on the basis of the
attributes it possesses of which environmental characteristics is one. For
exampleThe value of a house depends on several attributes, such as - 1) site
characteristics (Si) which might include the number of rooms, the age of the house,
the size of the garden etc.; 2) nieghbourhood characteristics (Ni) like how many
miles away it is from the bus station, how good is the local school etc.; and finally 3)
environmental characteristics (Ei), such as, the noise level, air quality etc.
Environmental characteristic may be an important determinant of the price of a
house. For example - if somebody values peace and quite and wants to pay a
premium for that then she will pay more for a house in a quieter part of the town than
for a similar house in a noisier part of the town.
The HPM, in this context, proceeds by collecting data on house prices along with
data on Si, Ni and Ei. These data can be used to apply suitable statistical technique
which finds out the effect of change in environmental quality on the price of house
whiling keeping other things (attributes) constant. This might give us the result that
a 5 per cent improvement in the air quality raises the price of the house by 2 percent
on average, which can then be used to work out the implied WTP in money for the
air quality improvement. In this manner, money values can be placed on
environmental attributes that are linked to house prices.
The HPM has been widely used to study the implicit prices of environmental
attributes like the changes in air quality, noise, and proximity to waste sites. The
technique, however, has a number of drawbacks. They are:
1) For those environmental goods which are not linked to housing market, HPM
won’t work. Even for those goods which are so linked, the method provides only an
indication of partial value. For example- air quality improvement benefits the visitors
to a city, but only the house owners’ values are picked up.
2) The method assumes that for every attribute, house-buyers are able to locate
a house for which the marginal value for each environmental attribute is equal to the
marginal cost.
3) It is also assumed that the buyers and the sellers are well informed about how
environmental attributes very spatially across the area being studies. This
assumption is unrealistic.

17
4) Investment on housing being a long-term investment, expectation plays a
crucial role. Not only the current level of environmental quality but the expectation of
changes in the level of environmental quality also affects the price of a house. The
role of expectation can not be captured by this method.

Liability law:

This is a type of economic incentive to control pollution or environmental

degradation. The basic idea is that if I perform an activity which may cause damages
to the society, I shall be responsible or liable for the damages and have to pay
compensation for that. Government does not dictate me as to how to perform the
activity or how to reduce damages. The fact that I shall be liable for the damages
makes me consider the potential damages while taking the decision as to how to
perform the activity. This works as an incentive for me to take the necessary
precaution to prevent the damages, which the society wants me to do.

Prisoner’s Dilemma:

It is the most widely used game-theoretic concept in environmental economics. The

concept is used to represent the idea: often a socially warranted situation can not be
attained because of distrust or lack of co-operation among the individuals. The
original prisoner’s dilemma has the following form. Two persons are caught by the
police suspected of conducting some illegal activity. Police, however, does not have
sufficient evidence to convict them and will be sure about their involvement only if
they confess. In other words, the crime can not be proved if none of them confess
and then both of them will go free. Both of the persons are kept in two separate
rooms and are being interrogated. Police offers the following outcomes to each of
them: if they both confess they will both get two years in prison; if one confesses, he
will go free while the other will get the maximum sentence of ten years. Aloof in the
room with no knowledge about the other person’s response and faced with these
possibilities, each of them considers his options: if the other person does not
confess then his best option is to confess and go free, whilst if the other person
confesses, then also his best option is to confess and get lesser punishment. Thus
the first person concludes that his best option is to confess. The other person will
also take the same decision. Consequently, both of them end up confessing to the
crime. While the best option would have been not to confess and go free, but both of
them end up with an inferior outcome. This situation is termed as tragedy of
commons. This happens because they could not communicate and arrive at an
agreement before they make the decision. They could not even trust each other that
none of them will confess. They thought of their individual benefits resulting in the
tragedy of both. The original prisoner’s dilemma can be applied in environmental
economics to explain similar type of situations. In environmental economics,
prisoner’s dilemma can be seen especially in case of common property resources.
For example: common property fishery shared by fishermen. The quantity of fishes
in the fishery although is limited at a particular point of time, the total stock can be

18
maintained if not over-exploited. Fishes will get reproduced overtime. Hence the best
thing is to catch the fish in such a way so that the total stock does not deplete. But
the fact that total quantity is limited at appoint of time and hence catch by one
fisherman will make fish less available by the same amount for another fisherman
encourages each fisherman to catch more fishes before somebody else fishes.
Since all the fishermen think similarly, they ultimately over-fish the fishery. The
results are: the depletion of the stock, no more fishes for the fishermen and hence
losses for all of them. While the best course of action would have been to conserve
the fish and get the benefits shared among them for a long period of time, the fisher
men end up with no fishes. This happens because they can not trust or cooperate
with each other to make it certain that none of them will over fish.

Travel Cost Method (TCM):

TCM is associated with the valuation of environmental goods such as outdoor

recreational sites. It involves collecting data on the total number of visits to a site
from one zone and the total visitor population of that zone. Then dividing the number
of visits by the total visitor population, the visitation rate is defined. This visitation
rate is assumed to be dependent on the cost of visiting the site and other socio-
economic characteristics. The total cost of visiting the site includes both the direct
expenditure during the trip and the value of the time spent. Value of time is also
considered as a component of expenditure because instead of making the trip had
the visitor worked he would have earned his wage. The fact that the visitation rate
depends on the visiting cost and other socioeconomic factors implies that if there is
any variation or change in the visitation rate that is due to some variations or
changes either in the visiting cost or in other factors. Using suitable econometric
technique and controlling for the other factors, i.e. considering as if there is no
change in other factors, the effect of change in the visiting cost on the visitation rate
can be found out. This might give us a result which shows that 1 percent increase in
the visiting cost reduces the visitation rate by 5 percent. The TCM usually assumes
that the increase in the visiting cost is equivalent to an increase in the admission fee
to the site. The result, thus obtained can be considered as a proxy for the demand
for the site which then is used to find the value of the site.

The technique has certain limitations: 1) while estimating the value of or demand for
a site, problems arise with multipurpose trips. It may be necessary to make a
distinction between meanderers and purposeful visitors. For those who are visiting
different sites on a single trip, only a part of their total travel cost is to be attributed to
a particular site. 2) TCM infers values of a site from the expenditure made on visiting
or use of the site. Therefore, if there is any non-use values associated with the site,
it can not pick up such values. 3) Calculating the monetary value of travel time is a
real challenge.

19
HS 229: Environmental
Economics

Mrinal Kanti Dutta (mkdutta@iitg.ac.in)

Dept. of Humanities and Social Sciences, IIT Guwahati
Course Outline

2
1. The Economy and
the Environment
▪ Economy-environment
interaction
▪ The first and second law of
thermodynamics
▪ Environmental degradation
as market failure
▪ Pigovian tax, property rights
and transactions costs 3
2. Economics of Natural
Resources
▪ Resource Taxonomy
▪ Renewable and non-
renewable resources
▪ Common property
resources
▪ Open access, the tragedy
of commons
4
3.Valuation Techniques
▪ Classification of environment
and resource flows, use and
non-use value
5
▪ Contingent valuation,
hedonic pricing, travel
cost method
▪ Environmental impact
assessment
 4. Pollution Control
▪ Pollution Prevention, control and abatement
▪ Command and control instruments and market
based instruments– taxes vs. tradeable permits
▪ Overview of different acts/laws for pollution
control in India

5. Environment and
Development
▪ Environment-development
trade off, environmental
Kuznet curve
▪ Poverty and environment
▪ Sustainable development-
concepts and indicators
▪ Environmentally adjusted
GDP, System of Integrated
Environmental and
Economic Accounting
(SEEA)

7
Texts/References

1. N. Hanley, J. F. Shogren and B. White, An Introduction to

Environmental Economics, Oxford University Press, 2001
2. C. Kolstad, Environmental Economics, Oxford University
Press, 2000
3. N. Hanley, J. F. Shogren and B. White, Environmental
Economics: In Theory & Practice, 2nd Revised edition,
Palgrave MacMillan, 2006
8
Texts/References

4. T. Tietenberg, Environmental and Natural Resource

Economics, Pearson Education, 2004

5. U. Sankar (ed.), Environmental Economics (Readers in

Economics), Oxford University Press, 2001
9
THANK YOU!

10
 HS 229
ENVIRONMENTAL ECONOMICS

Mrinal Kanti Dutta

(mkdutta@iitg.ac.in)

Department of Humanities and Social Sciences

Indian Institute of Technology Guwahati
Guwahati – 781039
 2

MARKET FAILURE
 3

▪ Market: an exchange institution that serves

society by organising economic activity
▪ Forces of demand and supply, in equilibrium,
provide signals through price regarding output
to be exchanged in a market
▪ If market provides correct signals regarding
demand and supply, then the decision about
equilibrium output and price can be optimal
▪ Leads to optimal allocation of resources
→Market success
 4

▪ Market: Different types

▪ Perfect Competition, Monopolistic
Competition, Oligopoly, Duopoly, Monopoly

▪ Nature and functioning of these different

markets vary considerably

▪ Number of sellers and nature of product

determine type of market

▪ The success of a perfectly functioning market

rests on a number of relevant issues
 5

▪ Market success-efficient allocation of resources

▪ Allocative Efficiency
▪ Also referred to as Pareto Efficiency (After
Vilfredo Pareto, 1848–1923)

▪ Pareto Efficient Allocation – resources cannot

be readjusted to make one consumer better off
without making another worse off

▪ Pareto improvement
▪ Social Efficiency = where external costs and
benefits are accounted for

▪ Technical Efficiency = production of goods and

services using the minimum amount of
resources
 7

▪ When a set of competitive markets fail to

generate an efficient allocation of resources
between and within economies
▪ Resources could be reallocated to make at least
one person better off without making any one
worse off (Pareto improvement)
▪ Prices often understate the full range of services
provided by an asset or simply do not exist to
send a signal to the market place about the value
of the asset
▪ For environmental assets market can fail if prices
do not communicate society’s desires and
constraints accurately
 8

▪ Habitat destruction and threat to bio-diversity in

Madagascar
▪ 4th largest island, bio-diversity hotspot but
economically very poor
▪ Deforestation: @200,000 ha/yr.
▪ Eco. cost of env. degradation: $100-290 m (5-15%
GDP)
 9

▪ Arises from several sources of market failure

▪ Public ownership of large areas of land (open
access regime and limited govt. capacity to
manage land)
▪ Insecure land tenure system
▪ Many of the services are non-rival and non-
excludable
▪ Bio-diversity in and of itself has no value
reflected by market prices
▪ Commodity resources are valued on the market
▪ Pressure to harvest the commodity goods at the
expense of bio-diversity
 10

▪ Six cases of Market Failure:

▪ Incomplete Markets
▪ Externalities
▪ Non-exclusion
▪ Non-rival and Public Goods
▪ Non-convexities
▪ Asymmetric information
 11

▪ Markets are complete when enough markets exist

to cover each and every possible transaction or
contingency so that resources can move to their
highest valued use
▪ A complete market requires a set of well-defined
property rights system
▪ Property rights system: a set of entitlements that
define the owner’s privileges and obligations for
use of a resource or asset
 12

▪ A well-defined property Rights system has

the following key characteristics:
▪ Comprehensively Assigned: all resources or
assets should either be privately or collectively
owned
▪ Exclusive: all benefits and costs should accrue
to the owner only either directly or through
sale
▪ Transferable: from one owner to another in a
voluntary exchange
▪ Secure: from involuntary seizure or
encroachment by other individuals, firms or the
government
 13

▪ Property rights in case of

▪ Air
▪ Rivers, etc.
 14

▪ One of the prominent reasons for market failure

▪ Normally actions or decisions by one individual
agent does not directly affect anybody else
▪ For example: purchase of shoes
▪ Some other actions affect others directly
▪ For example: driving near hospital (harmful
effects
▪ Inoculation of children (beneficial effects)
 15

▪ Decision makers do not take into account

the cost imposed on society and others as a
result of their decision

▪ e.g. pollution, traffic congestion, environmental

degradation, depletion of the ozone layer, etc.
 16

▪ Two Types of Externality:

▪ Positive and Negative
▪ Positive: when action of individual agent has
beneficial effects
▪ Examples:
▪ Vaccination
▪ Flower gardens
▪ Production of Honey
 17

▪ Negative: when action has negative effects

on the agents
▪ Examples:
▪ Playing of loud music at 4 a.m.
▪ Riding on a noisy motor cycle
▪ Smoking in a public place
▪ Dumping of waste in a river by a paper
mill
 18

Externality - the Problem:

▪ A.C. Pigou in his book titled Wealth and Welfare (1912)
dealt with the problem of Externality systematically for
the first time.
▪ Overall economic efficiency requires that:
MSB = MSC MSB = Marginal Social Benefit
MSC = Marginal Social Cost
where, MPB = Marginal Private Benefit
MSB = MPB + MEB MPC = Marginal Private Cost
MSC = MPC + MEC MEB = Marginal External Benefit
MEC = Marginal External Cost

▪ If, MSB>MSC, Output can be expanded because additional output adds

more benefits to the society than the cost.
▪ In a situation when MSB≠MSC, the optimal condition of efficiency can be
obtained through imposition of Tax and Subsidy
Why is externality a problem?
▪ An externality implies:
Social Cost = Individual Cost

Social Benefit = Individual Benefit

▪ The incentives for the individual are not what

society wants them to do

▪ As a result:
▪ too much of socially costly goods are produced
▪ too little of socially beneficial goods are produced
An Example : One Polluting Supplier of
Paper
Demand for Paper
= Marginal Social Value (Benefit) for Paper
Price

Quantity of Paper
An Example : One Polluting Supplier of
Paper
Supply of Paper
= Marginal Private Cost for Paper

Price

Quantity of Paper
Private Equilibrium determined by private
costs and demand
Price
Marginal Private Cost

Marginal Social Value

(Benefit)

Quantity of Paper
Suppose the social costs of paper production were higher
than the private costs (a negative externality)

Marginal Social
Cost
Price
Marginal Private Cost

Marginal Social
Value (Benefit)

Quantity of Paper
Consequences
▪ Too much of paper is produced
▪ The price of paper is too low and does not
reflect its true costs of production

So,
▪ Who gains here?
▪ What are the monetary values of the costs
imposed on society?
 25

Negative Externality in Production

Figure 1: Negative Externality in Production

Price, MC MSC
D
Fig. 1 illustrates negative MPC

externality in Production Po
(MSC>MPC) P1
C0
Assuming no externalities
in consumption, DD
shows MSB and MPB D (MSB=MPB)
(MSB=MPB)
Q0 Q1 Quantity

With MSC the optimal output produced is Q0 corresponding to

Price P0 (where MSC=MSB)
 26

The Competitive Market (when left alone) produces Q1

with a price P1 - there is a tendency to overproduce.

At Q0 the Price is P0 but the MPC is C0

Therefore the Govt. can levy a per unit tax of (P0 - C0 )

which in turn will increase MPC by (P0 -C0) and reduce
output from Q1 to Q0

At Q0, the consumers would pay P0, the full marginal

social cost of Production.
 27

The extra revenue earned from taxation can be used for

external damage from production of this product.

The tax revenue could be more or less than the external

damage

The tax revenue is equal to (P0 - C0)Q0 whereas the total

external cost would be equal to area between MSC and
MPC
The Net Gain to the Society is equal to (MSC-MSB)
over Q0 to Q1 (the shaded area) which is eliminated by
tax.
 28

Positive Externality in Production

Figure 2: Positive Externality in Production

Price, MC MPC
D
Fig 2 illustrates positive MSC
Co
externality in Production P1
(MSC<MPC) P0

Assuming no externalities
in consumption, DD
shows MSB and MPB D (MSB=MPB)
(MSB=MPB)
Q1 Q0 Quantity

With MSC the optimal output produced is Q0 corresponding to

Price P0 (where MSC=MSB)
 29

The Competitive Market (when left alone) produces Q1

with a price P1 where DD intersects MPC, under
production from social point of view

At Q0 the Price is P0 but the MPC is C0

Therefore to produce more output (from Q1 to Q0) the

Govt. has to provide a subsidy of (C0-P0)

At Q0 the consumers would pay P0 {Or (C0-P0)}.

 30

Govt. could collect the money from people reaping the

external benefits

The expenditure on subsidy could be more or less than the

external benefit

The Net Gain to the Society is equal to (MSB-MSC) over

Q1 to Q0 which is obtained through subsidy.
 31

Externality in Consumption: Negative and Positive

Figure 3: Negative Externality in Consumption

Price, MC MSB D
Fig. 3 illustrates negative MPC=MSC
Po
externality in
P1
Consumption (MPB>MSC)
C0

Assuming no externalities
in production (MSC=MPC) D=MPB

Q0 Q1 Quantity

The optimal quantity is given by Q0 (the point where MSB=MSC)

 32

In the absence of any intervention, the quantity supplied

and produced is Q1 with a price P1

At Q1 there is overproduction of the commodity

compared to social optimality

To restrict the output to Q0 , the price has to be increased

to P0

But the supply price for Q0 is C0

Hence a tax equal to (P0 - C0 ) needs to be levied

 33

The price consumers pay is P0 (=MPC + Cost of Externality

in Consumption)

The revenue generated from the consumption of the tax

could be used to compensate those who are hurt by the
external cost arising from the consumption of the product

The shaded area measures net benefit of the tax policy.

 34

Externality in Consumption: Negative and Positive

Figure 4: Positive Externality in Consumption

Price, MC D
Fig. 4 illustrates positive MPC=MSC
externality in
Consumption (MPB<MSC) C0
P1
Assuming no externalities Po
MSB
in production (MSC=MPC)
D=MPB

Q1 Q0 Quantity

The optimal quantity is given by Q0 (the point where MSB=MSC)

 35

In the absence of any intervention, the quantity supplied

and produced is Q1 with a price P1
At Q1 there is underproduction compared to socially
optimal level

To produce output Q0 , the price is P0 But the supply price

for Q0 is C0

Hence a consumers need be given a subsidy equal to (C0 -

P0)

The price consumers pay is P0 the producers get C0

 36

At least part of the cost of the subsidy (C0 - P0)×Q0 could

be collected from those reaping external benefits
arising from the consumption of this good

The shaded area measures net benefit to the society

from the subsidy. It’s the (MSB-MSC) for the output
range Q1 to Q0
 37

Summary:
1. In the presence of externalities, the socially optimal level of
output (Q0 in our example) is given by the condition MSB=MSC
2. The private production of output Q1 is given by the condition
MPB=MPC
3. To bring about an output to Q0 we can use the tax and subsidy
programs shown in Table-1.
Table 1: Taxes and Subsidies in the presence of Externalities
Condition Tax or Subsidy Amount of Tax or Subsidy*

MSC>MPC Tax Producers MSC – MPC

MSC<MPC Subsidize Producers MPC – MSC
MSB<MPB Tax Consumers MPB – MSB
MSB>MPB Subsidize Consumers MSB - MPB
*These amount are measured at the socially optimal level
HS 229: Environmental
Economics

Mrinal Kanti Dutta (mkdutta@iitg.ac.in)

Dept. of Humanities and Social Sciences, IIT Guwhati
The Economy and the Environment

2
Environmental Economics

▪ Concerned with the impact of economy on

environment, significance of the environment to
the economy, and the appropriate way of regulating
economic activity for achieving balance among
environmental, economic and other social goals

▪ Essence of environmental problem is the economy

-producer behaviour and
3
consumer desires
The Economy and the Environment
▪ Economy: Population of economic agents, the institutions
they form (firms, government) and the interlinkages
between agents and institutions (markets)
▪ All the firms that make up industry
▪ Environment: the biosphere, the atmosphere, all flora
and fauna
▪ Includes life forms, energy and material resources, the
stratosphere and troposphere
▪ All natural resources, including land, land cover and
ecosystems
4
The Economy and the Environment
▪ The constituent parts of environment interact with each
other
▪ Effects of human activity on the environment, and the
consequences of these affects on human well being
▪ Generation of electricity
▪ Agricultural support policy

▪ The economy operates from inside the environmental

system, with conditions in the two systems being
simultaneously determined
▪ Many links between the two systems
5
Economy-Environment Interaction
R1 Goods and Services R2

Production Consumption
Factors of Production

E1:
Energy and E2: Waste Sink
Materials

E3: Amenity

E4: Global Life Support Services 6

Linkage between the Economy and
the Environment
▪ Environment provides inputs of raw materials and energy
sources
▪ Waste sink for the economy
▪ Direct source of amenity to the environment
▪ Basic life support services
▪ Climate regulation, operation of water cycle, regulation
of atmospheric composition and nutrient cycling

7
Role of Environment as a Waste Sink
▪ May result from production or consumption
▪ In some cases, wastes are biologically or
chemically processed
▪ Assimilative capacity for the wastes
▪ For some inputs, no natural process to
transform them into harmless substances
▪ Metals, DDTs, PCBs

8
Role of Environment as a Waste Sink
▪ For degradable pollutants, the stock in any time period
‘t’ is given by-
Sta = Ft–At----------------------› (1)
Ft= Flow of pollutants
A=Amount assimilated in any period

▪ For cumulative pollutants, the stock in any period t* is-

t=t*
St*c = ∑Ft----------------------› (2)
to
9
Role of Environment as Amenity Provider
▪ Amenities - the economic value

▪ Economic value dependent on social well-being

▪ Social welfare is the sum total of individual utilities

Uj= U(X1,X2,…,Xn; Q1,Q2,….,Qm)
Uj=Utility; X=Goods and services; Q= Env. Assets

▪ Trade off between different uses of the environment

10
Role of Environment as Amenity Provider
▪ If Uj= U(X1,X2,…,Xn; Q1,Q2,….,Qm)
Uj=Utility; X=Goods and services; Q= Env. Assets
▪ Let Q1 be local air quality, Q2: Water Quality,…..
▪ X1: consumption of services provided by owning a car
▪ An increase in consumption of car services increases utility
(δUj/δX1>0)
▪ But this increase in car use decreases air quality
(δQ1/δX1<0)
▪ This fall in air quality reduces utility by an amount
(δUj/δQ1*δQ1/δX1)
▪ The net effect is thus ambiguous
11
Conflicts in Resource Use/Trade-offs
▪ Using a mountain region for minerals and amenities
▪ Using a river as a waste-disposal unit and provider of
amenity
▪ Felling a forest for timber and electricity generating
capacity of a dam
▪ Preserving a wetland for its aesthetic qualities and
availability of drained land for agriculture
▪ An increase in the use of environment as a waste sink
may reduce the ability to supply basic life support
12
Conflicts in Resource Use/Trade-offs

▪ Environment is a scarce resource - Many conflicting

demands placed on it
▪ Relative vs. absolute scarcity
▪ Absolute scarcity from economic growth

▪ Role of economics and price system

▪ Market (Success/Failure)

13
Global Life Support Services
▪ Maintenance of an atmospheric composition suitable
for life

▪ Maintenance of temperature and climate

▪ Recycling of water and nutrients

▪ Hydrological, carbon and oxygen cycles

14
The First Law of Thermodynamics:
Materials Balance Principle
“Matter, like energy, can neither be created nor be
destroyed”

Implications:
▪ As more matter is extracted by the production
process, more waste is generated
▪ Puts limits on the degree to which resources can be
substituted
15
The Second Law of Thermodynamics:
Entropy Law
“In a closed system, the use of matter-energy causes a
one way flow from low entropy resources to high entropy
resources; from order to disorder.”

Implications:
▪ Energy can not be recycled in such a way that we get
back all the capacity of the original energy source
▪ Helps in understanding the limits of matter-energy
recycling
16
Texts:
N. Hanley, J. F. Shogren and B. White, An Introduction to
Environmental Economics, Oxford University Press, 2001

N. Hanley, J. F. Shogren and B. White, Environmental

Economics: In Theory & Practice, 2nd Revised edition,
Palgrave MacMillan, 2006
17
THANK YOU!

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