Environmental economics
Summary
Slides and notes
KU Leuven
,Chapter 1: Foundations: welfare, market failure and environment
Welfare and ranking alternatives
Economic efficiency
A gain by one or more persons without making anyone else suffering is a Pareto
improvement. When all such gains have been made, the resulting allocation is Pareto
optimal (or Pareto efficient). An allocation of resources is Pareto efficient if it is not possible
to make one or more persons better off without making at least one other person worse off.
Efficiency in allocation requires that three efficiency conditions are fulfilled:
1. Efficiency in consumption: marginal rates of substitution are equal across consumers:
MRSAX,Y = MRSBX,Y
2. Efficiency in production: marginal rate of technical substitution is the same in production
of all commodities: MRTSXK,L = MRTSYK,L
3. Product-mix efficiency: marginal rate of substitution of consumption between sectors (for
any given person) is equal to marginal rate of transformation of production between sectors
(for any given input): MRSAX,Y = MRSBX,Y = MRTLX,Y = MRTKX,Y
All three conditions must be satisfied simultaneously, and the results readily generalise to
economies with many inputs, many goods, and many individuals. The only difference will be
that the three efficiency conditions will have to hold for each possible pairwise comparison
that one could make.
An efficient allocation of resources is not unique. The criterion of efficiency in allocation
does not serve to identify a particular allocation. The utility possibility frontier (UPF) shows
the UA/UB combinations that correspond to efficiency in allocation, situations where there is
no scope for a Pareto improvement. Choosing a point along the UPF is about making moves
that must involve making one individual worse off in order to make the other better off. The
criterion of economic efficiency does not provide any basis for making interpersonal
comparisons.
Pareto optima are not unique. Practical policy suggestions very seldom are Pareto
improvements since most policies will entail re-allocations that will involve some individuals
gaining and some losing. If a re-allocation involves winners and losers, it is outside of the
terms of the Pareto improvement criterion.
Social welfare function
A social welfare function (SWF) can be used to rank alternative allocations: W = W(UA, UB, …,
UN) with the only assumption that welfare is non-decreasing in UA, UB, …, UN. Just as we can
depict a utility function in terms of indifference curves, so we can depict a SWF in terms of
social welfare indifference curves, WW. So, when social welfare is maximised WW is
tangential to UPF at the optimum where the combination of UA and UB maximizes the SWF
and that the optimum lies on UPF means that all the necessary condition for efficiency must
hold at the optimum.
,Any change which is a Pareto improvement must increase social welfare and given that the
SWF is non-decreasing in UA and UB, increasing UA/UB without reducing UB/UA must increase
social welfare. So, given a SWF, a Pareto improvement is an unambiguously good thing.
The relative weights to be assigned to the utilities of different individuals in SWF are an
ethical and political matter. Economists prefer to avoid specifying the SWF if they can –
precisely the appeal of the Pareto improvement criterion.
Hicks-Kaldor criteria
Suppose a project brings benefits to some and costs to others: its welfare evaluation
depends on choice of SWF and economists seek to separate efficiency from ethical question
of distribution.
Kaldor’s test: could the gainers compensate the losers after the project is implemented and
still be better off
Hicks’s test: the losers could not compensate the winners for the project not occurring, and
still be as well off as they would have been if it had taken place
Hypothetically; you do not actually have to make the transfer
The welfare effect of change in quantity or quality of an environmental good using
compensation variation (CV): if the change does happen and equivalent variation (EV): if the
change does not happen
Willingness to pay (WTP) for the good thing, whether the change is bad or good and
willingness to accept (WTA)
Scitovsky reversal paradox: the project is desirable if both the Kaldor and Hicks tests are
satisfied: moving from a Pareto inefficient allocation to a Pareto efficient one will always
satisfy both the Kaldor and the Hicks tests.
The compensation tests do not align with maximising social welfare: we use redistributive
taxation to optimise a social welfare objective, though it clearly creates dead weight loss
(DWL) and so it is not Pareto efficient. A second reason is that it gives equal weight to
winners’ gains and losers’ losses irrespective of income and wealth levels. These issues are
generally ignored in practice regarding small projects: theoretically (under certain
conditions), the most efficient way to deal with inequality is via re-distributive income
taxation. So, assume all will come out in the wash, but practically, it could be difficult to
, identify winners’ and losers’ relative wealth levels. For large problems like climate change,
we cannot assume all will come out in the wash via re-distributive taxation.
Market failure, public policy and the environment
First welfare theorem: the competitive equilibrium is efficient
Necessary condition:
- Markets exist for all goods and services produced and consumed
- All markets are perfectly competitive
- All transactors have perfect information
- Private property rights are fully assigned in all resources and commodities
- No externalities exist
- All goods and services are private goods: there are no public goods
- All agents are optimisers
Externalities and public goods
When the actions of one economic agent affect another other than through the price
mechanism/market transaction we say that there is an externality. They can be positive
when they have beneficial external effects or negative when they are harmful to others.
Non-rival: a good is non-rival if one person’s consumption of it does not diminish its
availability for anyone else
Non-excludable: a good is non-excludable if, once it is provided, it is not possible to prevent
anyone from consuming it
MRSx,g(g) = MCg: the willingness to pay for g (public good) in units of x (private good)
What one person pays for, everybody gets. So (hypothetically) merge of the entities
involved. This internalises the externality. They then act in a jointly optimal way, which must
be efficient. Everyone chips in according to their own willingness to pay. So society’s
willingness to pay for the public good is the sum of the willingness’s to pay. This does give a
Pareto optimum. This condition is known as the Samuelson condition:
If g =/= g* there is dead weight loss (DWL). The MC(g) of additional units is way above their
MRS(g), so they contribute nothing, nor does the next person. If we leave things to the free
market, our stack collapses.
Suppose property rights are assigned to the polluting agents: individuals will not pay for the
pollution to be reduced until it reaches to the efficient point as there is an incentive to free
ride: the MB to the polluter at q* is way above each individual MEC
