Property Rights, Externalities & Environmental problems

According to normative criterion, an environmental problem exists when

resource allocation is inefficient

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

Why the interests of individual are different than that of a group? Under what circumstances does this happen?

Efficient PR structures

3 main characteristics:I. Exclusivity: C+B to ownerII. Transferability: voluntary exchange of

rightsIII. 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

Consumer’s net benefit

Area under AR (dd) curve - cost (expenditure)

PS

CS

D/AR

S

Q0

P

Price is adjusted by demand & supply, where both maximise their benefits.

Efficient allocation by static efficiency.

Net benefit= PS+CSVC

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

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

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

Private MC of steel plant is MCp & for society it is MCs.

Price

production

P*

Social marginal cost

Private marginal cost

Q* Qm

O

Pm

With no control onEmission production = OQm – not efficient OQ* is efficient as NB are maximised – if costs external no search for ↓ pollution – releasing waste outside is inefficiently cheap

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.

Improperly designed PRs system

Entitlements to resource use:

a. Private

b. State ownership

c. Common property ownership

d. Open access regimes: common pool,

non -exclusivity & divisibility.

Exploited by anyone

Capture of resource by one group ↓ availability for others

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

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

Harvest effort

Total benefits / cost €

Total cost

Total benefits

QO

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

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.

Static efficiency is achieved when OB is supplied – net benefit is ∆ HIC. But monopoly will sell OA & charge OF.

price

quantity

MC

D/AR

A B

E

MR

D

C

I

F

G

O

Producer’s surplus is maximised is clearly inefficient. Society looses net benefit = ∆ EDC

H

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

Private & Social Rates

Social discount rate= social opportunity cost of capital

Risk premium = additional cost of capital required to compensate owner when actual ≠ expected

Risk-free cost of capital – rate of return when no risk = rate 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.

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

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

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.

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

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: o Both are on the bank of a river.o Both have PRs to use river.o Water flowing from plant towards resort.o Resort gets polluted water, due to

dumping of waste by the plant.o Its’ clientele is affected.

If accepts - returns higher = A+B (surplus)+ C+D (bribe)

Price

production

P

Social marginal cost

Private marginal cost

Q* Qm

A

B

DC

O

If resort offers a bribe of C+D less production from OQm to OQ*. Damage less.But if plant refuses PS = A+B+D.

Society better off by C.

Net benefits from production OQm = A – C. and from OQ* = A

Find:

Whom should PRs belong? To the party who seized it first? How to handle environmental risks? Answers By whom?

By the court system

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.

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. (uses Soc MC as Prv MC due to compensation

PRs to resort – cost borne by steel co. PRs to Co. cost borne by resort Either way efficient production

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.

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