L ECTURE NO. 4 MARKET FAILURE LECTURE NO. 5 CLASSIFICATION OF NATURAL RESOURCS

1. EC 5106: (2) RESOURCE & ENVIRONMENTAL ECONOMICS I SEMESTER I : 2006/2007 LECTURE NO. 4MARKET FAILURELECTURE NO. 5CLASSIFICATION OF NATURAL RESOURCS Post Graduate Institute of Agriculture, Peradeniya, S.THIRUCHELVAM

2. The economic system will not always achieve efficient resource allocations. Market Theory: If property rights is defined & enforced, if perfectly competitive market prevails, the market would allocate resources efficiently. Reasons Market failure - Externalities – non compensated cost - Public goods – non exclusive & non rival - Improperly defined property right sys. (OA) and - Imperfect market - Monopolies. - Missing preference – intra & inter generationalWhen these circumstances arise, market allocations do not maximize the social welfare. L.3 MARKET FAILURES

3. Market Failure : Externality Externalities "Uncompensated side effects of any econ. activity which are not taken into account when making pvt. decisions" "Interdependencies between production and consumption that are not traded in the market" Lead to divergence of pvt. & social costs & benefits. Carries away e resource allocation from Pareto opt. Solu MSC = Marginal Social Cost Price MPC = Marginal Private Cost Quantity, Soil Erosion Q**Q*

4. Divergence of Pvt. & Social Benefits in Vaccination S MSWP MPWP Q* Q** Quantity Price Externality occurs when some benefits or costs of an action is external to the actor (decision maker) UJ = UJ ( X1J, X2 …XnJ,, Xmk), j & k two individuals Utility occurs whenever the U of an individual J is affected by some activity Xmk which is undercontrol of somebody else k. If externality is to be an analytical useful concept, It must be defined more precisely.

5. Property Rights (PR) and Externalities How individuals use e resources making up e env. asset depend on e nature of e PR governing resource use. When PR systems are Universal, Exclusive, Transferable & Enforceable, the owner of a resource has a powerful incentive to use that resource efficiently. Scarce Nat. resources, e owners derive a scarcity rent. In properly specified PR sys. this rent is not dissipated. It serves the social purpose of allowing owners to effi. balance their extraction and conservation decisions. PR regimes are continuous - PP & OA are the extremes. "Tragedy of Commons" occurs when e resource use is governed by open access PR regimes.

6. Property Rights (PR) and Externalities If property rights are non-attenuated that would ensure that e Bs & Cs of any action (production or consumption)to bear upon the actor (decision maker) Therefore, the actor would undertake activities of which benefits exceeds costs. Every individual acting independently to undertake acts which benefits > costs will ensure that e social Bs > Cs. However, in reality this does not occur, because PR are not always non-attenuated. i.e Cs & Bs of an act is not totally born by the actor. Pollution occurs not because SC > PC, Because PBs > PCs of act. The Social Cost of act includes e PC + e Cost H health.

7. PARETO RELEVAANT EXTERNALITY (PRE) Externality include many activities to have external such as one person buying a commodity in the market will make it unavailable to the other effecting the U of those. Such externality that occurs through changes in prices does not cause inefficiency, in fact it promote efficiency. Such externalities are not e cause of market failure An externality is relevant when the affected party j has a desire to induce the acting party k with respect to Xmk. PRE exists when it is possible to modify the activity, Xmk in such a way so as to make the affected party, J, better off without making the acting party k, worse off. When PRE exits, there is the unrealized potential for a Pareto improvement.

8. Type of Externalities and Examples Positive E -Positive impact of vaccinations on others Negative Externalities -Water pollution by a paper mill Reciprocal E -Excess harvest in an OA fishery Unidirectional E - Soil erosion in upstream areas Consumption E - Air pollution by driving a car Production E - Air pollution by a coal power plant Pareto Relevant Externalities Pareto Irrelevant externalities Pecuniary Externalities Government intervention in terms of Direct regulations, Negotiations, Taxation, Subsidies, Marketable permits are necessary in order to internalize externalities.

9. ALLOCATVE EFFECTS OF EXTERNALITIES UJ = UJ ( X1J, X2 …XnJ,, Xmk), Activity Xmk isnot undercontrol of j & since it is a -ve externality, increment in Xmk will lead to –ve MU= (- dU/ d Xmk) n j individual’s budget constraint is Yj - PiXij i= 1 i = 1, n ; i =/= m ; Yi = income of j, Pi = price of i Since j is unable to influence the level of Xmk that activity does not appear in the jth budget constraint. Individual j max. U s.t to his constraint. MRS = P Ratio MRS X1j,X2j = (MUX1J/MUX2j)=(PX1j/PX2j) MU & Ps + ve. MRS X1j,Xmk = (MUX1J/-MUXmk)=(PX1j/PXmk= 0) If PXmk could be made –ve then effi. could be achieved. The acting party , k will have incentive to reduce Xmk Improve j’s budget constraint Yj - PiXij + PmXmk

10. RE. ALLOCATION EFFECTS OF EXTERNALITY Allocative Effect of External Diseconomy Price of Electricity De Demand for electricity S*e Supply including externality SO2 Coal burning generated P*e Pe Tax = P*e - Pe Se Privately supplied electricity Quantity of electricity Qe* Qe Allocative Impact of External Economy Price of Communication Services De Demand for Communication Service Sc S*c Communication New Tech Pc P*c Subsidy = Pc –P*c Quantity of Communication Services Qc Q*c

11. 3.2 The Coasian Market / Institutional Solutions Market Solution to Externality One way to internalize externalities is through taxation Decide the level of tax – measurement of externalities Pigovian Tax If the government could estimate the Pe, then a tax could be imposed to internalize externality or could provide a subsidy to acting party to cut down production. Coase Theorem Given the well defined PRs, trade among the involved parties eliminate the Pareto relevant externalities, resulting an efficient solution. Final allocation of resources will be invariant to the Initial specification of PRs.

12. Internalizing an Externality through Negotiation • Consider a PRE with two parties J and K in a legal Env. • With non-attenuated PRs for the Externality. • PRs are defined in terms of two legal situations. • Non-attenuated Full Liability Rule • Rule specifies that, no appeal from affected party, the • Government will enforce e pollution is brought to zero. • MC of pollution abatement = D for pollution abatement • Zero Liability Rule • Affected parties have no rights to relief from pollution • i.e. affected parties have no right to relief form pollution • i.e. actor has the right to pollute. • Transaction would occur where the affected parties will • Pay to abate pollution to actors.

13. Key Points of Coase Theorem • Importance of market mechanism – thin market & TC • Importance of property rights – legal procedure, • Possibility of Trading rights – need for outside regu. D Demand for Loudness by Stereo Owner A Price of Loudness (Rs. per decibel) Marginal Cost of Loudness on Neighbor C P* B Quantity of Loudness (decibels) 0 E q* qm Loudness of music,Negotiation & Optimal loudness.

14. Coase Theorem suggests that if non-attenuated • PRs could be defined and enforced the market • would resolve inefficiency of externality • But, such property rights even if established may not work because of • high transaction costs • High enforcement costs • The full & zero Liability rules have different • implications on resulting distribution of income In realitythe demand curvefor abatement cannot Be known if PRs are not established for the pollution Abatement commodity – although S curve can be known. Therefore, the government would not be able to accurately know the amount to tax. This may lead to inefficiency.

15. Government has to make rough estimate for tax Rates S D D S Tax Tax 0 Q* Q0 Abatement • Pt is the rough estimate; • What is the tax collection? • Total tax = Pt (Qo – Qt) • Up to Qt poll. will be abated. • Beyond Qt , pollution is taxed. • The resource cost of abatement is the area below • the S curve and Qt. • Total cost of the industry is (I) + (ii) • Taxes provides an incentive to the industry to • Invest low cost solutions to pollution abatement (drop S curve). Therefore favours tech. progress. • Still there is pollution(not zero) • There is an optimal level of pollution. D Emission

16. 4.1 The Concept of Natural Resources “RESOURCE” are some thing which accomplish human needs and are identified & defined by people. Components of natural resources: Energy, Atmosphere, Water, Land, Mineral, Plant, Animal & Human themselves Resource is a Dynamic Concept Multi Attributes:Quality,Quantity, Time & Space Dim. Properties of Resources Knowledge - Functional change Technology - Human capabilities – No limit to Re.s Demand - Scarcity Economics of extraction – Cost and Benefits

17. TYPOLOGIES OF ECOLOGICAL CAPITAL Natural Resources are a form of Capital 1.HUMAN CAPITAL - KH - The Stock of Knowledge & Skills.  2.ECOLOGICAL OR NATURAL CAPITAL - KN - Existing Stock of Natural Resources - Biosphere’s Capacity to Sustain Human & Non-H Source; Sink: Entropy, Esthetic,Life Support RESOURCE CONTINUUM Exhaustible Renewable Continuous Flow Fund/ Critical Flow Non Diminishing Mineral Fish/ Forest Solar Radiation 3.HUMAN MADE CAPITAL- KM - Man’s Productive Efforts. Nature is Capitalized - Nature combined with Labour to provide a flow V - Accumulation of human made assets

18. I. Fund / Stock / Depletable / Exhaustible Resources • Quantities - Finite: Present use reduces e future 1. Depletable, Non Recyclable Energy Resources Oil, Gas, Coal and Uranium 2. Recyclable Resources: Minerals, Paper, Glasses, 3. Replenishable but Depletable Resources: Water II. Flow / Renewable Resources Yields the flow of services with e right management. 4. Storable, Renewable Resources: Forest 5. Renewable Common Property Re.s:Fisheries III. Cultivated Ecological Capital/ Bio Resources 6. Reproducible Private Property Resources: Ag. Increased Productivity & Increased Tech. & Mgt.

19. 4.2 PROPERTY RIGHTS & NATURAL RESOURCE USE The ways in which producers & consumers use NRs depends on the underlying Property Rights (PR). A PR is a bundle of characteristics that convey to the owner (Individual/Group./Government) Certain powers of the rights • Characteristics of Non Attenuated PR: Efficient PRs • 1. Exclusivity – Complete right to collect price • Universality/ Ownership – All entitlements are complete • Transferability – Allows gravitation to the highest value • Enforceability - Enforceable & Effectively Enforced. Four Basic Categories of Property Rights Private Property : Divisible / Rival / Individual – Res-nullis Common Property : Indivisible / Exclusive Group rights Open Access: Indivisible / Non Exclusive Public Goods: Indivisible / Non Rival – Res- communes • Many NR problems are due to imperfectly defined PR

20. Rival Private Good Open Access Rivalry Marketability Non - Pure Public Good Club Good rival Local Global Locality Natural Resource as a Public Good Excludability Non - Excludable Excludable

21. Common Property Resources Problems It is important to distinguish between OA and CP If appropriate policy is to be formulated CP Resources can be indivisible and non exclusive or un-depletable or non rival in consumption within limits 1.Culture, tradition and political reasons 2. Basic physical characteristics of the NR themselves Stable pattern of CPR use in traditional societies may change due to: Population growth, technical & rapid climatic change. The breakdown of CP Institutions results from lack of assurance, externality,competitive rush. Incentive to increase one’s input level beyond the limits even though this leads to over all group welfare. “Tragedy of Commons”

22. Public Goods Public goods are different from the conventional goods because of indivisibility and non-excludability. Many environmental goods such as clean air, clean water, biodiversity, scenic views etc. have these two characteristics. If the market is allowed to supply public goods, they will be under-provided. This happens due to free riding. Once certain amount of a public good is provided, individuals have incentive to enjoy it without paying. This leads to economic inefficiency.

23. Free Riding with a Public Good Market Demand MC MC DA DB Qb QaQ* Price of Diversity (Rs. Per Unit) Pa Pb Quantity of Diversity Here every resource user faces a huge uncertainty. This induces harvest as much as possible today. Otherwise, some one else will harvest it and There may not be resource for harvesting tomorrow. The leads to excessive harvesting & leading to "ToC".

24. Attitude resulting in non-compliance Criminal Messy Sloppy Careless Overloading Of system Forgetful Lack of Attention Incentives Malicious intent Criminal Law Administrative Sanctions, e.g. Civil suits, incentives, information Negligence Informal Enforcement Response Technical information Financial aids