ENVIRONMENTAL ECONOMICS pot

ENVIRONMENTAL ECONOMICS Guide Questions, Problem Sets & Answers Supplementary to Environmental Economics Teachers Manual Developed for Undergraduate Environmental Economics Course August 2005 Economy and Environment Program for Southeast Asia 1 LECTURE 1: INTRODUCTION TOPIC 1: What is Environmental Economics? Discussion Questions & Answers: Cf: F & O (2005) and F, O, & F (2002) Q1. Why should a tax on gasoline provide a larger incentive to reduce air emissions from motor vehicles than an annual tax on owning a vehicle? Answer: The answer depends upon the magnitude of the fuel tax relative to the vehicle tax. A fuel tax targets the three components of emission reduction (i.e. a) number of vehicles on the road; b) miles per vehicle; and c) emissions per mile). On the other hand, an annual tax affects only the marginal decisions to put a car on the road (including purchases or retirement of a car). However, if the vehicle tax was sufficiently high such that very few people put a car on the road, then, emissions might fall relative to a low fuel tax as people can only drive a given car a maximum amount per day. Since such a high vehicle tax is politically unfeasible (equity reasons), then, it is still likely that a fuel tax will have larger impact on emissions reduction. Q2. What factors influence the trade-offs illustrated in the production possibility frontier? How can environmental policy affect these trade-offs? Answer: Both technological capacity of the economy and ecological facts could influence the trade-offs along PPF. Adverse impacts on the environment occur due to flows of resources from the natural world into the economy and the release of residuals during production and consumption. Any technological innovations that reduce inputs or residuals per unit output would shift the PPF upwards—which means more goods are being produced per unit of environmental quality. This is the case from recycling and re-using technologies. Policy can also influence tradeoffs by providing incentives to consumers and firms to conduct research and development (R & D) and adopt technologies that reduce the environmental impacts per unit of output. Governments may also conduct their own R & D and provide information about available technologies so that potential PPFs are actually realized (e.g. potential from Clean Development Mechanism for both developed and developing countries). Finally, the role of improving the ecology to decrease trade-offs can be discussed. The idea is that organisms that are in ecological equilibrium do produce wastes and use inputs that facilitate the workings of the ecosystem as a whole. Q3. Show how technological change could allow firms to produce goods and services with less pollution. Show the answer graphically using the PPF. 2 Answer: More goods can potentially be produced with a given amount of environmental quality so that PPF (see Figure 1.1 in F & O) pivots upward, with the environmental quality intercept remaining the same. Whether environmental quality rises or falls would depend upon the community/social indifference curve (CIC). Suppose that the increase in technology allows people to have more children. Decreased consumption per capita should increase the value of goods relative to environmental quality so that CICs may become flatter reflecting an increased marginal willingness to trade environmental quality for goods. In this case, environmental quality may fall relative to before the technology short. This is what has happened throughout most history. On the other hand, if people are richer on average, they may get increased value from environmental quality relative to consumption. In this case the CIC should become steeper reflecting a lower marginal willingness to trade environmental quality for goods. Q4. Can you think of any incentives that you face that encourage you to behave in ways consistent with sustainability? Can you think of any that have the opposite effects? How could the latter be changed? Answer: One must first answer what behavior is consistent with sustainability. In many contexts, this is contentious. For example, it is widely believed that more recycling is always and everywhere a good thing as far as sustainability is concerned as it reduces both waste discharges and the extraction of virgin resources. This is not always true. Recycling uses natural resources, such as energy. Single purpose car trips to recycling facilities by individuals may well do more environmental damage, via fuel combustion, than they avoid. Reducing fossil fuel combustion always certainly, via the prospects for climate change mainly enhances the prospects for sustainability. Traveling by boat, train, or bus, rather that private motorcar or airplane, is generally more consistent with sustainability. The incentive structure for choice of travel mode varies across countries and with local circumstances. Moving incentives in the direction of the reduced use of private motorcars and airplanes is a matter for government policy. Given that most people in advanced industrial societies have become used to, and the democratic systems of governance in place in such societies, the prospects for moving incentives in that direction are probably not great Could mention littering, buying products with lots of packaging versus no packaging, minimizing water use in the household. LECTURE 2: ECONOMY-ENVIRONMENT LINKAGES & OVERVIEW OF ENVIRONMENTAL/NATURAL RESOURCE ISSUES TOPIC 1: Economy-Environment Linkages Discussion Questions & Answers: (Cf: F & O, chapter 2; and F, O, & F 2002) Q1: How does population growth affect the balance of flows shown in Figure 2.1? 3 Answer: Population growth breaks the direct linkage between the quantity of materials/energy being taken into the system and the quantity being discharged. Growth means that some portion of the incoming resources accumulates in the expanding population. The same is true for growth of the physical system, such as in the accumulation of physical capital. As long as growth continues, the discrepancy between input and output will persist. Q2: If all goods can be changed overnight so that they lasted twice as long as before, how would this change the flows shown in Figure 2.1 in the short and long runs? Answer: This would vastly decrease the quantity of residuals needing disposal because it would substantially decrease the quantity of incoming resources required to maintain economic activity at a given level. In effect, this is a reduction in Rp, in the terminology of the model. Of course, this does not break the long-run balance of inputs and residuals. But the quantity of resources required supporting a given level of economic activity, and thus, the level of residuals required, would be essentially cut in half. Q3: A given quantity of a residual discharged at one time and place can be a pollutant; if it is discharged at another time or place, it may not constitute a pollutant. Why is this true? Answer: This question is meant to emphasize that it is not just the type of residual that matters, but when and where it is discharged. A pollutant is something that causes damage, and the amount of damage cause depends on the assimilative capacity of the environment as well as the population and ecosystem resources exposed to the discharge. Examples are: noise from an airport close to a city vs. same level of noise at a remote airport; airborne emissions during temperature inversions as compared to windy days, etc. Q4: Why are long-lived cumulative pollutants so much harder to manage than short- lived, non-accumulative pollutants? Answer: A short-lived, non-cumulative pollutant does its damage and then disappears, so that if we want to reduce damages we need only reduce current emission levels. But a cumulative pollutant stays around to cause damages in the future, so foresight is needed to manage damages, and that is usually difficult to get. It is hard because the science becomes more difficult—having to predict effects that are a long time and in the future; and it is hard because people ordinarily discount the future. Q5. Suppose that we observe that emissions of pollutants have decreased but that environmental quality has not increased—what might be the explanation? 4 Answer: Some reasons are listed: 1) the rate of emissions release may fall, but the pollutant may be accumulative so that the level of the pollutant increases. In order for the pollutant to fall, the rate of decay or absorption by nature needs to be greater than the rate of residual release. 2) Environmental quality may have deteriorated so much before the emission reduction, that the low levels of emissions cause as much damage to the environment as high levels of emissions did when the environment as more robust. 3) There may be time lags between the release of emissions and environmental deterioration due to complexity of ecosystems. Ecosystems may reach threshold levels of damage after which they rapidly deteriorate. 4) Environmental damages may be due to synergistic effects from various pollutants. For example, scientists report that high CO2 levels appear to speed up the rate of ozone hole formation. 5) Although emissions of a particular pollutant are lower, firms may find substitutes that are also damaging. There may be a lag time before the government regulates such substitutes. Q6. “An examination of natural resource matters ought to recognize technical/scientific, economic, and socio-political considerations.” Explain (Perman, Ma, McGilvray, and Common, 2003) Answer: This quotation suggests that to obtain a complete and coherent account of natural resource matters, one should be willing to adopt a multi-disciplinary approach. However, in studying environmental issues, the economists will soon find that the interactions between the economic and environmental systems necessitate taking on board some of the contents and approaches of the physical, earth and life sciences. Moreover, questions of distribution of income and wealth within and between nations and overtime, and issues of policy design and implementation, ensure that socio- political considerations will always be significant. LECTURE 3: CAUSES OF ENVIRONMENTAL PROBLEMS & CONCEPT OF ECONOMIC EFFICIENCY Discussion questions, Exercises & Answers (cf: Analytical problems in Field& Olewiler, p.84, F, O & F, 2002) Exercises E1. Below are portions of the demand curves of three individuals for air quality in their neighborhood. Air quality (integer value only) is measured in term of µg/m 3 (micrograms of SO 2 per cubic meter of air). If the marginal cost of reducing ambient SO2 is $40 per µg/m 3, what is the socially efficient level of air quality, assuming that “society” in this case consists of just these three people? Quantity Demanded Costs of Sulphur Removal (dollars per microgram/m 3 ) A B C 5 60 50 40 30 20 10 0 1,400 1,300 1,200 1,100 1,000 900 800 1,200 1,100 1,000 900 800 700 600 1,500 1,400 1,300 1,200 1,100 1,000 900 Answer: This is a question to give student practice in finding aggregate demand curves for public goods. The horizontal axis measures increasing air quality to the right, i.e., diminishing SO2 in the air. In this case he aggregate demand curve, found by summing vertically the individual marginal willingness-to-pay is: µg/m 3 Aggregate MWTP 1200 1100 1000 900 800 700 600 130 100 70 40 20 10 0 The aggregate demand curve is not well defined at µg/m 3 level higher than 1200 because that’s as far as B’s demand curve goes. Efficiency is reached at 900 µg/m 3 . E2. For the exercise in 1, prove that the socially efficient level of air quality maximizes the net social value. Answer: There are two ways that students can “prove” that the socially efficient level of air quality maximizes net social value. Using method 1, for air quality levels above 900, MWTP (marginal social benefits) to reduce SO2 exceeds marginal social cost of abatement. Hence, if air quality is improved, damage reduction must exceed costs so there must be a net social gain. Conversely if air quality is below 900, MWTP is less than the MAC. By decreasing air quality by one unit, abatement costs saved will be greater than damages reduced for a net gain. Social surplus cannot increased here if MAC=MD. A second method is to graph the MWTP and MAC and use areas under curves to calculate the net social value. Supposing that the air quality index is initially 1200, the gain in net value due to cleaning up to the following level is illustrated below. Air Quality Index Total WTP Total Costs Net Social Value 6 7500 1000 900 800 700 600 500 400 300 11500 20000 25500 27500 29000 29500 29500 29500 29500 4000 8000 12000 16000 20000 24000 28000 32000 36000 7500 12000 13500 (MAX) 11500 9000 5500 1500 -2500 -6500 Discussion Questions and Answers (Perman, Ma, McGilvray, and Common, 2003) Q1. What is the relationship between public goods and open-access resources? Answer: When people are overusing an open access resource, restraint by any individual user will confer benefit on all other users; individual restraint, in order words, is a public good, the under supply of which (because of free riding) leads to over-use of the resource. Q2. Some seemingly public goods, such as radio waves, lighthouse services, and even police and sanitation services, can be supply by private firms. Why is this so? Are there differences between these public goods and environmental services? If so, what are they? Answer: Private firm may fail to provide the public good resulting in a need for collective action. The government acts as agent for the public. In some cases, this may involve contracting out the provision of the public good to private firms. Why might the government contract out some services and not others? The answer depends on the nature of the public good or service. If it is something that can be readily produced and is appropriable, a private supplier can provide it. The government can pay the bill and oversee the delivery of the service. For example, a private contractor hired by the municipality could provide environmental services such as garbage collection and sanitation services. On the other hand, environmental regulation of some sorts is needed to ensure that the environmental quality targets are met for the most public of goods such as air quality. Private firms do not have the legal authority to regulate other firms and consumers’ actions. Q3. Discuss the relevance and application of the concept of externalities in environmental economics. Answer: The theory of externalities is one of the key foundations of environmental economics. Much of the economic theory on pollution for instance is build around the 7 externalities framework. Environmental economics is mainly geared towards internalizing externalities, and this drives the topic on pollution control instruments. This notion is also critical in other topics covered under environmental economics and may be appropriately labeled as the ‘heart of environmental economics’ discussions. Q4. Economists see pollution problems as examples of the class of adverse externality phenomena. An adverse externality is said to occur when the decisions of one agent harm another in an unintended way, and when no compensation occurs. Does this mean that if a pollution source, such as a power station compensates those affected by its emissions, then, there is no pollution problem? Answer: This depends on what is meant by a ‘pollution problem’. In general, even if compensation is paid, then, some emissions still takes place and so some ‘pollution; will continue. However, economists tend to use the phrase ‘pollution problem’ to refer not to existence of pollution as such but to describe level of pollution that is economically inefficient. If compensation is paid to all adversely affected parties, that compensation properly compensates those individuals for the damage inflicted on them, and the firm paying the compensation adjusts its behavior optimally taking into consideration the compensation payable, then, the post compensation situation will be economically efficient, and so not a pollution problem. Q5. While some economists argue for the creation of private property rights to protect the environment, many of those concerned for the environment find this approach abhorrent. What are the essential issues in this dispute? Answer: The establishment of private property rights is likely to improve static and dynamic allocative efficiency of environmental resources. Owners of the resources can take account of the opportunity costs of access to, or extraction/harvesting of, the resources. These costs can be built into prices by resource users. This setting is more likely to be one in which the path of resource use over time would correspond to a social optimum than would occur in the absence of property rights. It may also lead to resource allocation closer to a sustainable pattern (although an efficient outcome is not necessarily a sustainable one). However, it is not difficult to find ethical objections to the creation of private property rights. In the more affluent economies, many individuals argue—largely from ethical premises that mountains and other wilderness areas are and should be held collectively by some more or less widely defined community. In many parts of the world, there are long established collective or common rights to water, grazing lands, harvestable species or the like. It is not difficult to see that there are potential conflicts between maintaining cultural tradition and the goal of economic efficiency. Having said this, there is no reason why private property rights need to be individual- based. All that this requires is that well-defined set of persons is endowed with 8 property rights and that this set is sufficiently small so that those rights can be enforced at reasonable costs. Q6. “A clean environment is a public good whose benefits cannot be privately appropriated. Therefore, private industry which is run for private gain will always be the enemy of a clean environment.” Comment on this proposition. Answer: If a public good possesses the characteristics of being both non-rivalries and non- excludable (so that it a pure public good), then, markets cannot provide them in the amounts that go with allocative efficiency. This suggests that if a clean environment is a pure public good, it will be underprovided by a market economy with supply decisions taken by profit-maximizing firms. Indeed, considerations of the free-rider problem suggest that there may be gross under-provision. However, it is not clear that a ‘clean environment’ is properly described as a pure public good. Nor is it impossible to imagine that schemes should be devised—albeit imperfect ones— whereby private firms are compensated for provision of public goods at socially efficient levels. These schemes might involve, among other things, changing the form of property rights. There could also be profits from environmentally-friendly business behavior. However, it seems a sensible presumption that unregulated market behavior is likely to be inimical to a clean environment. LECTURE 4: BRIEF REVIEW OF WELFARE ECONOMICS CONCEPTS TOPIC 1: Market Efficiency: Benefits (demand) and Costs (supply) Discussion Questions and Answers: F & O (2002), and F, O, and F (2002) Q1: What happens to aggregate demand curves when consumers expect the price of the good to rise (or fall) in the future? Would this situation undermine the theory developed in the chapter? Answer: Expectations of higher (lower) future prices should shift demand curves outward (inward). Whether the situation of speculation in prices undermines the theory that markets work to maximize surplus depends on whether the speculation is based on correct expectations. Assuming that the speculators beliefs are correct, they are attempting to take advantage of an expected increase in price, that people will be WTP more in the future than today. Hence, they are acting as middle-persons moving goods between low and high WTP consumers. As there are gains from trade, there should be utility gain on net. Secondly, they act as a specialist “barometers” of future conditions. A price rise indicated that firms should increase output. Speculative actions may bid up the price early so that firms increase their output the following year. Now the basis of the price rise may be an increase in demand so the speculation serves to increase the probability that markets clear the following year increasing the private surplus. Such speculation is stabilizing. On the other hand, the speculation may be destabilizing and may decrease social surplus. The belief that prices will rise 9 may not have any correct basis in reality and may become self-fulfilling. Incorrect beliefs that prices will rise may induce speculators to purchase goods thereby bidding up prices and so on. The price increase might lead to increased production so that too many goods are produced next year resulting in falling prices. In this case, speculators lose and so do consumers due to the high prices and lower supply. The following year excess supply may result in low prices and a loss of producer surplus resulting in net welfare loss. Q2. The logic of equating benefits with willingness to pay could lead us to the conclusion that cleaning the air to which low-income people are exposed would probably create fewer benefits than if it were done for high income people. Does this undermine the idea of defining benefits as equal to willingness to pay? How should economists deal with this potential dilemma? Answer: Distributional considerations do not undermine the notion of willingness to pay but do imply that it must be used with caution, especially in cases where different income classes are involved. There are plenty of cases where this is not an important issue. Examples are comparing WTP for something (like environmental quality) by a particular group, and looking at differences in WTP across groups that do not differ substantially in terms of income. One way to deal with distributional issues involving diverse income groups is to assign welfare weights to marginal WTP. This amounts to giving a poor person a higher marginal utility for a dollar than a rich person. Aggregation of MB should then take into account the different ability to pay vs. willingness to pay. Q3. Explain to a non-economist why marginal values are so important in economic analysis. How would you counter the argument of a non-economist that he or she never makes decisions based on a marginal valuation? Answer: Economists assume that agents attempt to act in self-interested manners although this does not necessarily imply pure egoism. They also assume that activities have benefits and costs and there is often a tradeoff. Ask the students to imagine a day in which they did not make tradeoffs. For example, although getting up might give more benefits than sleeping another minute, if they were not acting in a self-interested manner, they might stay in bed. They might not drink a coffee, even though the experience has told them that without the coffee, they are likely to get a headache and so on. You might also consider that for many of these actions, they may not have engaged in a process of conscious optimization. However, if they look back on the day, they will realize that without even thinking they often acted in a manner consistent with attempting to get marginal benefits and costs into close correspondence. Q4. Why should we care about attaining social efficiency? Answer: [...]... validity of the argument often advocated by environmentalists, that revenues from environmental taxes should be earmarked for environmental protection or clean up purposes The idea is that revenue and expenditure decisions should be made on different criteria If $x million are derived from a new environmental tax, there is no reason to suppose that using it for some environmental project will necessarily... sulphur scrubbers is the environmentally best way of using environmental tax revenues (even ignoring non -environmental uses), it seems to be unlikely that this will always be the best way, or is the best in all circumstances and for all scales Is it not best to give polluters an incentive to reduce emissions, but let them select the method which is least costly for them? LECTURE 6: ENVIRONMENTAL VALUATION...Social efficiency (SE) provides one means of evaluating how well society is working and whether policy changes might result in” improvements” SE is particularly relevant for environmental economics because it attempts to place value on environmental amenities that do not have a market price In doing so, it draws attention to numerous and substantial market failures, In case of highly inequitable wealth... tax; perhaps it will be easier to implement as a part of an environmental package deal And there may be scope advantages The information gained from researching, monitoring, and implementing an environmental tax may be useful in applying the proceeds in that sector 28 However, once the earmarking becomes more and more tightly circumscribed, the potential for efficiency losses becomes very large For example,... reducing the incumbent’s profits through decreases in the price of good and potential increases in the price of inputs Another factor that may further reduce incentives to innovate under the standard is the potential for the regulator agency to increase the stringency of the standard following the innovation TOPIC 6: Evaluating Environmental Policy Instruments Discussion Questions, Exercises & Answers:... case for excluding environmental defensive expenditures could raise fundamental questions about any welfare interpretation of GDP type measures, and about economic growth as welfare enhancing Q3 Given the valuation problems inherent in assessing many forms of environmental damage or degradation, is it better to concentrate efforts on developing a comprehensive system of physical environmental accounts,... defensive or preventive environmental expenditure from GDP Identify other components of GDP, which could be excluded for identical or similar reasons Answer: The standard argument for is that the expenditures are not welfare enhancing but are intended to offset—or remedy, changes, which would otherwise reduce welfare The arguments against are the difficulties of identifying defensive environmental expenditures... 10.25 + Y0.75N for YN = 99.3298 gives ES = Y0 – YN = 100 –99.3298 = 0.6702 Q5 ‘Only the highest standards of environmental quality will do if society’s welfare is to be maximized.” Discuss Answer: This statement suggests that resources should be devoted without limit to cleaning up (or preventing) environmental pollution or degradation, irrespective of the magnitude of the benefits that this would bring... concentrate efforts on developing a comprehensive system of physical environmental accounts, rather than attempt to incorporate environmental costs and benefits in the conventional system of national accounts? 31 Answer: This is a matter of judgment To what extent and for what purposes, are environmentally adjusted national income accounts useful, given that the adjustments are not necessarily inaccurate? It... consumer surplus for the higher income situation illustrates the dependence of willingness to pay on income Q4 Suppose that an individual has the utility function: U = E0.25 + Y 0.75 Where E is some index of environmental quality and Y is income From an initial situation where E =1 and Y=100, calculate CS and ES for an increase in E to 2 and for a decrease in E to 0.5 Answer: For the improvement in E, we have: . ENVIRONMENTAL ECONOMICS Guide Questions, Problem Sets & Answers Supplementary to Environmental Economics Teachers Manual Developed for Undergraduate Environmental. application of the concept of externalities in environmental economics. Answer: The theory of externalities is one of the key foundations of environmental economics. Much of the economic theory. notion is also critical in other topics covered under environmental economics and may be appropriately labeled as the ‘heart of environmental economics discussions. Q4. Economists see pollution