Environmental Economics

Vijaya Raj Sharma, Ph.D.

LECTURE NOTES ON PART I: BASIC CONCEPTS AND THEORY

These notes are not edited. They also do not necessarily cover everything that would be discussed in the class. Students are responsible for any additional materials discussed in the class.

These notes frequently refer to exhibits and tables in the textbook - Environmental Economics, An Introduction by Barry C. Field, Second Edition, Irwin/McGraw Hill, 1997.

I. INTRODUCTION

(Chapters 1 and 2)

Environmental Economics

• Application of principles of economics to study use of environmental resources
• Distinguish between environmental resources and natural resources
• Environmental resources
• indivisible.
• Examples: ozone layer, ecosystem, air quality.
• not consumed directly, only their services are consumed
• focus on optimal quality of a resource
• this course is about these resources
• Natural resources
• divisible into smaller units.
• Examples: barrels of oil, tonnes of fish, cubic feet of wood
• consumed directly
• need labor, capital, and/or energy inputs to utilize them
• focus on optimal quantity of extraction of a resource
• such resources are a subject matter of Natural Resource Economics

Scarcity of Resources

• All fields of economics, including environmental economics, deal with issues arising out of scarcity of resources
• Households, firms, societies, countries, and the entire World face scarcity of resources
• Societies face scarcity of environmental resources also
• Example: air resources
• need clean air to breathe, remain healthy, and survive
• need air to discharge emissions of numerous vehicles and factories
• conflicting uses of air resources force societies to determine how clean thry want their air to be

Social Choice between Market Goods and Environmental Quality

• Tradeoff between market goods and environmental quality
• Production possibility frontier of two goods: market goods and environmental quality
• The more the production of market goods, the lower the environmental quality, given a state of technical knowhow
• Values placed by a society on environmental quality and on market goods determine the choice of the society where to locate in the PPF
• Value of environmental quality vis-a-vis market goods may differ among societies according to educational level, income, and information.
• A short-run choice can affect long-run choices between environmental quality and market goods
• Excessive emphasis to market goods in the short run may damage the assimilative capacity of the environment and thus future productive capability of an economy (this shifts the PPF inwards).

Economics Approach

• Two principal characteristics of "economics approach"
• Rationality
• Anthropocentricity
• Rationality
• Assumes that when a decision maker faces choice among alternatives, he or she compares benefits and costs of each alternative and chooses the alternative that yields the largest net benefits (benefits net of costs)
• Example 1: Should you fly or rent and drive a car to Chicago?
• Flying costs more than renting and driving, but air travel is comfortable and saves travel time.
• If the value of time saving and comfort exceeds the additional cost of flying, you will fly. Else, you will rent a car and drive.
• Example 2: How many hours a week to allocate to study of environmental economics?
• For each additional hour devoted to economics, you compare the possible gain in grade in economics with the possible loss in grade in other courses (because fewer hours available for other courses).
• You will choose the allocation that maximizes total grade (GPA).
• Anthropocentricity
• Economics approach is completely human-centered.
• Evaluate environmental issues based on value of resources to people.
• Example 1: should we preserve an animal species?
• A species is worth saving only if benefits of saving the species to human beings at least exceed the costs of saving the species.
• Contrast this with the Principle of Minimum Interference expounded by ecologists
• A species should be preserved regardless of the cost and importance of the species to the people.
• Example 2: should we allow mineral extraction in the Yellowstone National Park?
• Mining activities can destroy natural features of this Park
• Any mineral has no value apart from the purposes to which people intend to put it. The same is true of the services of a national park that mining would destroy.
• The issue is to compare benefits of mining with its costs, including the loss of benefits of the services of the Park.
• Do you agree with the following statement?
• In economics, someone who privately owns a forest but will not allow any trees to be cut for lumber despite offers would not be considered to be using the resource efficiently.
• Invite discussion
• The statement is wrong because economics compares benefits of letting trees stand with its costs (forgoing the revenue from sales of lumber). If benefits exceed costs, it is very well efficient to let trees stand.
• However, the problem is that many services of standing trees (e.g. ecological benefits) cannot be marketed, and hence the forest owner does not earn revenue from nonmarket benefits of standing trees. On the other hand, the forest owner can easily sell lumber by cutting trees. Therefore, it is very well possible that the owner finds cutting trees more advantageous than letting them stand.
• If nonmarket benefits are indeed greater than the potential revenue from sales of lumber, economics would consider this an example of market failure to allocate resources efficiently. It is therefore important that nonmarket benefits of standing trees be estimated.
• Do you agree with the following statement?
• Value of life is a hard to determine controversial estimate. What economists do is placing a monetary value on a life lost as a result of emissions, pollution, etc. How could you put a value on the loss of a child as a result of lead contaminated drinking water?
• Invite discussion
• A couple of issues here
• Mostly we seek to value a statistical life, i.e., value of a life saved (the saved life could be yours or others - a random happening). For example, how much are you willing to pay for reducing highway speed limit from 75 mph to 55 mph, if it reduces probability of highway deaths from 7 to 6 in 100,000? Obviously, the value you put on a statistical life is likely to be far different from the amount you may be willing to pay to save your life from a criminal who is pointing a gun on your head.
• There are people who prefer 75 mph to 55 mph speed limit, and obviously they are valuing risk to their life less than the perceived benefits of the higher speed limit. In many occasions, people consciously and subconsciously are putting values on risk to life (e.g. mountain climbers, labors choosing to work in risky jobs for higher wages). Economists simply try to estimate what is the value placed by these people on risk to life.

Private and Social Opportunity Costs

• There are two types of costs - private costs and social costs - depending on who is evaluating costs, a private individual or the society.
• If an individual or a firm or an institution pays money for something (e.g., labor, materials, taxes, etc.), the transaction enters into its book of accounts as a cost. However, a social planner may or may not consider the transaction as a cost or may consider it a cost after some modification. Consider costs of baking breads from the perspective of a baker and from the perspective of a social planner (who is determining the optimal quantity of bread for the society).
• The cost of flour ($0.30 a pound) purchased from a competitive flour market is considered a cost by both the baker and the social planner.
• A sales tax of $0.05 on each pound of bread sold is a cost to the baker, but not a cost for the social planner. For every $0.30 paid, the baker gets a pound of flour in exchange. But for a tax of $0.05, the baker gets no good or service in exchange. Tax is simply a payment obligated by law and, therefore, a transfer from the baker to the taxpayers.
• Payment of the Federally mandated minimum wage of $5.15 an hour to labor is a cost to the baker. Suppose the baker could hire a labor at a competitive wage rate of $4.50 an hour if this minimum wage was not mandatory. Then the social planner would consider $4.50 as the true labor cost, instead of the Federally mandated wage rate. Wages and prices in a competitive market reflect the true values of goods and services. Government interventions generally distort the competitive values of goods and services.
• The part time voluntary (unpaid) help of the spouse of the baker would not appear as a cost in the book of accounts of the bakery. But the social planner would include her services as a cost (probably at a rate of $4.50 an hour).
• The baker uses a diesel-fired oven to bake breads, which causes air pollution and is likely to create some health damages to neighbors. In the absence of regulations against pollution, health costs of neighbors do not appear in the book of accounts of the bakery. But, the social planner includes it as a cost.
• The above examples illustrate possible divergences between private costs and social costs. Private costs are also called monetary costs or accounting costs, and social costs are also called economic costs. Economic costs represent the real and full value of resources used.
• Let us consider costs of driving a car. Private costs consist of fuel, oil, maintenance, and depreciation expenses on the car and time expenses of the driver. Social costs include, besides the above private costs, costs of congestion and pollution created by the car.
• In environmental economics, we always evaluate environmental projects or issues from the perspective of the society. Therefore, we consider social benefits and social costs, instead of private benefits and private costs.

Marginal Cost versus Average Cost

• Marginal cost is the cost of one additional unit, whereas average cost is the total cost averaged over the number of units produced. Let us clarify this with an example.
• Example 1: DIAMOND SELLER IN A COMPETITIVE MARKET

Quantity Price, $ MC, $ Net Marginal Total Profit, $

Sold, carat Profit, $

1 5 1 4 4

2 5 2 3 7

3 5 3 2 9

4 5 4 1 10

5 5 5 0 10

6 5 6 -1 9

7 5 7 -2 7

8 5 8 -3 4

9 5 9 -4 0

• What is the average cost of producing 5 carats? ($1+$2+$3+$4+$5)/5 = $3 per carat. Marginal cost of the 5^th carat is $5 per carat.
• The average cost of producing 7 carats is ($1+$2+$3+$4+$5+$6+7)/7 = $4 per carat. Marginal cost of the 7^th carat is $7 per carat.

Efficiency and Cost Effectiveness

• According to the rationality assumption, a decision maker compares alternatives for benefits and costs and chooses the alternative that is associated with the largest net benefit.
• In environmental economics, the emphasis is on maximization of collective net benefits to the society. Maximization of collective net benefits to the society is called economic efficiency. Let us now establish a rule of achieving efficiency (MB=MC rule), using two examples. Note that an individual decision maker also attempts to maximize total net benefits to the individual, by equalizing private MB to private MC. On the other hand, a social planner attempts to maximize total net benefits to the society, by equalizing social MB to social MC. The outcomes of the individual's evaluation and the social planner's evaluation may be the same, or they may differ. Whether the outcomes differ depends on whether there is divergence between social MB and private MB and also between social MC and private MC differ.
• Example 1: Costs and Benefits of Diamond Production

Quantity Price, or MC, $ Net Marginal Total Net

Sold, carat MB, $ Benefit, $ Benefit, $

1 5 1 4 4

2 5 2 3 7

3 5 3 2 9

4 5 4 1 10

5 5 5 0 10

6 5 6 -1 9

7 5 7 -2 7

8 5 8 -3 4

9 5 9 -4 0

How many carats should be extracted? Either 4 or 5 carats. Up to 4 carats, MB>MC , so the seller should extract more. Above 5 carats, MB < MC, so the seller should extract less. Ideally, the seller should extract 5 carats where MB = MC to maximize total net benefit.

• Example 2: A CRAZY MONEY EXCHANGER

Exchange Get MB MC Net Total

Benefit Net Benefit

First $1 $1.60 $1.60 $1 $0.60 $0.60

Second $1 $1.50 $1.50 $1 $0.50 $1.10

Third $1 $1.40 $1.40 $1 $0.40 $1.50

Fourth $1 $1.30 $1.30 $1 $0.30 $1.80

Exchange $4, Get $5.80

Average for $1, Get $1.45

Fifth $1 $1.20 $1.20 $1 $0.20 $2.00

Sixth $1 $1.10 $1.10 $1 $0.10 $2.10

Seventh $1 $1.00 $1.00 $1 $0.00 $2.10

Eighth $1 $0.75 $0.75 $1 -$0.25 $1.85

Exchange $8, Get $9.85

Average for $1, Get $1.23

Ninth $1 $0.65 $0.65 $1 -$0.35 $1.50

Tenth $1 $0.50 $0.50 $1 -$0.50 $1.00

Exchange $10, Get $11.00

Average for $1, Get $1.10

How many dollars would you exchange? $10? Why not, for every $1, you receive average $1.10? You mean average benefit or average cost is not important for the decision? In total you gain $1 by exchanging $10?

How many dollars would you exchange? The answer should be: either $6 or $7. Because up to $6, for every $1, your MB > MC. For more than $7, MB < MC, you do not like this. Ideally, you want to exchange where MB=MC, i.e., $7. That maximizes total net benefits.

• Cost effectiveness
• Distinguish cost effectiveness from efficiency
• Cost effectiveness - achieving a given target at the minimum possible cost
• Suppose a city decides to reduce air pollution by 50%. A number of alternatives exist to achieve this target, like reducing auto emissions, reducing factory emissions, or a combination of the two.
• Benefit of each alternative is the same, no matter which alternative is chosen (because each alternative cleans air by 50%). This allows us to focus on cost of reducing pollution only.
• The objective then would be to choose the alternative that achieves the given target at the minimum cost possible.
• The Equimarginal Principle of Cost Effectiveness
• To minimize the total cost of abating pollution by a given level, allocate abatement among multiple sources such that marginal costs of abatement are equalized.
• Discuss an example to show the equimarginal principle: MC_a=MC_b=... across all plants.
• Depending on the time available, discuss the textbook example (Figure 3.8, Page 58) of the minimum cost allocation of a given level of total output (say 100 units) among multiple plants to show the minimum cost allocation is achieved by equalizing marginal costs across plants.

Economic Incentives Work

• Since people compare benefits and costs of undertaking an action, public policies that change either benefits or costs or both are likely to influence the decision of individuals to undertake that action.
• Exhibit 1-1 of the textbook.
• Exhibit 1-1 talks about reducing household wastes. It compares a monthly flat fee system with a pay-per-bag system of household waste disposal. Under the monthly flat fee system, every household pays the same fee, irrespective of the amount of waste generated by the household. The pay-per-bag system encourages recycling and composting and saves waste disposal cost. The system is more beneficial to poor households because they generate less wastes. The introduction of this system (an incentive to recycle) worked in Chester Township, NJ. The possible demerit of this system is illegal dumping of wastes.
• Exhibit 1-2 of the textbook
• Exhibit 1-2 talks about reduction of auto emissions and traffic congestion. The suggested policy is "roadway pricing," i.e., charging drivers the full cost of use of roads. Costs drivers impose on the society are smog, congestion, and increased probability of accidents. Full pricing will offer incentives to drive less, and it will generate fund for developing mass transit. The possible demerits of this policy are social engineering, more taxes, and greater regulation.
• Exhibit 1-3 of the textbook
• Exhibit 1-3 talks about the failure of the Mexican Clean-Air Law. The Law prohibited driving of cars on certain days according to their license numbers. The even-numbered cars were allowed on some days every week and the odd-numbered cars only on other days of the week. The objective was to reduce the number of cars driven on any day and thus to reduce auto emission in the Mexico City. The Law failed to achieve the objective because the regulation provided perverse incentives to households to purchase of more than one car, which increased the total number of cars and thus auto emissions.

Linkage Between Economy and Environment

• Draw a box diagram to show linkages between Nature and economy.
• Nature provides raw materials and energy to the economy. Economy uses the resources to produce goods which are then consumed. During both production and consumption processes, residuals are emitted to Nature.
• Environmental economics is the study of the flow of residuals (see the box diagram) and its impact in the natural world.
• According to the First Law of Thermodynamics (also known as the Law of conservation of matters), matters only change in shape, size, or phases, the total weight is conserved. What goes in must come out. Thus, the total weight of raw material and energy inputs to economy must be balanced by the total amount of residuals flowing to the environment.

Materials Balance Concept

• The "materials balance" concept tells us that there are only three ways of reducing residuals in the environment.
• Reduce output
• Reduction of output reduces amount of inputs; therefore, some people advocate "zero population growth."
• Improve productivity of inputs
• Improvement of technology or productivity leads to requirement of less inputs for the same amount of output. It may as well change the composition of outputs to reduce inputs (for example: a change from manufacturing sector to information or service sector).
• Increase recycling of residuals (refer to the box diagram)
• Increased recycling of residuals also reduces the amount of virgin inputs.
• Land, water, and air are the three different environmental medium that receive residuals. Materials balance concept also tells us that emissions in one medium are reduced by increasing emissions in another media.

Few Terminologies

• Distinguish between ambient quality and environmental quality.
• Ambient quality is the quality of surrounding air and water, whereas environmental quality includes visual and aesthetic quality of the environment.
• Effect of emissions on ambient quality depends upon physical, chemical, biological, and meteorological processes of the natural system, which may change from day to day.
• Besides depending on the different processes of the natural system, damages resulting from degradation of environmental quality also depend on human choices of where and how to live and on susceptibility of living and nonliving systems.
• Source would mean the location where emissions occur, such as a factory, an automobile, or a leaking landfill.
• Some sources can easily be identified; for example, power plants as sources of SO₂ emissions. Such sources are called point sources.
• Sources that are difficult to identify are called nonpoint sources; examples are agriculture runoff polluting streams and rivers, urban storm water runoff, etc.
• When emissions from two sources mix up and cannot be separated, design and implementation of environmental policy may be problematic. Assigning reduction in emissions among sources would be difficult.
• Depending on whether a pollutant accumulates over time, it is categorized as a cumulative or non-cumulative pollutant.
• For example, noise is a non-cumulative pollution.
• Nondegradable wastes, such as radioactive wastes and plastics, are cumulative pollutants; they may bring inter-temporal problems.
• Noise is a local pollution, but acid rain is a regional pollution, whereas greenhouse effect is a global pollution.
• Emissions from power plants are continuous, but oil spills and Chernobyl nuclear disaster are episodic emissions. Certain environmental damages are not related to emissions, e.g. logging or strip mining, the conversion of land to housing or commercial purposes.

II. REVIEW OF MICROECONOMIC CONCEPTS

(Chapters 3 and 4)

Demand, or Marginal Willingness to Pay, Curve

• The higher the price, the lower the quantity demanded. Draw a downward-sloping demand curve to show this negative relationship.
• Demand curve is also a representation of marginal willingness to pay. It is also a marginal benefit curve.
• Implicit in the demand curve is the law of decreasing marginal returns. The more apples you eat, the less tastier is the next apple.
• Marginal benefit from a good decrease with increasing consumption of the good. Therefore, people are willing to pay larger quantities only at lower prices.
• The value you place on a good depends on how much you have already consumed.
• Height of the d-curve measures the marginal willingness to pay.
• Area under the d-curve measures the total willingness to pay for a given quantity. Area also measures the benefits (of, say, improvement in environmental quality).
• Different persons may have different demand curves, reflecting different values placed by them on the same good, either because of different preferences or income levels.
• A person's demand may change over time with changes in knowledge (experience or information) about the good or with changes in income. The same individual can place more value on the same good when income increases.
• Demand for normal goods increases with income, and environmental assets are generally considered normal goods.
• Higher income people are likely to have higher d-curve for environmental quality.
• An implication is that the same improvement in environmental quality is tagged a lower value if implemented in an area inhabited by poor, compared to the value when implemented in an area inhabited by rich.
• This difference in value arises from the lower ability to pay of poor people.
• Market demand (demand of all individuals in a market aggregated together) is the horizontal summation of individual demands. For each price add quantity demanded of all consumers to obtain the market demand. Show the addition graphically.

Supply, or Marginal Cost, Curve

• The higher the price, the greater the quantity supplied. Draw an upward-sloping supply curve.
• The supply curve is also a representation of marginal cost of production.
• For a producer to supply a given quantity, the producer must be offered a price at least equal to the marginal cost at that level of quantity.
• Note that marginal cost includes a normal return on equity capital (a return that could have been earned if invested elsewhere; this return is considered a part of profit by accountants).
• Implicit in the supply curve is the law of increasing marginal costs, i.e., marginal cost increases as more and more of a good is produced.
• Increase in MC with increase in production is a general case, but there are cases of decreasing MC (for at least up to a certain level of production, primarily due to economy of scale). In some cases, MC may remain constant with production.
• Consider supply of clean water as an example. The marginal cost of supplying water depends on degree of cleanliness sought. The cleaner the water supplied, the greater the marginal cost of supply. Cleaning costs increase progressively. Water can be easily cleaned of solid residues and suspended particles by filtering it through a filter or strain (a physical process). If further cleanliness is desired to get rid of dissolved substances in water, water may have to be boiled or distilled (a relatively more expensive procedure). If still more cleanliness is sought to get rid of chemicals in the water, it may need still more expensive chemical processes.
• Height of the supply curve is a measure of marginal cost (the opportunity cost of production). Improvement in technology lowers marginal cost, or shifts the s-curve to the right.
• Area of the supply curve is the total cost of supply.
• Firms may differ in their marginal costs (s-curves) because of different technologies they use. Example: new and old firms. Accordingly, the total cost of providing the same improvement in environmental quality may be different for different firms. The cost of a firm may also go down with improvement in technology of the firm.
• Market supply curve is the horizontal summation of firms' supply curves (just as in case of market demand).

Competitive Market Generally Achieves Economic Efficiency

• Competitive market generally achieves economic efficiency.
• When demand curve measures both the private MB and the social MB and when supply curve measures both the private MC and social MC, market equilibrium coincides with the efficient allocation.
• Discuss graphically.

Issue of Equity

• Economic efficiency guarantees maximum possible net benefits to the society.
• But, economic efficiency does not guarantee equitable distribution of net benefits among members of the society.
• In a market system, one who has the ability to pay gets most of the goods and services and, therefore, gets most of net benefits available to the society. In other words, market allocation is generally efficient, but not necessarily equitable.
• This is the reason, many times governments interfere in a market place through price floors and price ceilings to affect distribution of market outputs. But in the process, the government intervention makes the market outcome inefficient. That is the society is now left with a lower amount of net benefits (because net benefit is not maximized).
• Efficiency guarantees the largest possible pie, but poor are likely to get a smaller share of the pie. On the other hand, government intervention in market for the purpose of increasing the share of poor reduces the size of the pie.
• Equity is a normative issue.

Performance of Market in the Presence of Negative Environmental Externalities

• A competitive market fails to achieve economic efficiency in certain cases. There are two such cases of interest in environmental economics.
• Production of goods associated with environmental externalities
• Production of public goods (many environmental services are public goods)
• Firms in their production decision consider only private costs and ignore external costs (those costs that are not borne by the firm but are true costs to the society).
• Market S-curve only represents private MC, whereas the social MC would be higher because it includes external costs.
• Draw a figure to show this.
• To the society, costs are higher and therefore fewer amount of such goods should be produced.
• Market output exceeds the efficient level of output.
• This presents a rational for the government to intervene to correct the market failure to produce efficient quantity.
• We will discuss many types of government interventions related to pollution (a negative externality) control.
• One such intervention can be a pollution tax.
• Let us consider an example of open-access externalities presented in the textbook.
• Four similar firms are situated on a lake (an open-access resource).
• Each firm uses water of the lake as an input to production and discharges emissions back into the lake.
• Treatment costs of each firm depend on the ambient quality of water in the lake.
• Let the treatment costs be $40,000 per year for each firm.
• A new firm is contemplating to begin operations on the lake.
• With the new firm, treatment costs of each firm would go up to $60,000 per year.
• What is the cost of operating a new firm on the lake?
• The new firm adds $60,000 of treatment costs to its other costs to determine its operating cost. It will ignore the fact that each of the other four firms will now have to spend $60,000 a year on treatment, instead of the current expenditure of $40,000 a year.
• But a social planner includes the increase in treatment costs of existing firms, which amounts to $80,000 a year. $80,000 is the external cost imposed by a new firm on existing firms.
• Since market outcome would not be efficient, the government may intervene in this case. A possible method may be to impose a tax of $80,000 a year on the new firm. This tax internalizes the external cost.

Public Goods

• A public good, if made available to one person, automatically becomes available to other persons. For example, national defense, radio signal, clean air, clean rivers, ecological benefits of forests, etc.
• You can be excluded from consuming a hamburger if you are not willing to pay for hamburger. But, a nonpayer cannot be excluded from consuming a public good.
• Since no one can be excluded from consuming a public good, there is an incentive to free ride (consume without making full payment, or making payment below the level of benefits). Very few people pay the full price of a public good.
• The amount of payments (contributions) received to supply a public good in a market place - therefore a demand curve estimated from such contributions - understates the true benefits of the public good, because of free riding.
• The true social MB is higher than what such a market-revealed demand curve shows. Market is therefore likely to supply less than efficient quantity of public goods. Show graphically.
• Market demand of a public good is the vertical summation of individual demands (unlike private goods we discussed earlier). For each quantity of public good, add prices or marginal willingness to pay of all individuals to obtain the market demand, or true marginal willingness to pay of the society.
• It is very likely that a private entrepreneur is unwilling to supply public goods because the entrepreneur cannot exclude nonpayers from consuming the goods. Therefore, public goods are provided by either the government or activists nonprofit organizations.
• Whenever an activist organization supply environmental goods of public nature (e.g. protecting forests), their effectiveness is dependent on contributions they can raise for the cause. You can expect that the amount of contributions would be lower than the true value of such environmental goods, because of free riding.

Possibility of Government Failure

• Implicit in a request to government to formulate, implement, and monitor environmental policies is the assumption that public officials pursue public interest. One may, however, question this assumption.
• The assumption that public officials pursue public interest while making public policies contravenes our more general assumption that economic agents are self-centered.
• Public officials while making a decision in a market place weigh personal benefits and personal costs associated with an activity.
• How do we then expect that the same individual, in his or her capacity as a public official, essentially ignores personal benefits and personal costs and focuses only on public interest while formulating or implementing public policies?
• It is possible that personal interests of a public official conflict with public interest while formulating a public policy. Public interest requires appropriate control of pollution, but polluting firms want least control and are willing to contribute a large amount of money for the forthcoming election campaign of the politicians involved in the issue of pollution control policies. Is campaign contribution likely to affect pollution control policy? Perhaps, yes.
• Lobbyists, politicians, bureaucrats, and voters are engaged in the process of public policy formulation and each of these may be influenced by their private interests in this process. There are some systematic tendencies and incentives within legislatures and enforcement agencies that work against the attainment of efficient and equitable public policy.
• Rational Voter Ignorance
• Voters vote for electing politicians and also vote at times on issues put to referendum. Mostly voters are uninformed; consequently, they either do not vote or make uninformed choices during voting.
• A voter finds that the cost of being informed is substantial whereas the benefit of being informed for voting is generally very small.
• Consider from the perspective of a voter, what is the probability that the person or the issue preferred by the voter wins in an election or referendum just because of his or her vote? This probability is almost negligible. In other words, the benefit of being informed and voting is very small. On the other hand, the voter needs to spend substantial amount of time and perhaps some money too to become informed.
• Since cost of informed voting far exceeds benefit, voters generally make a rational choice to remain ignorant. This phenomenon is called "rational voter ignorance." This can lead to many economically sensible issues losing in referendum.
• Short-sightedness Effect
• A politician is generally concerned with his or her electability in the next election. To improve electability, the politician is eager to show before the next election at least some policy achievements that are positive or beneficial to his or her constituents. The pursuit of personal interest of improving electability for the next election makes politicians often short sighted. In their legislative agenda, they tend to favor projects that generate immediate benefits even at the expense of large future costs.
• Special Interest Issue
• Certain issues are of interest to special interest groups. A limited number of people will benefit from such issues. On the other hand, costs associated with these issues are often shared among a large number of people.
• An example is the proposed financing of Broncos' stadium from sales tax collected in six counties of Colorado.
• The Broncos franchise and people associated with football (owners, players, coaches, sportscasters, etc.) make up the special interest group who will benefit from sales tax financing of the proposed stadium.
• Costs, however, are shared by taxpayers of the six counties. To each individual taxpayer the cost would be minuscule.
• Taxpayers (who are also voters) tend to ignore the cost because it is minuscule. Most probably they also choose to remain uninformed on economic desirability of the financial proposal (rational voter ignorance effect). So, taxpayers or voters care less on this issue. For this reason, politicians too do not see a threat of voters' backlash if they support the tax financing proposal - a special interest issue.
• On the other hand, the group which is likely to benefit would lobby and contribute to campaign funds of politicians.
• Therefore, politicians tend to give precedence to special interest issues in the legislative process, although it may be a bad economics.
• Regulators often become captive of the regulated.
• Public officials depend on those regulated (polluters) for information on cost of abating pollution.
• Polluters may have incentive to mislead or confuse officials to avoid stiffer regulations.
• Polluters may attempt to convince public officials (and even coerce or threaten them, depending upon how strong they are politically) that high pollution taxes or stiff regulation would force the polluting sources to close operations, rendering many workers jobless.
• Public officials often do not dare political risks and they succumb to polluters' political pressure while setting emission standards and while sanctioning violators of existing regulations.
• The above problems should, at least, convince you that government intervention is not necessarily the best answer always
• The government can as well fail in achieving efficiency.
• Before proposing government intervention, you should pause and think about alternative market-oriented approaches to solve environmental problems.

III. A SIMPLE MODEL OF POLLUTION CONTROL (Chapter 5)

Marginal Damage Function

• Pollution causes many types of damages. The benefit of pollution control is reduced damages.
• Let us define marginal damage. Marginal damage is the additional damage caused by an additional unit of emission.
• Example:
• If total damages increase from $30,000 to $35,000 when emissions increase from 10 tons per week to 12 tons per week, marginal damage is $2,500 per ton. [($35,000-$30,000)/(12 tons-10 tons)]=$2,500 per ton.
• Marginal damage function is a relationship between quantity of emissions and the damage caused by it. Draw an upward-sloping marginal damage curve.
• The curve assumes that marginal damage increases with increasing emissions.
• There is a threshold below which marginal damage is zero.
• The area below the function measures total damage.
• Marginal damage is a time-specific function; it may shift with time because of changes in natural environment.
• Let us focus marginal damage from a non-cumulative pollutant (a pollutant which does not accumulate over time).
• The function is a population-specific function; it may shift with an increase in the number of people exposed to the pollutant.

Marginal Abatement Cost Function

• This function denotes the additional cost of achieving a one more unit decrease in emission level.
• It is sloping upward to the left. Draw a marginal abatement cost curve.
• The higher the emission reduction, the greater the marginal abatement cost.
• At its right end, the curve starts from the maximum level of emissions with no abatement efforts, i.e., from the uncontrolled level of emissions.
• This function reflects the minimum costs of achieving different levels of emission reduction. In other words, pollution abatement is being carried out in a cost-effective manner.
• Note that there is always an upper limit on abatement costs, which is the cost of stopping the operations of the polluting plant (zero emission).
• Area below the curve measures total abatement costs of achieving a reduction in emissions.
• Different sources may have different MAC functions because of different technology of operation.
• For the same source, the function may shift with time periods because of improvement in technology of pollution control.
• Aggregate marginal abatement function of the industry is the horizontal summation of the MACs of individual firms.

Efficient Level of Emission

• Let us assume that MD and MAC have been evaluated from the perspective of society.
• MD can be interpreted as the marginal benefit of reducing emissions (damages saved), and MAC is the marginal cost of reducing emissions.
• That is, they are social marginal benefits and social marginal costs of reducing pollution.
• The efficient level of emissions (the level that maximizes social net benefits) would then be where MD and MAC are equal (MAC=MD), the point of intersection of MAC and MD. Explain graphically.
• Alternatively, we can interpret both MD and MAC as costs.
• No matter which level of emissions a society chooses, it has to incur costs on bringing down emissions to that level, and at that level, there are some damages remaining. At any level of emissions, therefore, the society incurs abatement costs plus costs of damages.
• The society would be efficient if it chooses that level of emissions which is associated with minimum possible total of abatement costs and damages.
• The area below the MAC is total abatement costs and the area below the MD is total damages. Show in the graph that only at the intersection of the two curves (MAC and MD), the sum of the two costs is minimum.
• Here, we ignored costs of enforcing emission standards.
• Sources (polluters) may not follow the chosen emission standards voluntarily, and the society may have to incur costs on enforcement. If so, enforcement costs should be included while deciding the efficient level.
• The more emissions polluters are asked to cut back, the more expensive it gets to them to cut back each additional unit of emissions. (This is because of the increasing MAC).
• Therefore, polluters are more likely to cheat on cutbacks when the efficient level involves larger emission reductions.
• Consequently, the cost of enforcing cutbacks is also likely to increase with requiring additional reductions of emissions. That is, marginal enforcement cost would be increasing with increasing abatement.
• Thus, there are two types of cost: cost of abating and cost of enforcing the abatement target. In other words, the total marginal cost (TMC) of emission reduction is the sum of MAC and marginal enforcement cost (MEC). TMC=MAC+MEC. Show in a graph.
• Note that the gap between the TMC and MAC increases progressively with additional reductions (the gap is increasing as move to the left along the MAC), reflecting increase in MEC with increase in emission reductions.
• Efficient emission level is then given by the intersection of the TMC and the MD curve.
• This efficient level would be lower than the previous efficient level with no enforcement costs.
• This tells us that the society should be willing to accept lower emission reductions for the sake of enforceability of emission standards.

Cost-Effective Allocation of Emission Reduction Target

• Once we have decided the target level of emission reduction, we can use the equimarginal principle to allocate emission reduction among different sources. We have already discussed this principle.
• We will equalize marginal abatement costs across sources for the given level of emission reduction.

Long-run sustainability

• Efficiency is maximization of net benefits, and cost effectiveness is the minimization of costs.
• Evaluation of efficiency, however, measures costs and benefits from the perspective of the present generation.
• This raises a concern whether benefits and costs to future generations are appropriately considered. Is the efficient level sustainable over generations?
• If all environmental resources were renewable and if all pollutants are noncumulative, sustainability would not be an issue. What is efficient today would always be efficient, assuming that preferences remain the same over generations.
• If pollutants are cumulative, damages are likely to increase over time. Time dimension of damages and abatement costs (i.e., long-run and short-run impacts) should be incorporated in MD and MAC.
• But, how would you compare present effects with future effects? It is a human nature to value less or discount future effects. If it is the same amount of benefit, you prefer to receive the benefit sooner than later. If it is the same amount of cost, you prefer to pay the cost later than sooner. In other words, the damages that happen in future and the benefits that accrue to future generations are likely to carry relatively lower weight to present generation.
• There may be a problem of lack of information on long run effects of a proposal. This would then hamper inclusion of such effects in MAC or MD. There may be a probability of serious or irreversible future consequences, like extinction of a species. It may be necessary to use caution if there is a possibility of irreversible long run effects.

Criteria for Evaluation of Policies (Chapter 9)

• There are five criteria generally used to evaluate environmental policies.
• Efficiency/cost effectiveness
• Equity
• Incentives for long run improvements
• Enforceability
• Moral considerations

Efficiency/cost effectiveness

• We know these two terms. If there are alternative methods of abating pollution, cost effectiveness is to choose the method associated with the lowest MAC curve. Explain this graphically.
• Efficiency is to balance marginal abatement cost and marginal damages, i.e. to determine the point of intersection of the MAC curve and the MD curve. Show this in a graph.
• This maximizes net benefits from emission reduction.
• The MAC curve that is considered for efficiency should be the lowest possible curve, if there exist alternative methods of abating pollution.
• In other words, efficiency also implies cost effectiveness, but cost effectiveness does not necessarily imply efficiency.

Equity

• Equity evaluates the distribution of net benefits of environmental policies across different sections of the society, mostly the distribution between poor and rich, and many times also the distribution across ethnic groups.
• Relative weights of efficiency and equity in the evaluation of policies is a normative issue and often controversial.
• Some take the view that resources are scarce but environmental problems pervasive, so we should emphasize efficiency to achieve the greatest possible net benefits from the use of scarce resources.
• On the other extreme, some argue for even avoiding efficient policies if they are regressive in equity. Let us discuss the following table.

• There would be differences of opinion in the class on which program is better.
• Program B is better than Program A because it is equally efficient but relatively more progressive. However, some may consider A fairer because both income groups get the same amount of net benefits.
• The choice between B and C is likely to be very controversial because C is more efficient but regressive.
• Controversy between B and D should be milder because D is more efficient and also provides more net benefits to poor; however, net benefits to rich increase proportionately more than those to rich.
• Obviously, the choice among programs can differ from person to person according to their individual notion of fairness.
• Some studies have raised doubts that toxic wastes in the U.S. have been generally dumped at sites mostly inhabited by poor and minorities. But, some other studies have refuted this.
• A study commissioned by the Environmental Protection Agency (EPA) found no relationship between hazardous waste sites and income level of the community.
• The EPA has now suggested adding "population distribution analysis" to benefit-cost analysis of environmental projects.

Incentives for Long-Run Improvements

• Besides efficiency or cost effectiveness, it is preferable to have a policy that also provides incentives to the private sector to find new and innovative ways of reducing emission.
• This would help shift the MAC curve downward, reducing over time the cost of controlling emissions.
• Incentives become more effective, when policies are perceived stable and when the envirotech industry (the industry that develops and manufactures pollution control technologies) is competitive.

Enforceability

• Policies have to be enforced to become effective, and enforcement requires energy and resources.
• Polluters may try to outwit or confound the pollution monitoring process.
• The general enforcement practice in the U.S. is:
• self reporting of emissions by firms to the central pollution control authority
• periodic audit of firms' records by the authority
• periodic, but generally very infrequent, testing of emissions by the pollution control inspectors
• sanctioning violators through penalties and even litigation, if necessary.
• Like any other government agency, the pollution control authority often faces budget constraint.
• According to a study done by the Resources for Future, enforcement is expensive. See the table below.

• According to a General Accounting Office study in 1993, about one-third of major water waste dischargers were not in compliance of regulations.
• This highlights the need of enforcement.
• Rather than having a dazzling but nonenforceable emission standard, it is better to have a modest standard that is enforceable.
• While determining the efficient level of emissions, the marginal abatement cost should also include the marginal enforcement cost. Show this in a graph.
• When enforcement is also considered, the efficient level would be lower, compared to the level with no enforcement.

Moral Considerations

• Proposed policies are not likely to gain support if they are not considered morally right.
• This may explain the general lack of emission subsidy programs that subsidize sources for reducing emissions. Instead, emission taxes may be preferred to control pollution. People perceive subsidy to polluters morally incorrect, a reward to culprits.
• Moral considerations are also important in international environmental problems.
• There is no agreement on developed and developing countries' shares of costs of reducing greenhouse effect.