Chapter-1

Introduction to Natural Resources and Environmental Economics

1.1 Introduction

Environment is defined as the complex of physical, chemical and biotic factors (as
climate, soil and living things) that act upon an organism or an ecological community and
ultimately determine its form and survival. It is the aggregate of an individual or
community.
In economics the environment is viewed as a composite asset that provides a variety
of services. It includes raw-materials, which are transformed into consumer products by
the production process, and energy, which fuels this transformation. These raw-materials
and energy return to the environment as waste products. Environment also provides
services directly to consumers; the air we breathe, the nourishment we receive from food
and drink, and the protection we derive from shelter and clothing and all benefits we
receive either directly or indirectly from the environment.
If the environment is defined broadly, the relationship between the environment and
the economic system can be considered a ‘closed system’. Here it means no inputs
(energy, matter, and so on) are received from outside the system and no outputs are
transferred outside the system. In contrast, an ‘open system’ is one in which the system
imports or exports matter or energy (Figure 1.1).

Figure 1.1
Economic system and the Environment

Firms
(Production)

Inputs Economy Outputs

Household
(Consumption)

Energy Air Pollution

Air Solid wastes
Water Environment Waste heat
Raw Materials Water pollution
Amenities

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 1.2 Emergence of Natural Resources and Environmental Economics

Here we examine the development of resource and environmental economics from

the time of the industrial revolution to its modern form.

1.2.1 Classical economics

A central interest of the classical economists was the question of what determined
standards of living and economic growth. Natural resources were seen as important
determinants of national wealth and growth. A strand running through classical political
economy concerns the prospects for living standards in the long-term for an economy
subject to constraints on the supply of land. Land (natural resources in general) was
viewed as limited in its availability. When to this were added the assumption that land
was a necessary input to production and that it exhibited diminishing returns; the early
classical economists came to the conclusion that economic progress would be a transient
feature of history, and the inevitability of an eventual stationary state, in which the
prospects for the living standard of the majority of people were bleak.
To Malthus, a fixed land quantity, and assumed tendency for continual positive
population growth, and diminishing returns in agriculture implied a tendency for output
per capita to fall over time. So that, there is a long run tendency for the living standards
of the mass to be driven down to a subsistence level. At the subsistence wage level,
conditions would permit reproducibility of the population at an unchanging level, and the
economy would attain a steady state. This notion of a steady state was formalized and
extended by David Ricardo.
Mill’s work utilizes the idea of diminishing returns, but recognizes the
countervailing influence of the growth of knowledge and technical progress in agriculture
and production.

1.2.2 Neo-classical economics

The neo-classical has little of intrinsic interest to environmental economics. What
is noticeable in early neoclassical growth models is the absence of land, or any natural
resources, from the production function used in such models. Classical limits to growth
arguments, based on a fixed land input, did not have any place in early neo-classical
growth modeling.
The introduction of natural resources into neo-classical models of economic
growth occurred in the 1970s, when neo-classical economists first systematically
investigated the efficient and optimal depletion of resources. This body of work, and the
developments that have followed from it, is natural resources economics.

1.2.3 Welfare economics

The final development in mainstream economic theory that needs to be briefly
addressed here is the development of a rigorous theory of welfare economics. Economists
have attempted to find a method of ranking different states of the world, which does not
require the use of a social welfare function, makes little use of ethical principles, but is
nevertheless useful in making prescriptions about resource allocation.
Where the conditions do not have markets do not attain efficiency in allocation,
and a state of ‘market failure’ is said to exist. One manifestation of market failure is the

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phenomenon of externalities. The problem of environmental pollution entered economics
as a particular example of the general class of externalities.

1.3 Ecological economics

Ecological economics is a new inter-disciplinary field. In the 1980s a number of
economists and natural scientists came to the conclusion that if progress was to be made
in understanding and addressing environmental problems it was necessary to study those
in an inter-disciplinary way, which they decided to call ecological economics. The first
issue of a journal with that title appeared in 1989.
Ecological economics treat the economic system as part of the larger system that is
planet earth. It starts from the recognition that the economic and environmental systems
are interdependent, and studies the joint economy- environment system in the light of
developments in the natural sciences, particularly thermodynamics and ecology, over the
last two centuries.

1.4 Fundamental themes

There are three fundamental themes in the natural resources and environmental
economics.

1.4.1 Efficiency
One way of thinking about efficiency is in terms of missed opportunities. If
resource use is wasteful in some way then opportunities are being squandered;
eliminating that waste (or inefficiency) can bring net benefits to some groups of people.
An example is energy inefficiency. A substantial part of environmental economics is
concerned with how economies might avoid inefficiencies in the allocation and use of
natural and environmental resources.

1.4.2 Optimality
Optimality is related to efficiency, but is nevertheless conceptually distinct from it.
To understand the idea of optimality we need to have in mind:
a. A group of people taken to be the relevant society.
b. Some overall objective that this society has and in terms of which we can measure
the extent to which some resource use decision is desirable from that society’s
point of view.
Resource use choice is socially optimal if it maximizes the objective given any
relevant constraints that may be operating.

1.4.3 Sustainability
The third theme is sustainability. It involves taking case of posterity. Al allocation
of resources is socially optimal and then surely it must also be sustainable. If
sustainability matters, then presumably it would enter into the list of society’s objectives
and be taken care of in achieving optimality. The pursuit of optimality as usually
considered in economics will not necessarily take care of posterity. If taking care of
posterity is seen as a moral obligation, then the pursuit of optimality will need to be
constrained by a sustainability requirement.

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 1.5 Fundamental features in the economic approach to natural resources and
environmental economics
There are three important features of economic approach to resource and
environmental issues.
1.5.1 Property rights, efficiency and government intervention
Regarding allocative efficiency the central issue is the role of markets and prices.
It is expected that the markets will bring about efficiency in allocation. However, well-
defined and enforceable private property rights are one of the necessary conditions for
efficiency. Many environmental resources fail to allocate efficiently, because there are no
clearly defined property rights. In such circumstances, price signals fail to reflect true
social costs and benefits, and a prima facie case exists for government policy intervention
to seek efficiency gains.

1.5.2 The Time Dimension of Economic Decisions

Many environmental resources exist as stocks, which from an economic
perspective are assets yielding flows of environmental services overtime. In considering
the efficiency and optimality of their use, we must take account not only of use at a point
in time but also of the pattern of use over time. That is, efficiency and optimality have an
inter-temporal or dynamic dimension as well as an intra-temporal or static dimension.
The relations between rates of return to capital as generally discussed in economics and
the rates of return on environmental assets must be taken into account in trying to identify
efficient and optimal paths of environmental resource use over time.

1.5.3 Exhaustibility, Sustainability and Irreversibility

Natural resource stocks can be classified in various ways. A useful first cut is to
distinguish between renewable and non-renewable resources. Renewable resources are
biotic, plant and animal populations, and have the capacity to grow in size overtime,
through biological reproduction. Nonrenewable resources are abiotic, stocks of minerals,
and do not have that capacity to grow over time. The distinction is sometimes made
between exhaustible or depletable, and inexhaustible or non-depletable resources.
Renewable resources are exhaustible if harvested for too long at a rate exceeding their
regeneration capacities.
Another property of natural resources is the extent to which they are substitutable
for one another. Matter of central importance is the degree to which environmental
resources can be substituted for by other inputs, especially the man-made capital resulting
from saving and investment.

1.6 Assignment
A wood pulp mill is situated on the bank of Abaya lake nearer to the Nech Sar
National Park. The private marginal cost (MC) of producing wood pulp (in $ per ton) is
given by the function MC = 10+ 0.5Y; where Y is tons of wood pulp produced. In
addition to this private marginal cost, an external cost is incurred. Each ton of wood pulp
produces pollutant flows into the lake which cause damage valued at $ 10. This is an
external cost, as it is borne by the wider community but not by the polluting firm itself.
The marginal benefit (MB) to society of each ton of produced pulp (in $) is given by
MB= 30 - 0.5Y.

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Answer the following questions using diagrams or algebra.
(Note: Profit maximization requires selection of an output level that equates marginal
revenue and marginal cost. Maximization of social net benefits should be taken to imply
equating marginal social benefits with marginal social costs)

1. Draw a diagram illustrating the marginal cost (MC), marginal benefit (MB),
external marginal cost (EMC) and social marginal cost (SMC) functions.
2. Derive the profit maximizing output of wood- pulp, assuming the seller can obtain
marginal revenue equal to the marginal benefit to society derived from wood
pulp.
3. Derive the pulp output which maximizes social net benefits (Social net benefit =
Gross social benefit – social cost)
4. Explain why the socially efficient output of wood pulp is lower than the private
profit- maximizing output level.
5. How large would external marginal cost have to be in order for it to be socially
desirable that no wood pulp is produced?

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