UNIT 2

Neoclassical economics as a foundation for environmental

economics
2.1 The concept of utility
2.2 The neoclassical model features
2.3 The Pareto-optimality as a normative criterion

Vatn (2005)

(20521) Environmental Economics in Tourist Areas

UNIT 2
Neoclassical economics as a foundation for environmental
economics
2.1 The concept of utility
2.2 The neoclassical model features
2.3 The Pareto-optimality as a normative criterion

(20521) Environmental Economics in Tourist Areas

CLASSICAL ECONOMISTS:

A. Smith distinguished between use value and

exchange value (Wealth of Nations, 1776).

Use value: Utility derived from the value an object

had in its use: it captured the real ability to satisfy
human needs (food, shelter, etc.).

Exchange value: relative to the amount of labor

needed for producing it (hours involved): Labor
theory of value allowing for the objective
measurement of the exchange value.
UTILITARIANISM IN PHILOSOPHY:

Developed by philosophers in parallel with Classical

economics.

It gained much of its position through the work by

Jeremy Bentham (Fragment on Government, 1776).

Utility viewed as happiness: individuals search

pleasure and avoid pain.

The value of goods/actions has to do with their

capacity to create happiness.

Change in the utility concept: from capacity to

cover human needs (objective use value) to its
influence on the (subjective) mental state (happiness)
LIBERALISM AND INDIVIDUALISM:

Bentham’s work also played a role in the process of

establishing liberalism and individualism.

Development from mid-18th century to free society

from the powers of aristocracy and religion.

Bentham was against tradition.

UTILITARIANISM IN ECONOMICS:

Introduced especially by John Stuart Mill (1861), who

emphasized that pleasure had not only a quantitative
but also a qualitative aspect (absent in Bentham’s).

Stimulated by the ideological, social and institutional

changes occurred in the Renaissance, utilitarianism
contributed to consolidate the capitalist firms’ desire
to build wealth by establishing a strict connection
between happiness and consumption of
produced goods.
EARLY NEOCLASSICAL ECONOMISTS:

Neoclassical revolution in 1870’s characterized by the

creation of the term ‘marginal utility’ (Marginal
Revolution)

Shift inspired by the utilitarian ideas about utility as a

subjective feeling of happiness (taken up by Jevons,
Walras, and later by Marshall and Pigou): utility in
the form of pleasurable sensations.

A relationship between price (exchange value) and

marginal utility was established (Jevons, 1871).

The use value of a certain quantity of a good

corresponds to its total utility, and the exchange
value to its marginal utility (multiplied by its
quantity).
EARLY NEOCLASSICAL ECONOMISTS:

Early neoclassical economists favoured a cardinal

measurement of utility: it can be compared across
individuals and it can be aggregated.

Utilitarianism had a ‘egalitarian flavour’: based on

the idea of declining marginal utility, some concluded
that the ‘utility of all’ would increase the most if more
were given to the poor (position endorsed by most of
neoclassical economists up until 1920’s).
LATER NEOCLASSICAL ECONOMISTS:

But, over the time, a different idea takes hold

gradually among economists: utility cannot be
compared across individuals and cannot be
aggregated.

Edgeworth developed the indifference curve as a way

to handle what he interpreted as a lack of a common
denominator across individuals.
LATER NEOCLASSICAL ECONOMISTS:

Pareto took Edgeworth’s idea further and defined

what was called later Pareto Optimum: an optimum
is reached if it is impossible to further increase the
utility of somebody without reducing the utility of
someone else.

From thinking in maximum aggregate happiness/

utility to changes which demand that none loses.

Optimality depends on the initial distribution,

thus it is criticized for implicitly supporting the status
quo distribution.
LATER NEOCLASSICAL ECONOMISTS:

Pareto rejected the idea of cardinal utility and move

to ordinal utility.

What made this idea become dominant was a debate

in the 1920’s and 1930’s about what constituted a
sound science:

Roots in logical positivists of Vienna Circle:

verification principle (the only valid knowledge is
the knowledge verified by sensory experience).

Distinction between ‘facts’ (‘pure’ observations)

and ‘values’ (‘non-scientific’ entities).
LATER NEOCLASSICAL ECONOMISTS:

Utility could not be observed.

Neoclassical economists of the 1930’s adhered to

logical positivits’ ideas: unsound conclusions of the
cardinalists.

Lionel Robbins’ work (1935) contributed to the

process of ‘freeing’ economics of cardinalists’
value statements: value judgements should not
be made in economics.

Samuelson argued preferences defined this way

could be ‘observed’ or revealed via the choices
made.
LATER NEOCLASSICAL ECONOMISTS:

From cardinal utility to ordinal utility

Utility can only be ranked (not compared in a

proportional scale): it becomes an index of
preferences established by the rankings revealed
when people make choices.

Utility says nothing about its value content, either

sujective or objective. It is a formal concept which
gives no information about what utility consists of.
UNIT 2
Neoclassical economics as a foundation for environmental
economics
2.1 The concept of utility
2.2 The neoclassical model features
2.3 The Pareto-optimality as a normative criterion

(20521) Environmental Economics in Tourist Areas

THE NEOCLASSICAL MODEL/Core of the model:

- rational choice as maximizing individual utility

- stable preferences
- equilibrium outcomes
THE NEOCLASSICAL MODEL/Core of the model:

Rational choice

Acting rationally involves:

a) Preferences must be rational

b) Individual must be able to make the necessary
calculations and choose what s/he prefers.
THE NEOCLASSICAL MODEL/Core of the model:

Rational choice

Preferences are rational if they are:

Complete: if the person is able to rank all goods

or bundles of goods.

Transitive: if the ranking is such that x is better

than y and y is better than z then x must be
better than z.

Continuous: if x is preferred over y and z is

sufficiently close to y, then x is also preferred
over z (this implies the consumer can distinguish
between goods even though the difference in
utility they offer is infinitessimal).
THE NEOCLASSICAL MODEL/Core of the model:

Rational choice

If preferences are rational as described,

rationality links directly with maximizing utility.

This type of rationality implies that preferences are

context-independent:

- Ranking of goods x and y is independent of the

presence of a third good z.

- The choice is independent also of the social

context –the institutional setting.
THE NEOCLASSICAL MODEL/Core of the model:

Stable preferences

Preferences are assumed to be stable or at least as

given.

This is the essence of individualism, for the

individual to be self-contained.

Some neoclassical economists accept preferences

change but to keep the economic individualist
perspective consistent, this change must not be the
result of external circumstances but that of learning
about their own (given) preferences.
THE NEOCLASSICAL MODEL/Core of the model:

Equilibrium outcomes

When rational agents act on the basis of their

preferences, the only acts they can undertake are
exchanges.

They can exchange (tangible or intangible) goods

which have the capacity to be demarcated and to
enhance utility.
THE NEOCLASSICAL MODEL/Core of the model:

Equilibrium outcomes

Rational agents will exchange a good until a point is

reached where no more gain appears (marginal gain
is zero): equilibrium states are produced.

With given and stable preferences, maximization may

seem to straightforwardly imply stationary or
equilibrium states.
THE NEOCLASSICAL MODEL/Standard application
area:

It is the context into which the core assumptions are

placed when analyses of real-world phenomena are
made.

It can be defined as:

- No information costs (full information)

- No transaction costs (zero costs of bargaining)
- Private property rights for all goods which are
exchanged in competitive markets.
THE NEOCLASSICAL MODEL/Standard application
area:

The market is the ‘natural order of things’ in a model

based on pure individualism and zero transaction costs.

What is accepted as a social construction is the

establishment of rights in resources.

Thus, the only institutional elements appearing in the

neoclassical model are those of rights in resources
(property rights) and the market.
THE NEOCLASSICAL MODEL/Problems:

1) Rejects rationalities or reasons for action other

than maximizing individual utility.

2) Changes in preferences, if observed, cannot be

explained.

3) In real-world contexts, information gathering and

transacting is costly.
THE NEOCLASSICAL MODEL/Problems:

1), 2) What if choices are ‘irrational’? Today I prefer A

over B and tomorrow B over A.

Is the theory falsified by such observations?

Maybe preferences have changed or maybe the

person is maximizing something else other than the
independent utilities of A and B?

The model may offer mechanical causes for action but

is unable to capture the reasons involved.
THE NEOCLASSICAL MODEL/Problems:

3) If information is costly (if no full information), it is

inconsistent with the core of rational choice:

The person has to decide whether resources should be used

on making choices or gathering more information as a basis
to make a better choice.

At every point, gathering such information may result in

much better choices this making worth the extra costs
involved.

But we won’t know this until the search of information is

finished. When should one stop searching? The information
already gathered says nothing about the value of the
information not yet acquired, implying there is not answer to
this question.
THE NEOCLASSICAL MODEL/Problems:

3) If information is costly (if no full information), it is

inconsistent with the core of rational choice:

The person has to decide whether resources should be used

on making choices or gathering more information as a basis
to make better choice.

At every point, gathering such information may result in

much better choices this making worth the extra costs
involved.

But we won’t know this until the search of information is

finished. When should one stop searching? The information
already gathered says nothing about the value of the
information not yet acquired, implying there is not answer to
this question.
THE NEOCLASSICAL MODEL/Problems:

3) If transacting is costly, it may furthermore be that

markets are not the best allocation mechanism, this
leading to wonder which economic structures are best
at economizing on transaction costs (firms?, states?,
common property?).
UNIT 2
Neoclassical economics as a foundation for environmental
economics
2.1 The concept of utility
2.2 The neoclassical model features
2.3 The Pareto-optimality as a normative criterion

(20521) Environmental Economics in Tourist Areas

NORMATIVE ASPECTS IN ECONOMICS (Vatn, 2005):

What is good for society? What is the best situation

of a society? What should be done?
UTILITARIANISM

1) Welfarism: the goodness of an action is a function

of how much utility/happiness it brings.

2) Consequentialism: every choice is determined by

the goodness of its consequences only (ability to
create utility)

3) Sum-ranking: utility information regarding an action

should be assessed by looking only at the total sum
of all the utilities in this state (utility can be
cardinally measured and summed across individuals)
UTILITARIANISM

Individuals decide what is good or bad according to

their mental states of happiness.

What’s the rule?

The aim is to maximize society’s total welfare as

measured in welfarist and consequentialist terms.

The optimum is the one maximizing the sum of utilities

for all individuals (‘egalitarian flavour’).
MODERN WELFARE THEORY

Though having its origins in utilitarianism, it resulted

from the changes within neoclassical economics taken
place mainly in 1930’s.

Utility cannot be cardinally measured and cannot be

compared across individuals without making value
judgements which have to be avoided (ranked order).

Welfarism and consequentialism are supported (though

incorporating the changes introduced by neoclassical
economists –eg. Utility is a preference index (formal
concept) rather than happiness, thus not giving
information about what welfare consists of either in
substantive terms or pleasure).
MODERN WELFARE THEORY

What’s the rule?

Social welfare maximization following the Paretian rule

(efficiency measured in Paretian terms): which avoids
interpersonal comparisons.

Pareto principle thought to avoid value judgements, that

is, subjectivism in the social evaluation of what is a
better or a best state.

However, it implicitly involves a value judgement:

favours the SQ distribution.
MODERN WELFARE THEORY

What’s the rule?

Fundamental theorems of welfare economics:

1st Theorem: Every perfectly competitive market

equilibrium is Pareto optimal (provided core
assumptions hold and there are not externalities).

2nd Theorem: Every Pareto optimal social state is a

perfectly competitive market equilibrium (provided the
core assumptions hold and there are not economies of
scale).
MODERN WELFARE THEORY

What’s the rule?

The essence of the theorems is to answer How can

efficiency in production and exchange be obtained
simultaneously?  how can we achieve social
efficiency?

For each distribution of endowments there is an

optimum.

Social optimality implies that given the initial

distribution, nobody can increase her/his level of utility
without decreasing that of others.
MODERN WELFARE THEORY

What’s the rule?

Thus they distinguished between efficiency

(economics) and distribution (politics): it is argued
economists have to work out what is efficient in Paretian
terms given the distribution of income (determined by
politicians).

Politics and economics can be kept apart.

MODERN WELFARE THEORY

What’s the rule?

This distinction implies that markets produce

efficiency.

If society wants another solution to the allocation, it

should redistribute income, not affect the functioning of
the market.

The 2nd theorem says first redistribute income and then

rely on competitive markets to achieve Pareto optimality
MODERN WELFARE THEORY

What’s a market?

Market functioning is based on the consumers’

sovereignty principle and works through a price
mechanism.
What’s a market?

The interaction of sellers and buyers (supply and

demand).

Demand:

- Assume a utility function U = U(X1, X2). People

want to maximize U(.) subject to:
p1X1 + P2X2 = Y

- Change in utility as X1 changes at the margin traces

out a Marginal Value or marginal utility curve.
This is typically downward sloping (law of
diminishing marginal utility)

- X1 could be watching birds, or theatre visits

What’s a market?

Individual demand curve shows this relationship in

(P1, X1) space: what is the most individual would pay
for increasing amounts of X1, at the margin?

Aggregate demand (or market demand) shows this

for everyone “in the market”.

Also shows law of demand: as price rises, less is

demanded.
What’s a market?

What else determines demand?

- Demand function can be written:

Qd = f (P, Y, Psubs, Pcomps, preferences)

where Y is income, Psubs is the price of substitute

goods and Pcomps is the price of complementary
goods; and P is the “own price”.

- Changes in anything apart from P will shift the D

curve (eg change in income); changes in P move us
along the demand curve. *
What’s a market?

Supply:

- A “supply curve” shows how much firms are willing

to supply (offer to the market) at different prices
(assuming price taking behavior).

- It derives from firms costs, in particular, from their

marginal cost curves.

- As price rises, Qs increases.

What’s a market?

What else will change supply? :

- A supply function is:

Qs = f(P, input prices, technology)

- The supply curve will shift if changes in technology

or input prices occur.

- But changes in own-price move us along the supply

curve
What’s a market?

Market equilibrium:

….occurs when demand equals supply.

- At this point, an unique equilibrium price (pe) and

quantity (qe) are generated.

- Shifts in demand or supply will change this

equilibrium (p,q) pair.

- What’s good about this equilibrium? At pe, firms are

supplying all they want to, and consumers are buying
all they want to: no excess supply or demand.
What’s a market?

Consumers’ surplus:

- Defined as the difference between maximum

Willingness to Pay (on the demand curve) and price
actually paid.

- Measure of consumer’s benefits from the market.

- Equal to area under demand curve and above price.

- Price increases will reduce it, price cuts will increase it

- Can be added up across all consumers

What’s a market?

Producers’ surplus:

- Defined as the difference between the price received

and the minimum price the good would be supplied
for (= points on supply curve).

- Equal to area under price and above supply curve.

What’s a market?

Market equilibrium:

In market equilibrium, the sum of CS and PS is

maximized ==> no alternative (p,q) combination
exists which increases sum of benefits across 2
groups (firms and consumers); although may be
unequally divided.
What’s a market?

So the market…:

…produces an outcome with no excess supply or

demand.

…gives everyone what they want given the

equilibrium price, their income and preferences.

…maximizes the sum of consumer and producer

benefits.

…produces resource re-allocations in face of changing

scarcity.
Bibliography

Vatn, A. (2005). Institutions and the environment. Cheltenham: Edward Elgar

Publishing, Inc.