welfare economics and the environment (ch. 5). welfare economics2 introduction welfare economics:...

Welfare Economics and the Environment (Ch. 5)

Welfare Economics 2

Introduction

Welfare Economics:

Provides framework for analysing many policy questions related to the environment

Structure:

1.Conditions for efficiency and optimalityA. Partial equilibrium analysis

B. General equilibrium analysis

2.Market failures related to environment

Welfare Economics 3

1. Conditions for efficiency and optimality

Definitions

1. Economic efficiency

An allocation of resources is efficient if it is not possible to make one or more persons better off without making at least one other person worse off (= Pareto optimality/efficiency, allocative efficiency)

2. Optimality

An allocation of resources is optimal if it maximizes the social welfare that can be obtained from these resources

Welfare Economics 4


Definitions3. Marginal rate of utility substitution (MRUS)The rate at which one commodity can be substituted at the margin for another without changing a person’s utilityNB: equals the slope of the indifference curve4. Marginal rate of technical substitution (MRTS)The rate at which one production factor can be substituted at the margin for another without changing the output of the commodity NB: equals the slope of the isoquant

Welfare Economics 5


Definitions

5. Marginal rate of transformation (MRT) of a production factor

The rate at which the output of one commodity can be transformed into output of another commodity by a marginal shift of a production factor from one production process to another

NB: Equals the slope of the production possibility frontier

Welfare Economics 6


Economic efficiency:

a) Efficiency in consumption

b) Efficiency in production

c) Efficiency in product mix

Welfare Economics 7

.

.

a

BXa

b

AXa AXbAX

AYa

AYb

BXb

BYb

BYa

IB0

IB1

IB1

IB0

IA

IA

B0

A0

BX

BY

AY

T

S

Figure 5.1 Efficiency in consumption.

Welfare Economics 8


Consumption efficiency requires that the MRUS is equal for all individuals

Welfare Economics 9

.

.

a

LYa

b

LXa LXbLX

KXa

KXb

LYb

KYb

KYa

IY0

IY1

IY1

IY0

IX

IX

Y0

X0

LY

KY

KX

Figure 5.2 Efficiency in production.

Welfare Economics 10


Production efficiency requires that the MRTS is equal for all commodities


a

Xa

b

XC

Yb

Ya

I

I

c

YM

0X

YFigure 5.3 Product-mix efficiency.

Xb

XM

Yc



Product-mix efficiency requires that the MRT of all production factors are equal to the MRUS

NB: For an economy with given quantities of resources, production functions and utility functions, there are many efficient allocations of resources


.

A

A

B

AX

B

C

B

B

B

B

A

A

B

A

B0

A0

BX

BY

AY

T

S

Figure 5.4 The set of allocations for consumption efficiency.

BB

B

A

A

A

A

CA


a

b

UA

W

W

c

0

Figure 5.6 Maximised social welfare.

UB

B

aU

B

cU

B

bU

A

aU A

cUA

bU



Optimality requires that the slope of the social welfare function (social indifference curve) equals the slope of the utility possibility curve

Hence:

• efficiency is a necessary but not sufficient condition for optimality

• an efficient allocation of resources may have lower social welfare than an inefficient allocation


E

UA

W2

C

0

Figure 5.7 Welfare and efficiency.

UB

D

W1



Basic Assumptions

1. Institutions

• Markets exists for all goods and services

• All markets are perfectly competitive

• All agents have perfect information

• Private property rights are assigned to all goods and services

• There are no externalities

• All goods and services are private goods (not public goods)

• All utility and production functions have standard properties



Basic Assumptions

2. Behaviour

• Producers are profit maximisers

• Consumers are utility maximisers

Assumptions are very strict & not realistic

Serve as a benchmark in welfare analysis of actual economies and for designing appropriate policies



Approaches:

A. Partial equilibrium analysis (for 1 good/sector)

B. General equilibrium analysis (all economic sectors)

20

g/

h/

Px

f/

X* XDX=MBX

SX=MCX

MCX

MBX

X* X

g

h

0

0

0

f

X

X

NBX

X*

X*

NB(X*)

NB(X)

B(X*)

C(X*)NB(X*)

0a

d

e

B(X)C(X)

(a)

PARTIAL EQUILIBRIUM: Figure 5.11 Partial equilibrium interpretation of economic efficiency.

(c)

(b)

(d)


1A. Partial equilibrium analysis

MB-curve:

• Demand curve

• Expresses ‘willingness to pay for a commodity’

MC-curve:

• Supply curve

• Shows marginal costs involved in producing an additional unit



Consumer surplus (CS):• Triangle g’f’px

• Shows gains of consumers (who pay a lower price than they are willing to pay)

Producer surplus (PS):• Triangle h’f’px

• Shows gains of producers (who receive a higher price than the price for which they are willing to sell)

CS+PS = maximised net benefit (=total welfare gain of trading a good in the market)



Advantages and disadvantages:

• Examines efficiency in consumption and production, but not production-mix efficiency

• Requires less data and research time than general equilibrium approach


1B. General equilibrium analysis

Can be used to show that if the basic assumptions for institutions and behaviour (see above) are satisfied:

A market allocation of resources is an efficient allocation


a

bY*

U*

U*

c

Ymax

0X

YFigure 5.8 Utility maximisation.

X* Xmax



Consumption efficiency:

Because all individuals face the same prices, the MRUS is the same for all individuals


a

b

X*

X*

c

0L

YFigure 5.9 Cost minimisation.

L2

L1 L3

K2

K3

K1



Production efficiency:

Because all producers face the same production factor prices, the MRTS is the same for all producers



Product-mix efficiency:

• MRUS is equal to the price ratio of products (Fig. 5.8)

• Because all producers are profit maximisers, the MRT for a production factor is equal to the price ratio of products (see p. 118)

Hence: MRUS = MRT for all production factors (5.11)


2. Market failures related to environment

Major result of Part 1:

A market allocation of resources is an efficient allocation, if the basic assumptions for institutions and behaviour are satisfied.

Market failures: Situations where actual circumstances deviate from the ideal.

Analysis of market failures —> policy recommendations to improve economic efficiency


2. Market failures related to environment

Basic assumptions on institutions:• Markets exists for all goods and services• All markets are perfectly competitive• All goods and services are private goods (not public goods)• There are no externalities• All agents have perfect information• Private property rights are assigned to all goods and

services• All utility and production functions have standard

properties


2A. Market failures: Public goods

Private goods:• Rivalry: Consumption/use by one person/producer reduces

amount available for consumption/use by others• Excludability: It is possible to exclude specific persons/

producers from consuming/using the commodityExamples: bread, ice cream, coca cola, cars, car parts

Public goods:Exhibit neither rivalry nor excludabilityExamples: lighthouses, national defence force, clean air



Open access resources:

Exhibit rivalry but not excludability

Examples: ocean fish, groundwater, migratory birds

Toll goods/congestible resources:

Exhibit excludability but not rivalry

Examples: wilderness area, city park, cinema, toll roads



Markets cannot supply public goods due to the non-excludability.

Public goods have to be supplied by an entity that can recover production costs from other sources than market sales: Government taxes



Efficient level of public goods provision:

Level where aggregate marginal willingness to pay equals marginal costs of provision

Problems:

• information is difficult to acquire

• individuals have incentives to provide incorrect information

• way of taxing has important equity implications


2B. Market failures: Externalities

Externalities / external effects:

• Consumption or production by one person/producer has unintended impact on utility or profit of other person(s)/producer(s)

• No compensation/payment is made by the generator to the affected person(s)/producer(s)

• Can be positive or negative

Examples:

Radio noise, vaccination, water pollution, bee hives



Consequences:

Due to absence of compensation/payment, the producer/consumer will not take the externality into account in decision making. Private costs (or benefits) therefore deviate from social costs (benefits), and the market will produce either too much (negative externality) or too little (positive externality) of the good.



Two cases:

1. Externality is private or toll good (e.g. noise pollution, water pollution)

2. Externality is public good (e.g. air pollution)


a

b

MECMB

d

0 Hours of music

£

1. Externality is private or toll good

Figure 5.13 The bargaining solution to an externality.

M* M0

c



Affected person/producer does not have a property right in an unpolluted environment. Hence, no compensation is paid and pollution will continue until the marginal benefit is zero.

Solution: Establish private property right in non-polluted environment (for affected person/producer)

This will cause a bargaining process until MB=MEC, and reduce environmental pollution to M*

NB: Pollution is not zero in M*; this level, however, is the efficient level of pollution.



Alternative solution: Establish private property right in environmental pollution (for pollution generator)Consequences:• Causes similar bargaining process until MB=MEC• Now the pollution victim(s) should pay the generator

Hence:• Both solutions lead to the same efficient outcome• Welfare/equity implications are different= Coase theorem



Assignment of property rights is not often used to correct externalities:

• Legislators also have non-economic objectives

• Bargaining is costly (espec. with many generators & victims)

• Many externalities have public good characteristics



2. Externality is public good (‘public bad’)

Assignment of property rights and private bargaining will not deal with the problem; public intervention is required, e.g. taxation of pollution generator

Optimal tax level:

Makes output price equal to social marginal costs SMC (= private marginal costs PMC + marginal environmental costs MEC)


PMC

SMC

0 Y

£

Figure 5.14 Taxation for externality correction.

Y* Y0

PMCT

t

PY



Taxing agency will have to identify the optimal production level Y* , and then calculate the tax rate t*. To do so, it will need information on the willingness to pay of the affected persons at different production/pollution levels.

Problems (see above):

• information is difficult to acquire

• individuals have incentives to provide incorrect information

• way of taxing has important equity implications


2C. Market failures: Imperfect information

Condition for efficiency: All agents have perfect information.

Reality:

• Some agents (victims, generators) may be unaware (e.g. smoking); result; no bargaining process; solution: information provision (= public good) by government

• No accurate or unambiguous information (e.g. global warming); implications: see Ch. 8

welfare economics and the environment (ch. 5). welfare economics2 introduction welfare economics:...

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