Property Rights, Externalities & Environmental problems

1. Property Rights, Externalities & Environmental problems According to normative criterion, an environmental problem exists when resource allocation is inefficient

2. Why the interests of individual are different than that of a group? Under what circumstances does this happen? • Let’s examine property rights • We all, including govt, undervalue environmental assets. • capitalist economy: PRs refer to entitlements – use of resource depends on PRs governing them • centrally planned economy: people’s needs more important is objective – efficiency

3. Efficient PR structures • 3 main characteristics: • Exclusivity: C+B to owner • Transferability: voluntary exchange of rights • Enforceability: secure from encroachment PRs exchanged in market economy – seller: right to stop consumer from using in absence of payment – consumer: chooses how much to buy at what price for net benefit

4. Consumer’s net benefit • Area under AR (dd) curve - cost (expenditure) Price is adjusted by demand & supply, where both maximise their benefits. Efficient allocation by static efficiency. Net benefit= PS+CS S CS P PS D/AR VC 0 Q

5. It is important to find how net benefits are distributed between the consumer & the producer. • Efficiency is achieved because of the price system & not because of C/ P’s self interests • Adam Smith: selfish people  efficiency • Freedom of choice to both Consumers & Producers

6. Scarcity Rent • Area under price line is TR • Area under MC curve is TVC • PS related to profits. It’s = profits + rent • new firms enter with rise in price  rent • Without price rise - zero rent • Most NRs give rise to rent • PS in the long run is scarcity rent

7. Externalities • A decision maker doesn’t bear cost of consequences of his decision • Externality exists when welfare of a firm / an individual depends not only on his activities but also on activities under control of some other agency e. g. waste in river water imposed external cost on resort. • Pvt sector doesn’t think of externalities ∴ doesn’t consider cost (control pollutants) for it – produces more quantity at lower price

8. Private MC of steel plant is MCp & for society it is MCs. Price With no control on Emission production = OQm – not efficient OQ* is efficient as NB are maximised – if costs external no search for ↓ pollution – releasing waste outside is inefficiently cheap Social marginal cost P* Private marginal cost Pm O Qm Q* production

9. Types of externalities External effects can be +ve or -ve External diseconomy/economy: pollution/garden Pecuniary externalities: when external effect is transmitted through altered prices viz rent ↑ with new entry ∴ all land up paying more rent = -ve effect on all those paying rent. Pollution is not pecuniary externality as the effect is not seen through prices.

10. Improperly designed PRs system • Entitlements to resource use: • Private • State ownership • Common property ownership • Open access regimes: common pool, non -exclusivity & divisibility. Exploited by anyone Capture of resource by one group ↓ availability for others

11. Open-access resources • First-come first-serve basis • Tragedy of the commons • American Bison were plentiful – hunting with no control – aggressiveness of one didn’t affect time & effort by other hunters • In absence of scarcity, efficiency was not threatened by open access. • As DD for bison  scarcity ∴ more time & effort

12. Bison harvesting • MB slopes downwards as amount of hunting efforts rises, number of bison falls. Thus smaller population supports smaller harvests per unit of effort expended. • Excessive exploitation of herd – cannot appropriate scarcity rent ∴ ignore it. • Destroying incentive to conserve Total cost Total benefits / cost € Total benefits O Q Harvest effort

13. Public Goods • Non-exclusivity – non-excludability – landscapes. Air, water & biological diversity • Consumption indivisible Biological diversity: • Genetic variability among individuals in single species • Number of species within community of organisms Genetic diversity has proved to be important in development of new crops e.g. disease resistant barley – interdependence of species within ecological communities, a particular species may have more value beyond its intrinsic value

14. Imperfect Market Structure • Environment problems – when one of the participants in an exchange of PRs is able to exercise an inordinate amount of power over the outcome – Monopoly – violates definition of efficiency in goods market • Monopoly always supplies less and charges more than in competition.

15. Static efficiency is achieved when OB is supplied – net benefit is ∆ HIC. But monopoly will sell OA & charge OF. I Producer’s surplus is maximised is clearly inefficient. Society looses net benefit = ∆ EDC F D MC price C G E H D/AR MR O A B quantity

16. Divergence of Social & Private Discount Rates • Producers while achieving max surplus, maximise present value of net benefits under “right” conditions, viz. absence of externalities • Firms must use the same rate to discount future net benefits, for efficient use of the resources, that is appropriate for the society • Higher rate: extract & sell faster than efficient • Lower rate: excessively conservative

17. Private & Social Rates • Social discount rate= social opportunitycost of capital Risk-free cost of capital – rate of return when no risk = rate expected Risk premium = additional cost of capital required to compensate owner when actual ≠ expected Therefore, due to the risk premium, the cost of capital is higher in risky business than in no-risk industries. Private & Social discount rates are different as the risk premiums in the two are different.

18. Risk taken by a single person is higher than when it is taken by society as a whole. • ∴ private risk > social risk • ∴ private discount rate> social discount rate  current production is higher than desirable to maximize net benefits to the society • Energy production & forestry both inefficient • Private & Social discount rates may not always diverge. • If they do, then market decisions are not efficient

19. Government Failure • Market & political processes are sources of inefficiency. • Improper incentives are the root cause • Rent seeking → net benefits to special group → but ↓ net benefits to society as a whole • Losers don’t protest? – voter ignorance – economically rational – high cost of keeping informed & low probability that a single voter is decisive – difficult to unite those – opposition to special groups is always under funded

20. Rent seeking – takes many forms - High price under ‘infant industry argument’ - Special subsidies to consumers • Govt. policies that are inefficient : rationing, low price of oil, free education to a few…. • Policies create evn problems: easy loans for cars → more cars → more pollution • Govt. failure - direct challenge: to assumption that intervention by govt. automatically leads to greater efficiency & sustainability.

21. Environmental problems due to divergence between individual & collective objectives – can be resolved by realigning individual incentives to make them compatible with collective objectives • Economists reluctant to argue that values of consumers are warped – assume ‘correct set’ of values • Capitalism & democracy on presumption: majority knows what it is doing – ballots for representative or $ votes for goods & services

22. The pursuit of efficiency • PRs are ill-defined ∴ evn problems • To restore efficiency when affected people are a few • Example: a Resort & a Steel Plant: • Both are on the bank of a river. • Both have PRs to use river. • Water flowing from plant towards resort. • Resort gets polluted water, due to dumping of waste by the plant. • Its’ clientele is affected.

23. If resort offers a bribe of C+D  less production from OQm toOQ*. Damage less. But if plant refuses  PS = A+B+D. If accepts - returns higher = A+B (surplus)+ C+D (bribe) Price Society better off by C. Net benefits from production OQm = A – C. and from OQ* = A Social marginal cost P C Private marginal cost D A B O Qm Q* production

24. Find: • Whom should PRs belong? • To the party who seized it first? • How to handle environmental risks? • Answers By whom? • By the court system

25. Resolving the conflict • The courts can resolve environmental conflicts by imposing property or liability rules • PRs specify initial allocation • Entitlement : right to add waste & right to attractive river view • Court goes by pre-eminent right –injunction on violating rights injunction removed by the Consent of the party whose right was violated • Out-of-court settlement – monetary gain • In absence of court - who can seize it easily -naturally • Goes to steel co. • Court should decide whether to overturn this allocation.

26. Coase Theorem: Ronald Coase (1960) • Negotiation costs are negligible + affected parties only a few, court - give PRs to anyone • Any way efficient allocation - theorem • C-B will change for parties • PRs to Co.  bribe by resort • PRs to resort  steel co. must bribe = compensation for all damages - ∴ produces OQ* as prv benefits maxm.(usesSoc MC asPrv MC due to compensation • PRs to resort– cost borne by steel co. • PRs to Co. cost borne by resort • Either way efficient production

27. Shouldn’t forget administrative cost + lawyer’s fees + court’s time… • Govt. can create regulations on pollution control – backed by fines, jail sentence, tax.. • Bribes : not the only means • If transaction costs high & benefits little – better to live with inefficiency • New ways of life: create problems • Role of govt.

28. To conclude, • producers & consumers determines how the environmental asset is Utilised • When PRs system is exclusive, transferable and enforceable, the owner of the resource has powerful incentive to use resources efficiently • Economic system will not always sustain efficient allocations