Natural Resource and Environmental Economics

Tony Prato is professorofresource economics atrd matragcmetrt, and director of the center forAgriorln'al, Resourceand E...

Author: Tony Prato

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Tony Prato is professorofresource economics atrd matragcmetrt, and director of the center forAgriorln'al, Resourceand Environmental sysrems at the univercity of Mssouri-columbia He has writtcn extensiveryon îhe assessment and management of nanral resounces" @ f998 [sn 4 grnreUniversity presq Ameg Iowa 5fi)14 All rigbts reserved Authorization to photocopyitems for interoal or personaluse, or the internal or per_ sonaluseof specificclients,is grantedby Iowa starc university press, provided th*r the basefee of $'10 per copy is paid directly ,o the copyrigùt clerance center,zl CongressStreet, Salem.MA 0f970. For thoseorgaizations th*r have been granted a photocopy licenseby ccc a s€piuatesystemofpayments has becnasanged-Tbe fee codefor'se* of the TransactionalReporting ser'ice is Ggr3&293&0r9s $.10. e) Prinred on acid-freepaperin tbe United Statesof America First editiou, 1998 International Stadard Book Number Ggl3&2g3g{ Library of CongressCaraloging-itr-publicationDaa Prato,Tbny NafiEal resourceand environmentaleconomics/ Tony prato._lst.ed. pcEL Includes bibliographical rcferencesand indcrrsBN0-813&2y384 l. Naoral resorrces-€conomic aspecB.Z Envhonmeatal economics. I. Title. 'IC2LYI3 1998 33334c2L g,_*,ga3 Lastdigitistheprintnunben 9 g 7 6 5 4 3 2 |

Contents Prcfiace xÍ Acknowledgments, xiii Importance of Natural Resourcesand Environnent Nature and Importance of Problems 3 Global Warming 4 Ozone Depletion 5 Acid Deposition 7 Conservation of Biological Diversity 8 Tempora[ Scientific and PolicyAspects

l0

Contuiburing Factors 1l Po'pulation 11 Per Capita Resourc-eUse 13 EnvironrnentatDamages 14 Technology 15 Approaches to Resource and Environmental f,ssnes 17 RoIe of Economícs 1!) Reductionist versrrsHolistic Science 20 gnrnrnary 2l Questions for Dirscussion Xz trhrtherReadings Notes

2.

23

23

Economic and Flnancial Concepts in Resource ll{anagement Conzumption and Demand Theory 2il Utility Function and Indifference Map ZB Constraints 29 HouseholdEquilibrium 31 hoductionand SupplyTheory 33 Production Function and Isoquant Map Constraints 35 Efficientlnput Use 37 Firm's InpufDemand Curve 38 Efficient Ouput 40 Ùfarket Equilibrium 4l Ma*et Demand and Supply 4 Example of Market Equilibrium

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34

27

vi

Contents

hesent Value 49 SummilY

51

Questionsfor Discussion Sz fhrtherReadings 53 Ffistorical Views of Natural and Environmental Resource Capacity Ss F,conomic Views Ss ClassicalEconomics 55 NeoclassicalEconomics 59 Conserationism

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Contenporar5r Views T.imitsto Growth 62 OtherFactors

62

63

Indicators of Resource Capacit5r 65 Physical Measures 65 Economic Measures 67 EnvironmentalResources 6g Summ4y 6E QuestÍons for Discussion Further Readings

70

70

Notes 7l

4.

Economy and Envirorunent Circular flow Economy

73 73

Material Balances 75 EcologicalEconomics

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Sustainable Development EO SustsinableResourceUse g3 Summsr-Jr E6 Questions for Discussion FurthcrReadings

t7

g7

Notes E7

5. ,^hoperty Rights and Externalities

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Markets and Efficient propert;r Rights Markets 91 Efficient prropertyRights 93 Transaction Costs 95 IVIarket Failures

96

Conúents

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Common Property and OpenAccess Resources 9? Public Goods l0O Extemalities 100 Types of Extemalities l0l Exarnples of Externalities .lO2 Edernalities and ko1rcÉy Rights 104 Assignment of property Rights 105 Governmentlntervention lO7 gnrnrnery 10E Questions for Discussion Flrther

Rindings

Notes

110

109

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6. Nahrral Resource Decisions 111 l{afirral Resource Management

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Tlpes of Resources lls ExhaustibleResources ll5 RenewableResources 116 Static Efficirmcy llE Pure Competition l18 ImperfectCompetition lZz gnmmalf tA Questions for Discussion FbrtherReadings Note

123

tL4

XU

7. Erhanrstible Resource Use . XIS Market Dynamics

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Net Social Benefit

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IbyoPeriod Dynanic Efficiency fzE case 1: TWo-period Efficiency with constant oil Denrand lzg case 2: Two-Period Efficiency with variable oil Denand 133 Multiple-?eriod f'.fFciency Í19 EquilibriumConditions I39 Tlme Path of Prices and Extraction 140 Underlyin{jFoto., 143 Technologrcalprogress 143 Imperfect Competition 143 Extemal Costs l4 DiscountRate 147 Recycling 149 Exploration and Developrnent 153

att

vru Contents

Summary lS3 QuestionsforDiscussion lS4 FhrtherReadings lS4

Notes ts5 Renewable Resource Managenent

fiÍ7

SinplifyingAssumpfions t5t Naturat Gruwth 159 Static Efficiency 16í2 Privare Property 163 Exanples l& Common propemy 167 Multiple Objective Management

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Dlmanic Efficiency lTs Objectives and Constaints 174 Necessary Conditions 175 RenerwableResource poficies lg2 Tax onllarvest lg2 Access Fees,Effort Resnictions and OtherApprroaches lE4 grrrnrnaly lgs Questions for Discussion FurtherReadin$ Notes

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ltr/

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9. Economics of Environmental pollution lE9 poautionand ForhúionDamages ResidualEmissions, Expanded Maerial BalancesModel l9l Efficient Reduction in Envimnmental pollution 1:A StaÉc Efficiency with hrre €ompetition 195 Static Efficiency with Imperfect Competition 2M Dynamic EfEciency 2W

*ro

Establishing Property Rights for Environmentar Reso'rces PollutionAbatementpolicies zlJPoint Sourcepollution 2ll NonpointSourcepollution ZZg grrmrnaîf

236

QuesúionsforDiscussion 23t FurtherReadings Z3g Notes 2N

zro

Contents

\

rx

N"t"ral and Envíronmentar Resourceaccounting u3 AccountingDeficiencics U4 DefensiveExpendiuues245 ResourceCapacity 246 ResidualPollutionDamages 249 ResourceActounting Methods zil PhysicalAccounts 2SO MoneqaryAccounts 252 SatelliteAccoune ?57 Resourcc-SpecificAccounting É7 Implications for SustàinableDevelopment 2Sg gqmmnry

Zffi

Questions for Discussion FfutherReadings Notes

?61

262

?Sz

Benefit-cost anatysis of ResourceInvestnents z6s SocialtyEfficientlnveshent Net Social Benefit 266 Timber Harvesting Exanple

2ó6 267

Special Topics in Investuent Analys.is Z7O Continuous versusDiscrete Time nl InvesmentEvaluaúon period Z7l Efficiency and Equity rmprications of the Discount Rate nz Selection of DiscountRate 273 Capital and Operating Costs ng Economic versusFinancial Feasibility ng Local versnsGlobal F.fficiency ZgO IndependentversusInterdependentlnveshents 2g0 Capital Rationing 281 Primary and SecondaryBenefits and Costs Zgl Risk and Uncertainty 2gz Alternative Investment Evaluation Criteria Payback Period 283 Avemge Rare of Retum 2U Net PrresentValue 295 AnnuatNetBenefit 286 Benefit{ostRatio ?AG Intemal Rate of Return 287 Exanple 287

2EO

Evaluation of rndependent and rnterdependent rnveshents Independentlnvestments Z9O

Do

Contents

Interdependentlnvesfrents 2gl Evaluationof Multipre Reso'rce Inveshents zg4 $rrrnrnary

D6

Questionsfor Discussion Z[n fbnher Readings 2ln Notes 29!t

12- Nonmarket varuation of Natural and Environmental Resources 301 Importance of Nonmarket valuation 301 Efficient Use of Exhaustible Resources 3ú2. Nanral and Environmental ResourceAccounting Resourceprotection policies 3U Efficient ResourceInvestrnent 304

3M

Theoreticar Basis for Nonmarket varuation 305 Mllingness to pay andAcceptCompensation 305 Valuing Changesin Resourcehice 306 Valuing Changesin Resource euality 309 rnequarity between wilinguess to pay and wilring4ess to Accept Compensation 310 Use and Nonuse Values Use Value 3ll Option Value 3I2 Existence Value 314 Bequest Value 314 -

Estinatiori of Nonmartet Values 314 Ir-rdircctMarketMethods 315 DirectValuation Methods 322 gurnrnany 3Zg Questions for Discusion Further Readings Notes ggz

Index

311

335

331

331

Preface

ewspapen,books,reportsand scientificjo,rr_ nals are replete with articles and research J- \ findings dealing with a wide array of naurral and environmental resource issues, such as depletion of fossil fuels and ozone,

global warming, deforestation, and conservatiouof biodiversity. Considering the abundanceof literanrre on these issues,it is appropriateto ask whether we really need another book on natural resourceand environrnentaleconomics.At the time this book was conceived,therewere severalintroductory bookson the subject; however' the most recent upperdivision undergraduate-and graduate-leveltext was l0 yearsold. Hence, the motivation for this bookNatural Resourceand Envirownental Economicsis a contemporaryupperdivision undergraduate-and graduate-levelbook that addressesa broad rang;òtoutural resourceand environmentalissuesfrom an economicperspective.It covers topics in natural resource and environmental economicswiùi griater analytical rigor than that found in introductory textbooks.The book is designedfor studlnts with a backgroundin introductory microeconomicsand algebra Natural Resouteeand,Enviroruruntal Economi'csemphasizesthe links between the economy and the ecosystem.It adopts a conceptualframework that views the econornyas a subsysternof a finite and nonexpandingecosystemthat imposes biophysicallimits on economicgrowth.This frameworkls consistentwith the concepr of sustainabledevelopmentand sustainableresourceuse.Addressingthe interconnectionsbetweenthe economicand ecological spheresrequiresthat naturaland environmental resource issuesbe approachedfron a mdddisciplinary trrrspective. Natural rqsource and environmental economics is one of the disciplines in rhis nexus. The initial chaptersof the bookprovide backgroundon the importanceand relevanceof natural tEsourcesand the environmentlChapter 1), basic economic and financial conceptsin Ésource nnnagement(Chapter2), anOhistorical perspectives ou nahrral and environmental resource capacity and its relationship io economic growth (Chapter3). The text then examinesfour paradigmsfs1 snd€rsrandingthe relationshipsbetween the economyand the environmentor ecosystem(chapier 4); effects prop_ of erry rights and extemalities on marketsand resourceallocaùon (Chapter5); anributes of natural resource decisions and types of natural resourcee(Chapter 6);

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principles of exhaustibleresourceuse(Chapter7) and renewableresource management (Chqpter 8)i privatefy and socialty efEcient levels of environmentalpollution and policies for reducing pollution (Chapter9); alternative methodsof accounting for changesin natural and environmentalresourcecapacity (Ctrapterl0); principles and application of benefit-cost analysisto resourceLvestnents (Chapter 11); ana th"ory and methodsof nonmarketvaluation of natural and.enviro"-""t"1resources (Chapterl2). ' Natural Resourceand,Ewircnmettal Economics contains more material ttran can be covered in one semester.Specific chaptersmay however, be selectedfor a couf,sein natural resourceeconomicsor environmental econouricsor one that combines both areas.Chapters 1 through 8 are appropriate for coursesin natural resourceeconomics'and ChaptersI through6 and 9 and 12 arc suitablefor courses in environmentaleconomics-chapters r0 and il covcr topics that are appropriate for coursesthat combine both are:s. A few sectionsof the book deal with topics that are better suited for stgdents familiar with the interpretationof derivativesand integrals. Thesetopics include ef-Chapter ficient intertemporal use of exhaustibleresourcesin 7 and renewable resourcesin Chapter 8' and dynamic evaluation of environmentalpollution ù Chap ter 9. These topics can be excluded from upper-division (rmdeigraduate)cogrseS and included in graduatelevel courses.

Natural Resource and Environmentat Economics

CHAPTER

Importance of Natural Resourcesand Environment If current predictìons of population grcwth prove àccurate and patterns of lurnan activity on the planet remain unchanged, scierrce and, technology may not be able to prevent either irreversible dcgradation of the envitonment or continued poverty for much of the world. -u.s.

NAfioNALACADEM'oFscmrcrs n,',onover Socnry or Lor*oou 1993

hile the history of environmentallegislation qualifies the 1970s as the decadeof the environmentin the United States.the 1990sdeservesto be billed asthe decadefor global environmentalaction. Is this becauseenvironmentalp'roblemshave becomemorr severe?IIas affluence increased the dernandfor environmental quality? Are the rate of resourcedepletion and.the magnihrdeof environmentaldamagesarousingpubLicconcern?Are rapid improvements in worldwide comm.unicationsand the democntization of countriesin the former Soviet Union sirnply increasingour awíuen€ssof past environrnentaldegradation? The evidencesuggestsaffirmative answetlsto all of thesequestions.Regardless of how you answered,you arelikely to agree'hatresourceand environmentalissues arc complea widespreadand deservingòf attention.This shapterdiscussesfive elementsof resourceand environmenkl problems:natureand impor-totce;temporal scientific and policy aspects;contríbuting factorsj ahemartveapproaches;and ttrc role of economics.

Nahrre and Importance of problems

incrudeerobarwarming;n",,,,ftffJ$ull,trffi #:ffi-Tm"m tion; acid deposition;

overexploitation of renewableresources (forests, fish and wildlife); depletion of exhaustible resources(oil, natural gas and coal); disposalof human and toxic wastes; losses in biodiversity; anOdegradation of ecosystems. Most natrual and environmental resourceproblems involve ttree elements:depletion of exhaustibleresources;overexploitation of renewableresources;and environmentalpollution. The remainder of this sectionprovides a brief oversiew of the

Natural Resourcc and Environmental

Economics

nature and importance of four major natural and enyironmental resource problems: global warmíng; ozone depletion; acid precípitation; and consentation ày nbbglcal diversiry

GLOBAL WARMING. Global warming refers to changes in climate (rainfall and temperature) caused by increased concentrations of carton dioxide and other greenhouse gases (nitrogen oxide, methane and ehlorofluorocarbons [CFCs]) in the upper aturosphere.Accumulation of greenhouse gÍuiesin the upper atnosphere traps the heat reflected from the earth's surface, which increases r.,.fa. temperatures. In the last two centuriesi a.tmospheric concentations of greenho*. g*o have increased 25 percent. Concentrations of greenhouse gases can double by the middle of the next century if no action is taken to reduce emissions of greenhóuse gases. Negative impacts of global warming include a'reduction in agriculural production and forest biomass and extensive property damages from coastal flooding due to a rise in sea level. hoduction of agricultural and forest products is expected to be negatively impacted by an increase in global mean temperature of between 3.6 and 4.1 degreesFahrenheit (2 and,2.3 degreesCelsius) by the end of rhe next century. While agricultural production in some countries would be enhanced by global warrning, the net effect on agricultural production is expected to be negative. Sealevel rises from global warmihg are expected to be between ll.8 and 39.4 inches (3O and 10Ocentimeters).r Hence, global warming is a form of environmental pollution. The root of the global warming problem is found in worldwide changes in fossil fuel consurnption. When world population and energy use per percon were low, wood was the major sotuce of energy for cooking, heating and transportation. Because wood is a renewable resource, its use can continue indefinitely provided the rate at which trees are harvested is no greater than the rate of u.ee gr"*th. As population and personal income increased, per capita demarid for energy increased and coal replaced wood as a primary energJ source. In the United Statls, coal had almost completely replaced wood by 1910. Coal is still the major source of energy for meny Asian countries. There are three problems associated with coal. First, rrnlike woo4 it is an exhaustible resource, which means that increased use of coal decreases coal reserves. Second' coal mining, especially strip mining, causesmajor land disturbance and, in humid climates, water pollution. Thirq underground mining of coal is hazardous to health. Underground mining accidents have also clairned -any lives. In an effort to improve air quality, reduce land disturbance and water polútion, and satisfy increases in the demand for energy to power motor vehicles, peholegm (oil and natural gas) began to replace coal as a source of energy. By 1957, petnoleunr" which is an exhaustible fossil fuel, had replaced coal in many uses. *o two màjor shifts in energy use (wood to coal and coal to petroleum), the - United States economy became heavily dependent on exhaustible fossil fuels. The share of total enerry use in the United States that is supplied by exhaustible energy sources increasedfrom 9 percent in 1850 to 95 percent in 1981.2The environmental consequences of this dependence arc further magnified by the rise in the per capita use of processed energy that has occurred in response to the use of more energy-intensive technologies. For example, in developed coungies, there has been a

l-

LmpoÉance of Natural Resourcesand Ewironment

5

major shift in transportationmodes from ftains and busesto automobilesand airplanes' In the meantime,developmentof renewable energysources,such as solar energy'has beenslow becauserenewablesourceshave beenrelatively more expensive than exhaustiblesourcesof energy.rn addition, energ"y policies and programs have generallynot supportedthe developmentand,rr" orr"o"*able energysources, such as solar energy. Heavy dependenceon imported oil hasgeopoliticalimplications aswell. Many developed counries import a significant shareoì tn"i. crude oil ftom Mddle Eastern countries' The implications of importing oil from politically a unstablepart of the world were dramaticallydemonstrateda*ing theArab oil ernbargoin 1973 and the haqi conflict in 1992. Enter the global wamring problem. As a result of significant growth in petroleum use in developedcountriei and steadygrowth in coal usein developingcountries, concentrationsof carbondioxide in the-upperatnosphere have increasedfrom 260 parts per million in 1860to 346 partsper million in the rnid-19g0s.3 The trend in global warming is exacerbatedby fossii fuel prices that are significantly below the fuIl social and environmental costs of extraction,processing and distribution. The underpricing of fossil fuels results in overco*o*piion of fossil fuels and.inadequatedevelopmentof renewableresourcesubstitutes, suchassolar and geothermal energy. Global warming hasan important spatial dimension. Becausedevelopedcountries bum proportionatelymore fossil fuèts ttrando developing countries,develolred countries account for the bulk of the carbon dioxide (cor) emissionsworldwide. country-by{ountry emissionsof carbondioxide areshown in Figure 1.1.while developed countries-accountfor 70 percent of the fossil fuel-basedcarbondioxide emitted since 1950(69 Percentin ig90), recenttrends suggestthat emissionsfrom developing countrieswill increasefrom 1.8 billion tons in 1gg0to 5.5 billion tons in 2o25'aHence, major reductionsin worldwide carbon dioxide emissionswill require reducing the curent use of fossil fu9ls in developed countriesand restraining growth in fossil fuel consumptionin developing.o,,ooio. uncertainty about the magnitude of-, ana Aamages frorn, grobal warming has hamperedthe willingnessof many countriesto r"rpoid. tro, o*ple, the cost of restricting carbondioxideernissionsin the united sttes to their lgg0levels hasbeen estimatedto be benveen$8 billion and $36 billion per year in 1990dollars. In comparison' the benefits of restricting greenhoor" go euissions to twice their preindustrial levels havebeenestimatedto be $g ani$oo p"itoo of emissions.sunilateral action by one country to r_educe grcenhous"g* is not going to solve the global warming problern.It will ake u "ioi."ions worldwide effort to reducethe upward trend in carbon dioxide concentrations "on""rì"4 in the upper atnosphere. International coordination in the area of global warming ** ult*"ed when the united states and 154 othergoyltries signedthe united tiations Frameworkconvention on climate change at thd"united Nations conference on Environment and Develop. ment in 1992' This conventionhas th9 of stabilizing soal ' emissionsof greenhouse gasesat their 1990levelsby the year 200O.0 OZONE DEPLETION. The stratosphere contains an ozone layer that protects the earth from the sun's harmfui ultraviolet radiation

known as uv-B. rncreased

Natural Resource and Environmental Econonics

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E A Figure 1.1. c"rnulative emissionsof ce ftom fossilftelt us9-19E9. rTbe European uniron (Etr) comprises 12 counries: Belgium, penrnart, FraDce,cernaav, Greece, rrelar4 ltaty, Luxemlourg; thc Netherfands, porilgal" Spai4 atrd the Unib{t KingdomsouRCE: carùon Dioride laformation Analysis ceú€r (cDrac), drtr (CDIAC Oae Ridge, TeDness€e,August t9g9l_

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UV-B radiation atthe earth'ssurfacecould increasethe incidenceof skin cancerand eye disease,reduceagriculhrratproductivity, and increasethe loss of terrestrial and marine biomass.Accumulation in thé skatosphereof indusnial compoundscontaining chlorine and bromine have the capacity to depletethe ozone layer over a long period of time- Compoundscontaining thesechemicals include CFCs, halons and chlorine-basedsolvents; For more than 30 years, these chemicals were used as rienosolpropelants, coolants in refrigerators and air conditioners, cleaning and foam-blowing agentsandfire extinguishers.Hence,ozonedepletionis a forrn of environmental lnllution. Io it was discoveredthat CFCs usedas aerosolpropellane could depletc . ,i !n!, stratosphericozone.In rixponse to this discovery,the United bt t"* Environmental kotection Agency (u.s. F-PA)banned this use of cFCs. In 19g5, a bole was discoveredin the ozonelayer aboveAntarctica. TWoyearslaîer, in 1987,the Montreal kotocol sn $ufsrances that Deplete the Ozone Layer (Montreal protocol) was signed by 24 countries,including the United States-the goal of the Montreal protocol was for eachcountry to achievea 50 percentreduction in emissionsof CFCs by 1996.In 1988,DuPont, the primary manrdacturerof CFCs,annormcedits deci-

l.

Importanceof Naturrt Resonrces and Envinonment

sion to phase out production of CFCsby the year 2@0. In lggz, the Montreal protocol was amendedto set a targetof banning cFCs by 1996.7 Actions to reduce ozone depretionappearto be palng off. Researchby scientists with the National Oceanic and Atmospheric aaministration reportedin mid1996 indicates that ground-level readings on the total amount of ozonedepleting chemicalstaken on three condnentsand two Pacific Oceanislandshavepeaked and are starting to decline. This turnaboutis expectedto lead to a recovery in tne ozone layer arorrndthe year 2005 or 2010.s The apparentsuccessof the Montreal Protocol and other eventsin protecting the ozone layer standsin stark cotrtrastto the global warming problem. iti, i" oot surprising given the high economicstakesof reducingglobal;;"i"g verspsozone depletion- In the caseof ozone depletion,the causesand effectsof otne depletion were indisputableand the developmentof substitutesfor ozonedepleting cheìoicats was relatively easy.In comparison,the benefitsof reducingglobalwarjing are uncertain and the costsare high becauseit will requirereaucin! greenhousegL emissionsand, hence,fossil consumption.

ACID DEPOSFIONAcid deposition is a processwhereby part of the sulfur and nitrogen gÍìsesreleasedto the aîmosphereby the burning ol fòssit fuels is converted to acids that can be carried to the earth's surfaceby rain, snow and dry deposits- Acid depositión can damagebiological resources Qakesand nees) and human health and stnrctures(buildings, bridges and statues)and can reducevisibility. Adverse biological effects of acid deposition were discoveredin the mid-l96os by fishersfrom Sweden,Norway, Canarlaand New york, who noticed,thar the produc_ tivity of mounteinlakes was declining.eIn New York's AdirondackMountains, 14 percentof the'lakes becameso acidified that they lost their ability to support many speciesof fish.r' rn the late r970s, Germanforestersobservedmajor decrines(pp to 50 percent) in the health of forest ecosystems.ShrntedE,eegrowth was alsoreported ; in Canada"the northeasternUnited Statesand southeasternCaliforniau The Office of TechnologyAssessmentreporùedthat sulfatepollution accounts for "P to 50,000 prematuredeathsper year in tne United States.rzStrucnrralrtarnagesoccnr as acid rain erodesthe surfacesof buildings, bridgesand stahres. Sulfate particles in the atmosphereca'uselight to scatter,which increaseshazeand reduces visibility. Hence, acid precipitation is a form of environmentalpollution caused by the burning of fossil fuels. Much of the acid precipitation in the United Statesis causedby conditions in the Midwest. Air massesin this regron transport air pollutans (primarily sulfig dioxide from coal-burningpowerplants)up theMississippiandOhio River uutt"yr. While in transit, the pollutants slowly form acids aoa s,tfat" particles, which become attachedto rain, snoufand dry deposits.Becagsethe physical andchemical re_ actions that lead to aciil depositionare very complex, mere is not n@essarily a l:l relationship bet'weenair emissionsfrom power plans and rainfall acidity. Even the evidenceregarding rainfat acidity is mixed. GeneLikens and associates at Cornell University publishedmapsshowingsubstantialincreasesin rainfall acidity from the mid-1950s to the mid-1970s. Datacollected.frorn the HubbardBrook Experimental Forest in New Hampshire (which maintains the longest record on rainfau acidity) indicates' however, that the acidity of precipitatíon-hasre,rnainedconsrent or de-

I

Natural Resource and Environmental

Economics

clined slightly since 1964.while sulfuric acid decreased,nitric acid increased-r3 T\ilo generalapproachescanbe takento reduceacid.deposition: reducingernissions of substancesthat contribute to acid rain and ameliorating the impactsof acid deposition in environmentally sensitiveareas.The first approachinvoives curbing emissionsof sulfur dioxide or nitrogen oxide at the **"" by installing ,,rn , dioxide scrubbersin smokestecks.The secondapproachinvolves adding fr*" to sensitive lakesand other areas.Lime helps to neutralizesulfuric and nitric acids.ra Despite uncertaintyregarding the extent to which reductions in sulfur dioxide and nitrogen oxide emissionswill reduceacid deposition and the geographic extent and severity of ecological darnagescausedby acid deposition damages f"spe"ialv to terrestrial ecosystems),political prcssurewas exerùedby canada *à th" N"* England stateson the United StatesCongressto pass legislation that would reduce emissionsof thesesubstancesIn responseto this pr"rr,ìr"; the United StatesCongressincludeda provision in the 1990Clean.tir ect to control acid deposition.The goal of this provision is to reducesulfur dioxide emissionsby l0 miùion tons per year relative to their 1980levels and nitrogenoxide emissions by 2.S111iffioo ron, per yefr by the year 2000. Theseernissionreductionsare deemed sufficient to protect aquatic ecosystems-Econonic analysisindicates that this provision has a favorablenet economicbenefit, with annuarbenefitsof $2 binion tó $g billion and an_ nual costsof $4 billion-r5 A unique featureof the acid precipitation provision is that the targetreduction in ernissionsis being achievedusing tradable eÀission permits, which are discussedin Chapter 9. CONSERVATION OF BIOLOGICAL DIVERSITY. Acceleraîed lossesin biological diversity have becomea major economic and environmental.issue and the principal motivation for achievingsustainableuseof land and waterresources. Noss and Cooperriderr6define biological diversity as follbws: "Biological diversity -* is the variety of life and its processes.It includesthe variety of Uving organisms, ,.netic differencesamong theru the communitiesand icosystems in which they occur, and the ecological and evolutionary prccessesthat keep them functioning, yet ever changing and adapting." Losses in biodiversity occur directly through exploitation of speciessuch asAfrica's black rhinocerosand indirectly-through modification of habitatsand ecosystems,as when mangrove forests in Asia are cleared to make way for shrinp ponds. Lossesin biodiversity occur at threelevels of biological organization: genetic diversity within species,speciesdiversity, and diversity olcommunities and ecosystems. Genetic diversity has declined for domesticated(food and fiber) and wild speciesof plants and animals. The successof the Green Revolution in developing high-yieldihg varietiesof cerealwas achievedat the expenseof fewer taditional vaarlaptedto local environmentalconditions. If current trends continue, 1"*o threefoufths of India's rice fields are likely to be planted to only 1o varieties by 2005. In the United States,71 percent of the corn is just using six varieties ir*t"a and half of the wheat land is planted ùonine varieties.Fewer rariJde, make crop production more vulnerableto pest and diseaseoutbreaks.Diversity within wild speciesof fish have alsodeclined-In the Pacific Northwestregion of the United Stab;, at least 1o6 major populations of salmon and.steelheadÈave been lost and zl4 anadromous speciesare at risk due to modificationsof the columbia River.rT

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Importane of Nahual Resourcesand Environueut

9

Extinction of speciesof plants and animatsis the móst familiar loss in biodiversity' Most of the lossesin species-@curÍrmonginvertebrates in hopical forests. wilson estimatesthat a minimum of 50,000 invJ,tebrate speciesbecomesextinct each year due to destruction of their rain forest habitat.rapeter Raven of the lrllissouri Botanical Gardeusstatedthat onc-fourttr of all tropical plants are likely to be lost in the next 30 years.tsAmerican oystersin Chesapearke Bay have decreased99 percent since 1870-In Soviet Asiq certain rivers anaìakes have lost more than 90 Percent of commercialfish species.2o More than half of the fish that existed before commercial logging operations in Malaysia have been lost and more than l,!eg speciesof native plants are in danger of extinction.2r Losses in ecosystembiodiversity-have beenespeciallysevere. Nearly half of the original areain tropical rain forest has beenrauceo dui to logging uoí"gri.oltural or urban developmenl The United Nations Food ano ngricurtùar o.fi;;tionz estimatedthat tropical deforestationproceededat the rate of 6,5&miles2 (17o'00o kilometers2)during the 1980s,whiòn is equivalent to destnoyingabout0.9 percent of the total forestedareain 1980. Lossesin uioaiversity due io iopica depreslation are especiallysignificant becausetropical rain fores6 contain the majori?-"{ terrestrial species-Less than l0 percent oi tn" old-growth forests of the pacific Northwest remain. Wetland ecosystems,which are among the world,s most productive ecosystems,have been especially hard hit due to d*iouge of wetlands aencultural production and aquacultural ponds. Hatf of f9r the wetlands in the united states that existedin precolonial times Lve beendestroyed. wetland losses not only reducefish and wildlife habihq but they increase *oòff and pollution of water bodies by sediment'nutrients and chemicals.otherexamples of lossesin biodiversity include lossesin the North American tall grassprairie, cedar groves iu Lebanon and old-growth hardwood forests in Europelz why conservebiodiverslty? Moral, ethical and economic reasonshave been used to justify the conservationof biodiversity. Barbier et al.u state that .Conseryation of biological diversity is of vital importanceto humankind because some level of biodiversity is essentialto the functioning of ecosystems on which not only human consumptionand production but also exis-tence depends.,,The International Union for the conservation of Nature, the united Nations Environment prograur and the World Wildlife Fund point out that 'tsiological diversity should be consenred as a naúer of principle, becauseall specieJdeserve rcspect regardlessof their use to hruanity - - - and becausethey ari all components of our life support system' Biodiversity dso provides us economic benefi-ts and adds greatly to the quality of our lives.'% In the UniùedStates'the prirnary legislation for conserving biodiversity is the EndangeredSpeciesAct of 1973-The purposeof this act is 'to protect the ecosysterns uPon which endangeredspeciesanj ttneatened speciesdepend.,,The act provided a legal basisfor protecting the habitat of the oo*h* spotted owl, which afforded ltrotection for oltl growth forests in the Pacific NorthwesLThe importanceof conserving biodiversity has beenrecognized.in several world forums inètuding ttre First World ConservationStrategy in 1980, the Seconds/orld Conservationstrategy in 1991 and the 1992United Nations Conference on Environmentand Development (uNcED)' At the UNCED confercnce,154 nationssigned the Convention on Biological Diversiry which attemprcto conserve biodiversity on a global scale.

l0

Natural Resourcc and Environmeutal Economics

Tenporal Scientific and Policy Aspects Public attitudes toward resource and environmentar issueshave changedover time. Prior úothe 1970s,therewas linle public concernfor resourcedepletion and environmentaldegradation.Most of the eriphasis wÍN on r€sourcedevelopmentand use-A notable excqltion was the concern over soil erosion in the Dustbowl (U-S- prairie states)that occurred in the 1930s. Stirred by Rachel Carson's1962book Silent SPring,on the hunan andenvironmentalimpacts of pes99ides'6 smog problemsin major cities, and the SantaBarbaraoil spill-of 1969, the United Statesbecane more concernedabout envircnrnentalissues in the late 1960s and early 1970s.During this period, there was a burst of envirounental legislation and activity, including the passageof tbe National Environmeltal protection Act in 1969and creationof the u.s. EpA iî lgTz.n In recenttimes,there has been grow_ ing pubtic concern over the protection of aestheticor amenity values such as solitude and scenic beauty. Concern about environmental degradation has been influenced by scientific studiesof physical' biological and social prccesses.It is not surprising, for example, that public interest in groundwatef,protection increasedwhenàgro"i", such as the U'S' Geological Survey and the U.S. EPA becameinvolved in testing or regulating the quality of drinking water.The finding that babies and pregnant womeriare especially vulnerable to pesticideresiduesin food heightenedpouti" and government interest in food safety. Solutions to resourceand environmentalproblems are complicated by the interaction of complex biological, hydrologrcal, geological, chcrnical, ,o"-iul, nomic and instinrtionalprocessesfrom which thesep-Ut"-*derive. Contamination ""oof rivers and streamsby agricultural pesticides illustrates this poinl Timely 4pplication of pesticides.tocrops is important in reducing yield losses due !o p".t". n"ls, use of pesticidesis motivated by ecosticides accordingto a schedule. When ticide application,there is a high likelixticides. Rain and nrnoff are hydrologicted by the amountof crop residue left on the land, which variesby_crop,the spe of soil in which the crop is grown, the way the soil is preparedfor planting and the steepnessof the land. Soif Úpe and steep. ness of the land are determinedby geological conditions. Concentration of, pesticides in nrnoff dependsboth on the rate and method of pesticide application to the crop and on the volume of nrnoff. The choice of crop rotations -td rar*iog: practices is infl'sassd by socioeconomicconditions and iublic policy. Biological effectsof pesticideson streamsand rivers depenàon the volgme of water in the sheamor river, as well as the potency andpersistence of the pesticide. . Porencyandpersistenceare chemicalpropertiesoipesticiO"s that influence their effects on plants and animals.Pesticidestnut *" pot"ìtiAty harmful plants to and animals and degradeslowly posethe greatestthreat to biological activity.If the waîer in the streastor river is usedas a sourceof drinking water and the concentration of the pesticide exceedsthe maximum ssarerninantlevel established for drinking wa: ter, then the pesticideis likely to pose a risk to hqmanhealth. On the social side, numerousprivate individuals, organizations and govern_ mental agenciesinflsgass the contarrination of streamsiod ri""., uy peJticiaes.

1. Importance of Naturat Resourcesand Environment

l1

Thesegroups are referred 164s srakehold.ers. They all havea stakein the useand/or effects of pesticides- The manufacturerof, ffts pesticide determines the chemical composition of the pesticide,which affects its potency andpersistence and the recornmendedrate of application under diffe ticide distributor makes recommendationr timing of application. In somecases,the l ticide applicators hired by ttrefarmer. per est health risk from pesticides.Severalorga Conservation Service and the Extension Senrice, assistthe farmer in determining farming methods that reducethe riskof pesticide contarrinadon. National, stateand local environmental groups want to reduce the ad.verseimpacts -- pesticides on r--- of plantsand animals. Agficultural and environmentalpolicies affect the useof pesticides. ^ National fanrr policy, which is updatedevery firr" y"urs, directly affects the profitability of growing different crops. In the pasl agriculhrral policy hasfavoredìhe production of crops such as corn, cotton and rice, which us" considerable pesticides.Finally, the generalpublic has bècomeincreasingly concernedabout the adverseheatthand environmental risks associatedwith pesticlderesiduesin food and water.This concern has led to stricter national environrnentalpolicies, such as the Safe Drinking WaterAct and the EndangeredSpeciesAcr Unàer the authority of thc Enrteqgered SpeciesAct' the U.S. EpA hasthe authority to restrict or ban the useof pesticiddsin areascontaining endangeredplants and/or animals. There are many successstoriesof efforts to curb naturalresource degradation and environmental pollution. The banning of DDT in the 1960s has contributedto the resurgenceof raptors' including tne uala eagle and the peregrine falcon. Development and 4pplication of no-till farming methodshave substantially reducederosion on cropland where this methodhasbeenadoptedby farmers. Legislation to reduce water pollution from point sources,such as factories and seliage troagnent plants' has been very successfulin reducingwater pollution from thesesources.rmplementation of safe drinking standardshas reauceo the risk of contaminationof public drinking water supplies,

Contributing Factors

tffi vironmentarporrution:""*",;:ilffi1x'"ff ;:T:"T,r,frH:ff #F; unit of re'sourceuse and technology,as

shown in Èigure 1.2. rn its simplesi forrru equals total resourceuse.Total resource t of resourcet'se equalstotal environinen_ rulation, resource use and environmental

PoPULATION' world populationis growing at an annuqlrate of 92 million peopl"'tt For the period 1950 to 1990,world popoi-utio.,grew at an exponentialrate, as shown in Figure l-3- populationgrowth ir tn ma3oiforce behindpopurationdy-

t2

PopulaÈion

ToÈa1 Resource Use

Natural Resource and Environmental Economics

X

Per CapiÈa Resource Use

X

Da:nage per Unit of Resource Use

ToÈal

Total

Resource Use

Enwiror:nrenÈal Damages

Figure 12. Detenninantsof resourceuseand environmentaldanages. namics.The inplications of exponentialpopulation growth can be seenby examining the number of years it takesto add one billion people to the world population, as shownin Table l.l. Sincecurrentworld populationis 5.5 billisa, the last two rows in Table l.l are basedon a population growth rate equal to the cwrent rate of 1.7 percent.projections are that the world population will reach l0 billion to 14 billion by the year 2100. Resourceand environmental impacts are firrther complicated by the uneven distribution of worldwide population growth. Figure 1.3 showsthat growth in world populationfrom 1950to 1990 is substantiallygreaterfor developin! countriesthan it is for developedcountries.For example,the United Stareshas a currcnt population growth of I percentper year,whereasthe population of many African countries is growing in excessof 3 percentper year.At thesegrowth ot"i population in the United Statesdoublesevery 70 years and the populationsof African countries double every 23 years. Differencesbetweenpopulationgrowth in developedand developingcountries are attributed to the higher fertility rates existing in developing countries. On a worldwide basis, total fertility rate$in 199Owere 1.7 childre" p.i worurn in highincome counties velEus3.8 children per woman in low- and middle-income countries. Fertility rates(births per childbearingwoman) generally decreaseasper capita incomeand educationallevel increases.One study showedthat the uu"*j. wornÍrn Table lJ-

Years required to achiwe succsrsiye one billion incrcnents in

Number of Years Increnents 2-5 million lst 130 2nd 30 3rd 15 4th L2 5th l0 6rh l0 7ú sowce: summarizgdfrom G. Tlrer Millcr, jn-, Resouie coru"*at',n o,rd, Managenent(Belmonr,California:WaOsworúpubtishint C"., lS90); +.

1. -InpoÉance of Natural Resourcesand Environrnent

13

É

o

Fr

3fil0

?l -il

E

Yèar

Figure 13-

world population by region ftom 19s0 to 1990 in $yearinteryars.

SOURCE:UnircdNations,l99ODenographicyeaÈook (Uuited Nations,New yu!

1992).

in developing countries has seven children when none of the women have a secondary educationand only threechildren whel +o prr""nt havea *onaury education'-zeRapid population growth contibutes dircctù tÀ resourcedepletion. For example' future growth in population over the next io y"un is expectedto increase total energy use in developedcountries by 70 po"oi even with current levels of per capita energy use.s

PER CAPTTA REsouRcE USE. Per capita resource use varies over time and space'worldwide useof fossil fuels on a per capita basisincreasedfrom 0.625tons of coal equivalentin r90o toz.4o to1s in l9gà, aztopercentincrease.3rEnergy consumption per capita is significantty greater in devàoped than in developing countries,as shownin Tabte 1.2. Relationships behleen population and per capita resourceuse have important implications for international attemptsto resòlveriro,ro" and enviroo11r"ntuì probIems' A disproportionate80 percenttr tn" world's pto""s.a cxhaustibleenergyand mineral resourcesare consumedby the 23 perceni of the world,s population tiving in developedcountries,as shownin Tabteì.:. e.":or-tactor contributingto this distortion is the higher per capita national income in-developedversusdeieloping countries ($10,700 versus$640). Part of the income distortion is explainedby the

t4

Natural Resourceand Environmental Economics

îable

Per capita

consumption in sdected countÍeg l9f/ Use (sisai,

DevelopedCounies Unied States Soviet Union WestGermany Japan Average

2E0 r94 l6s ll0

r87

DevelopingCountries Mexico Tirkey Brazil China Indonesira

50 29 22 22 E 8

frrlia Nigeria

5

sowce: u-S- Bureauof the census, statistical Absîactsof the united DC: U.S. GovemmenrprinringOffiie, 1990);World lutes: /990 (Washington" Resourceslostihrrc,world Resources, l99o-gl (New york oxford university Prcss,1990).

Table 13-

C^o^n_pari:son of, populatiou and rcsmrce use in deretopcd and dcveloping countrieg

19tt Characteristic

Number Location

Councies

33

NorthAmerica, Eruopg Japan,Australia, New

Countries 142 Aftica"Asia, LatinAmerica .

7.^land

Population (billion) r2 4 % \Yorld's population 23 TI % World's enÉ[S/ and mincral resourc€s 80 20 Average GNPperpersou $10,700 $ó4o Population doubling tim g tl7 @ 0.6% 33 @2.1% 6rea$ at indicated annual growù raÉ) Environsrental features Tbmperate lafifides wiú rnore Ttoplcal latitrrd€s with less favorable glimatc ad soils favórabte clirnaE and soils Sourte: Suumarized-from G. Ir., Resource Consettation and.Managemmt @elmont, lyler !{iller, Californie Wadsworth ftglishing Co-, l9f)), p. 5 and Figrue 14, p- g. GNp= gr*" i"tioort prroducL

more favorable clirnate and soils and lower population generally present in developed countries.

EI\IVIRONMEI\IIAL DAIì{AGES. Total environmentaldanages equal total resource use times environmental damagesper unit of resource use. Evidence is móunting tbat environmentalrlîmages are substantial.The Internatiorial Instihrte of Applied SystemsAnatysis estimatesthat lossesin forest productivity from sulfur dioxide ernissionsfrom automobilesand power plants amountsto $ó.4 billion annually.rzWhile not quantifiedin dollar tems, tropical deforestation(cxcass of harvest nlte over naturatregrowth and tree planting) amountsùo43'million aqies (12.4 million hectares)per year.33In the past decarle,deforestationhas claimed an arca, equivalent to the combinedsize of Malaysi4 the philippines, Ghana, the congo,

l. _Importance of NaturalResourtes and

ent

15

Ecuador' El Salvador and Nicaraguail Excessiveharvestingof forestsib usually the result of land clearing for agricultural production, export timber sales,shelter wood and fuel wood. The United Nations reporB that worldwide degradationin irrigated and rainfed cropland and rangelandresultedin crop and livestock productioo loss"s of $42 billion in 1990-About 70 percent of the lossesoccurred iu Africa andAsia35 Land degradation results from soil erosion, overgrazing, water loggng, salinity and chernical use.Cropland lossesfrom soil erosionin the United Statesaupunt to $3.5 billion per year-36Annualoffsite damagesfrom soil erosion in the United'states are approximately $10 billion.r One study indicates that a doubling_ofgreenhousegases(global warming) by 2025 would caus€agricultural lossesof $18 billion, increaseair conditioning cos6 by $11 billion, and increasethe cost of mitigating adverseimpactsof risesin ìfre sea level by $7 billion, plus other losses,for a total loss of $Sg Uittion annually.:r 41r, pollution in the United Stateshasbeenestimatedto cost the nation $40 billion per year in the form of increasedhealthcarecosts and lossesin workerproductivity.:e There are many other exarnplesof natural resourcedepletionand environmental degradationfrom around the world: o overfishing occurs in four out of the world's 17 fishing arcas.{ o Irrigation diversions of water from the river feeding the Aral Seahaveincreased satinity to the point at which fish òanno longer exist.+r o Waterpollution in the ChesapeakeBay, a major world estuary, hasreduced.oysrer production from eight million to lessthan one million bushetsper year.+2 o ComParedwith those living elsewhere,Bulgarian people living nearhearryindgstries havc asthmarates that are nine times higher,ir.i" ai.*res seventimes more frequenl liver disea^ses four times greater, and nervous systemdisorders three times higheLar o The head of the RussianAcaderny of Sciencesadmitted that chernicalsand organic toxins have taken a major toll on human health. Eleven percent of the children are born with defects,half of the drinking u'ater and a tenth of the food sup ply are contarrinate4 55 percentof the school agechildrcn havehealthproblems, and rates of illness and early deathof individuals in the Z54O age bracket have inqeased.s r Skin cancerfatalities in the United Statesare exllected to increaseby 200,00oper year as a result of a recent revision in the rate of ozone depletiol.+s r Cleanupof hazardouswastesitesin the United States is expectedto cost$750 billion.6 o At least 50,000 invertebratespeciesper ye:r become extinct as a result of the despoliation of tropical rain forests.az ';

TECHNOLOGY Technological changedirectly influences population growth, useof natural resourcesand environmentalOarnages.Rapid changesin agriluh'ral technologyduring the l95os and 1960sincreasedthe productiviry labor and causeda massive off-farm migration of labòr as illustrated "rugti*ltgral it rigrrn" r.+. Rapid growth in the nonagricultrual labor force, combined with major id1r*".mentsin industrial technology,stimulatedproduction and consumption of indusuiat

1ó

Natural Resourceand

nmental Economics

products and increasedper capita income. Developing countries have not experiencedthe sametechnofogydriven ioqeu.. in agricultural productiviry and the associatedgrowth in industrial production and per capita income as have developed counEies. Technology has benefited society. For example, technology has been instnrmental in rcducing food prices, increasingthe abundanceand d.iversity of food and fiberproducts, improving human health and nutrition, inc:reasinglaboiproductiviEr, and improving transportation and cornmunications.Technological aàvancements have also enhancedthe efEciency of exploring for petroleum resources;ex6acting and using energy,qineral, forest and fishery tesources;capturing, storing and utilizing solar energy; and in recycling productsderived from natural resources.Technological advancementhas significantly increaseduse of certain exhaustible rcsourcesand degradedenvironmentalquality. Agriculture is aprime exanrple.In the 1950s,farmersthroughout the world were essentiallyself-sufficient in enerry. Livestock wasteswere the major sourceof fertilizer, and draft animals were the dominantpowersourceforfamring operations.From 1950to 1985,worldwide useof energy in agriculture increased frorn 276 million to 1,903 miltìon barrels of oil equivalent,a sevenfoldincrease,and world use of fertilizer in agriculture increased

140

120 L

o T I 1oo d

E ú

ru

Boj

I,

r| , q

606

It

F

t h

40

Figure 1"4. Percentageof U.S. population on fams and farm [abor productivity, t!t32-1$3, United States. SOLIRCE: Economic Rercarch Sen ice, US. Deparhent of Agriculhue, Aeiìcutt rre Resurccs utd baiwmcnul lttdicaton, u@E no. 6 (Washhgton, D.C- JuIy e ieOey; and ti.S. Census Burcarl Cwtzru Populaion Àcporrs (W'ashington, D.C- fg4)_ NOTE: 1982= 1fl)96.

t7

ninefoldaE In addition, the use of farrn tractors quadnrpledand the area under irrigation tiple6-+e Intensity of energy use in agriculturealso increased.From 1950 to 1985,energy useper ton of grain producedincreasedfrom 0.44 to l. 14 barrelsof oil equivalenls Technologydriven growth in agriculnral productivity has increaseduse and depletionof other naturalresóurces.From 1950to 1985,world acreagedevotedto cereal grains increasedfrorn l,2lo to I,766 million acres (490 to ZtS miltion hectares;-stDuring the sarte period, expansionof dryland and irrigated acreagein the United Statescausedthe plowing up of grasslandsand the drainageof wetlands in the Great Plains. In the 1970s,fencerow-to-fencerowfarming wL encouraged andpracticed. Theseandother land usechangeshaveincreasedwind and water erosion; mining of groundwaterfor irrigation; pollution of surfaceand groundwaterby fertilizers, pesticidesand wastes;and loss of wildlife habitar Mioi"É of groundwater occurs when the rate of pumping exceedsthe naturalrate of recharge.The water table for the Ogallala Aquifer in the central United Stateshas fallen substantially over the past severalyearsdue to groundwatermining. Technological optimists and proponentsof thecornucopianview arguethat the potential for technologicalchange,information mînagementand substitutionof less abundant for more abundant resourcesrernoves any natural limits to economic growth and developmenl Cornucopiansoften disputethe claim that there is an environmental crisis.52Othersarguettrat degradationin natural and environmental resourcesis a direct.resultof unbridled economicgrowth, which is not sustainable, and that immediateaction is neededto restorebalancebetweenhumansand the natural environment.53 Other factors besidespopulation growth, per capitaresourceuse,environmental damagesper unit of resourceuse, and technologyinfluence the occurrenceand persistenceof resourceandenvironmentalproblems.Theseother factors include religion, culture, tradition, customs,poverty, hunger,public policy, resourceendowments and climate.

Approaches to Resource and Environmental Issues Resource and environmental issues can be. analyzed several ways- Two extrerne approaches are discussed here: the reductionist method and the holistic method. Most analyses use an approach that is somewhere between the two extremes. The reductionist method applies scientific concepts from a particular discipline to a narrowly defined issug. The issue is examined, in terms of a set of hypotheses supported by the knowledge base in that discipline. Hypotheses are tested by applyrng statistical techniques to data obtained from controlled experiments or surveys. The reductionist approach has a long history of use and acceptance in the scientific community. The reductionist approach is illustrated for the issue of whether or not petrolerrm resources are becoming more scarce over time. An economist is likely to address this issue by exarnining the Eend over time in relative prices of oil andnatqral

IE

Netural Resour,ce and Environmental

Economics

gas'If relativepricesof peholeumdecreaseover time, the economistconcludesthat petroleum is becoming less scarce:This conclusion was reached by Barnett and Morse.5a A petroleum geologist is tikely to approach scarcity in terrns of the trend in world petroleum renerves'which reflects use and additions to reserves resulting from new discoveries.For the geologisl scarcity increasesas world reserves decrease'An energy analystmight judge scarcity in terms of the nurnber of years it takes to use up remainingreservesat curent or expectedtut"r orì1"1l""*o*"ratio) or by the percentof use supplied by domèsticproduction. 11e The energy analyst interprets an increasingreserves-úo-use ratio * a *do"tion in scarcity and a decreasingratio or grcat€rreliance on imported oil as an incrcase i;;;ù. Scarcity indicators chosenby the economisl geologist and.enelgy *.tyr, *" not always consistentwith one another.Because àarkets uo ri'u5""t to gov"o"rgy ernment intervention,political upheavals,-warsand mónopotisticpower, relative petroleum prices are not necessarilya good indicator of pe'toteurnr"uoity. la 1973, crude oil prices quadnrpledin a relatively short perioair time becausetire organization of PetroleumExporting Countries(oPECi cartel effectively conholled a significant shareof the world's oil supply. when OPEC's grip on thé world oil market weakened' etrergyprices declined-Moreover, relative èo."gy prices do not necessarily move in the samedirection as the reserves-to-useratio aooror dependenceon imported oil- There havebeenperiods when United Statesdependence on imported oil, and oil prices, haveboth increased.For theser@sons,ttr" t"a""tiooirì approa"t to energy scarcity in particular,and resourceor environmentalissues geniral, r,"s in its limitations. The holistic approachaddressesresourceand environmentalissues by synthesizing and integrating concepts,data and results from severaldisciplinessy*."*. analysis,'whichis thehallmark of the holistic approach,aÉemp6to consider the relevant dimensionsof an issue.The International Institute of Aipl"ied SysternsAnalysis55capturedthe essenceof the systemsapproachin the following rernark: *The existence of many linkages among the elenents of a complex ,yrt"ro implies that a change in some part may reverberatethrough the sysiem, evenhrally triggering changesin ways ttrat are not immediately obvious, especially if one is examining, becauseof a narrow jurisdictional or scientific speciatty,only part of the system-,, Asysterns analystrecognizesthat resourceandenvironmentalproblems are inherently complex andinvolve multiple interactionsamongphysical, biological, social' economic,political andlegal processes.A systemsapproachtries to un-derstand the relationships amongthe elenents in the *yri"tn. syJtems analysts usually take the position that resourceand.environmental issues,súch as global warming, acid precipitation, land degradationand.deforestation,involve multiple processes and multiple political entities (statesand nations) that cannot be understood and resolved using a nilrow disciplinary approach. 'i The systemsapproachhas its .ttur" of problerns.First, it rtrns counter to the way generationsof scientistshave been trained- The reductionist approach is the cornerstoneof scientific inquiry. Second,as a holistic or systems 4pproachto problern solving is more complex,it requiresconsiderableinteraction between the practitioners of severaldisciplines.This is a difficutt task becauseof differences in theory, methodsand data.For example,classicalecology views humansasjust another specieswithin a resource-limitedsystem.Human utir.iti", are generally ignored in

1.

portarceof NaturalResources andEnvironment

classicalecology except to the extentthey alter the naturalenvironmenl In contrast, classicaleconomicsreaB humansatisfactionas the ultimatepurposeof economic activity' The resourcebaseis viewed as essentialtyuntimiteo dui to technological changeand resourcesubstitution.Despite theseproblems, there is growing suppon for the holistic approachto resourceand environmental issues.

RoIe of Economics

theerEcient arocatio,, or*#:":ffi

H#:illAT"H:: ff:#:ffi:

ciplines of econonricsdeal with natural and environmental resourceuseand the interactionsbetween the economyand the natural environmenl Thesesubdisciplines include resource economics,envirorunentaletonomics andecological economics. All three suMisciplines rely on the conceptsof supply, demandand market equilibrium, which are discussedin Chapter2Resourceeconomicsprovides an analnical framework for determining an efficient allocation of natural and environmentalresources over spaceand time. Eficiency is defined a,smaxirnizing one or more objectives subject to technical and physical limitations- while the objective of maximting profit i, t"y to conventional economictheory, resourceeconomicsernphasizestn" óu3"ctive of maxinizing benefits to society-The production technologyavailable foi extractiug or harvesùnga t"y."t is a technical limitation, whereasthe amountof the resource availTs:urce ls is a physicallimitation. Efficiency can ; the cost of achieving one or rnore objecysical limitations. broadcategoriesof resources:exhaustible resources'such aspetroleum andminerals,and rcnewable resources,suchasfone$s, fish and wildlife. Exhaustible resourcesare finite. use of an exhaustibleresources iurplies depletion. Economics of exhaustibleresourceuse explains where and how rapidly exploration and developmentshould occur and how much of the developed resourceshould be used in the production of different consumer producB. RenewablerEsourceshave the capacity to rcgenerateover time. ffgrowth and ulie are in balance,then the stockof a renewableresourceis maintainea inaennitety, apdrt from natural disastersand events.The economicsof renewable resourceuse describesthe efficient ratesof harvestin different locations and time periods.It provides a basis for evaluating whethersociety is better off by increasiig commercial harvestrates to meet the expandingdemandfor products madefrom renewableresourcesor by reducing harvestratesto protect biologicat diversity. Finally, resource economicssuppliesa rational franework for determiningthe economicbenefitsand costs of investing in tecbnologiesto develop substitute-s for exhaustibleresources and for determining the economicbenefiB and cose of expanding Se boundariesof a national park or a national wildtife refuge. Environmental economicshas three primary thrusts. First, the material balancesapproachin environmentaleconornicsaddsan environmental sectorto the traditional circular flow model of conventionaleconomics.The environmental sector

20

Natural Resource and Environrnsarql

Economics

explainsthe origin and fate of wastesgeneratedby production and consumption activities and the potential impacts of wasteson environmentalquality. Second environmental economics affords a framework for evaluating alternative technologies andpublic policies for reducing eirvironmentalpollution. Third, environmental ecoDomicsprovides analytical methodsfor estimating the economic value of improving environmentalquality. Thesemethodsare especiallyimportantwhen marketsdo not exist or are inadequatefor determiningthe value of improving enyironmental quality. ' Ecological economicsgoes a stepfurther than the material balancesapproach of environmentaleconomicsby recognizingthe fulI range of interrelationships between the economic systemand the ecological system.The economy is recognized as a subsystemof a finite and nonexpandingecosystem.Ecological economics Íìrgues that depletion of exhaustible resources,overexploitation of renewable resources, and environmental pollution constitutes natural limits to economic growth.s Natural limits are incorporatedin conventional national income irccounts through a processknown as natural resourceand environmental accounting. REDUCTIOMSî \IERSUS HOLISTIC SCIENCE. The traditional way of advancing knowledgein economicsand other disciplines is through specintizsli6p, which implies comparúnentaliz4lisri-This mode of scientific inquiry supports the reductionist method, which breals down a subject into its elementary parts. Each part is studied from a nÍurow disciplinaryperspective.speciatizationand reductionism have allowed scienceto make significant contributions to understandinga wide rangeof phenomena An alternative view is that the value of economicsor of any single discipline in understandingand resolving complex resourceand environmental problems is maximized through its integration with other disciplines. In the holistic approach, economistsdo not blindly cling to the assumptions,prescriptionsand predictions of economicù*ry; rather, there is willingness to view economic conceptsin ligbt of physical andbiological principles.The goal of theholistic approachis much broader than advancingthe knowledge baseof individual disciplines. It is to develop theoretical andpractical knowledge ttratis useful in achieving greaterhannony between humansand the environment Early supportfor a holistic approachis reflectedin the writings of Schumacher, who was an economisl He makes a strong plea for practicing metaeconomics, which he definesas having the *aims and objectivesfrom a study of.man, and . . . at least a large part of its methodology from a study of nanrre." Conventional economicsderivesmuch of its methodologyfrom qrranlilagivesciencessuch asphysics, not from the shrdyof nature.SchumachersT is critical of this quantitative orientation, nolng that *the great majority of economistsis still pursuing the absurd ideal of nfÌrking their lscience' as scientific andprecise as physics, as if there were no qualitative differencesbetweenmindless atorn and men made in the image of God." This sarnecriticism of conventionaleconomicmethodology is echoedin the writings of Herman Daly. The implications of the holistic approachfor the shrdy of economicscan be illustratedwith regardto a pivotal assumptionof economic theory, namely, that hu-

2l mans are motivated by selfishness-This assurnption underlies the th"ory of household behaviorand the theory of the firrn, whictris centralto microeconómics..Daly and cobbps criticize- the assumption that households maximize utility and firms mÍudmize profit oblivious to social community and biophysical interdependence, stating: "'what is neglected is the effect of one p.tron,, welfare on that of others through bonds of synpathy and human community, and the physical effects of one person's production and consumption activities ón others through bonds of biophysical communiqr.,' Another consequenceof taking a holistic approach to resourceand environmental issues is tbat it raises.seriousconcenn aboutpursuing unbridled economic growth- until recently, growth has been the und.isputà goa of economicdeverop. menl while this goal maximizes livit g standardsin terms of material wealth, there is strong evidencethat it contributes to natural resource and environmental degradation' which decreaseshuman welfare and the quatity of life. what are the implications for economicsof a rroustic approachto natural resourceand environmentalproblems?It requiresthe studentof economicsto become familiar with physi"l -*d biological principtes go""*Àg rhe natural world and to integratetheseprinciples with econoori"ooì* iti"aarÀring resourceand environmental problerns' In this franework, naturalresource and environmentaleconornics is viewed not so much as a self-containedbody of knowledgebut rather as a set of conceptsthat in combinationwith other sciendfic principlesenhancessociegr,sunderstandingof resource and environmental issues. rniJr.iew has evolved túrough the contributions of many conternporaryeconomists including Kenneth Building, Nicholas Georgescu-Roegen, Richard Norgaard,rrermun paly and others.

Summaly Economic development has improved income and living standards,acceleratedthe use of namri.ro*"o, and increasedenyironmental pollution' Four major resourceand environmental problems a.ssociated with economic developmentinclude global warrning, ozonedefbtion, acid precipitation and loss of biological diversity-Theseand other resourceand environmentalproblems can be viewed in terms of three elements: depletioi of exhaustible*sources, overexploitation of renewableresources,and environmental pollution. Resourceuseand glvironmental pollution have i*po*, spatialand temporal dimensions-In the spatiardimension,àeveloped accountfor only 23 wr_ cent of the world's populationbut use80 percent"o;d; orme worrd,senergyand mineral resourcesand generate70 percent of the fossil fueLaasedcarbon dioxidc emitted since l95o' rmportant'temporal aspectsof resorxcc use are the replacernentof renewableresources(wood) with exhaustibleresources and petroleum) and the i; slow developmentand adoption of solar energy. Total resourceuse is the product otpopot-ution and per capita resourceuse.Total environmentaldamageequalstotal resource usetimes environmentaldamageper unit of resourceuse' while per capita resource useis higher in developedcountries

n

Natural Resourceand Environmental Economics

than in developingcountries,population growth is lower. Technological

H:HH:rJ":T:*'olvt'

percapita *Jou* *" *J

progressin-

a',,,,ie",p", "o..riroo*"ita

Resourceand environmentalproblemscan be addressed from a reductionist or holistic perspective--Reductionrsm applies scientific concepts from a single discipline to a narrowly definedproblem ór is*. Holtsnrynùoir"s and integrates theory methodsand data from severaldisciplines. systeis analysis is the,hallmark of the holistic approach' conventional economics typically akes a reductionist a1> proach to natural resourceuse that ignores the rel,ationshipsbetween the oooo*y and the natural environmenl The *uair"iptirres of *ro*"", environmental and ecological economicsfocus on one or more aspects of this relationship. rni." i, u growing trend toward addressingresourceand environmentalissuesfrom a holistic perspective

Questions for Discussion 1. Many developingcountries desireto achievethe samestandardof living as developed counties- several scientists and econo-ists uau; ah", ;; af,e not enough naturalresourcesin the world for developing counties to achieve the same per capita use of resourcesas that of develop"a'"oíonil. oir"*s ways in which this apparentconflict can be resolved2' Many developing countries believe that developed countries should assist them in applying technologiesthat reducecarbon dioxiàe emissions, which il.s rhe primaty calrseof glolal warming- They claim that developedcountries generated most of the carbon dioxide emissionsand should p"t th; cost of helping developing countries red'ce emissions.what is your opii* .f ,hi- viewpoint ? 3' Advocates clarm that increaseduse of-solar energy would reduce dependence on exhaustibleenergy resources,the incidence of environmental pollution, and vulnerability to disruptions in crude oil production. what are some of the advantagesand disadvantagesof increaseddepndence on solar energy? 4' In the spottedowl controvefsy,economic development interests argued that lnco.leand employmentlossesfromreaucedharvestiog'ororogrowth forestsin the Pacific Northwest wele t9o high a price to pay to this ecosystem-To what extent should economicimpacts of consenring "or**" biodiversity be considercd? 5- In an effort to control population growth, thepeople,s Republic of china severely penirlizescouples who have more rhan s1s child- Some view this policy as *"*.T:^o_3::be\ve population control is the onry effective way to reduce adpowth in developing cqrrnries. Do you drastic? in technology and substitution of manurfficient to offset the resourcesand curb elvironmental pollution- Neomalthssians depletion of natural arguethat technologi_ cal changehas contributedto incriased total and *t-""nu" resource use and environmentalpollution an$ such impacts wilt immediate acrion in frat taken. What is your opinion of both Ec.sitions?"ootioo"-ootess

1. -Importance of Natural

ounsesand Environment

?3

Further Readings Building' IC E. 1981.EvolutìonaryEconomics.BeverlyHills, California:Sagepublications. Bonnann,F. Herbert, and stephenR KelleG eds. 1991.Ecobgy, Economics,Ethics: Tlu Brolcencìrc|c. New }laverl connecticuc yale university press. Fiel4 DonaldR., and'WilliamR Burch,Jr. 1988.RuralSociotogyarrdtlu Enviruwnent. New York GreenwoodPress. Flavin, Christopher. 1996.'Tacing Up to the Risks of Climarc Change."ln Stae of the WorlL /99ó. New Yorlc rgt/.Y/.Norton & Co. Norgaard'Richard B. 1989.'"TheCasefor MethodologicalPluralism." Ecologicat Economics,l:37-57. Pormey,Paul R *Acid Raiq Making SensiblePolicy." Resoutces,Winrcr 1994, pp. 9-72-

Notes l. Joel Darmstadter, 'The U.S. Climate Change Action Plan: Chatlenges and Prosl)ects," Resources,Winter 1995, pp. lg-23.

2- Nicholas Lenssen, "Providing Eneqgyin Developing Countries," in State of tte Worl4 /993 (New Yorlc W-W.Norton& Co-, 1993),p. 106. 3. I-esterR. Brown and SandraPostel,'Thresholds of Change,' tn Stateof tIrc World /987 (New York W.\l/. Norton & Co., 1987),p. 9. 4. JohnGever et zl., Bqond Oil: TheThreatof Food and Fucl in the ComingDecad,es, 3rd ed- (Niwot, Colorado:Univenity pressof Colorado,l99l), p. 435- Williaur D. Nordhaus,'"Io Slow or Not to Slow: The Economicsof the Greenhouse Effect"' TIu EconomicJournal l0l(1991):920437;andAS. ManneandR.G.Richels,..Ce Emission Limits: An Economic cost Analysis of the usA,- The Energy Journal 11(1990):51-7a. 6. Darmstadter(1995). 7- Peter M- Morrisette, "Negotiating Agreementson Global Change," Resources, Springl99Q pp. &-ll. 8. colwnbia (Missourt) Tibtme, "shrdy: ozone Layer May Begin to close," 3l May, 1996. 9. HilaryFrench,'tlearing theAir,- inStae of tlrc World, 1990,LesterR.Brown, ed(New Yorlc W'tff. Norton & Co., Inc., l99O). 10. NAPAP,Natbnal Acid Prccipitation prcgranq IggO Integrared Assessment Repon D.C-: National Acid precipitation program, l99l). CWashington, 11.French(1990). 12- Office of TbchnologyAssessmengUnited States.Congress,Acìd,Rainutd. Trarcported Air Pollutants: hnplícaions for PubtÍc Poticy(WashingtouD.C.: Uuited StatesGovernmentPrinting Office,,N984),p. 47. 13. Glen E- Gordon, *Acid Rain"What is It?- Resources, V/inter 199{ pp. GS. 14. Y/inston Harrington" Breaking the Deadlock on Acid Rain Controì,n Resources, Fall 1988,pp. 14. 15- Paul Portney,*Pohcy Watch:Economicsand the CleanAir Act " Journal of EconomicPerspectives4(1989):173-182. 16- Reed F- Noss and Allen Y. Cooperrider,SavingNaturekLegaq: prctecting and RestoringBíadiversity (Washington,D.C.: Island press,l9g$), p. 5.

21

Natural Resourceand Environmental Economics

17' John C. Ryan' 1992' 'tonserving Biological Diversiry" rn State of the World, 1992 (New Yorlc W.'W.Norton & Co., l9g2), pp. g-26. 18' Edward o- Wilson, Thc Divercityof Lìfe (Cambridge,Massachusete: Haward University Press,1992). 19' Peter H. Raven' "Biology in an Age of Extinctiou lVhat is Or Responsibility?' @enary Address' Fourth InternationalCongressof Systematicand Evotutionary Biology, CollegePartg Maryklnd July l-4, 1990). 20' Carl Safina and Ken Hirunan, "stemrning the îde: Conservation ofCoastal Fistr Habi|dt in the united states- (summaryof a Nadonal symposium on coastal Fish Habitat Conservation"Battimore, Maryland,March 7-9, lggl). 21' JaredM- Diamon4 'The PresenqPast and Future of Hrunan4aused Extinctions," n Philosophical Transactionsof the Royat Socictyof London, vol. 8325 (19g0); and philip Shabecoff'"Plant Lovers'Ambitious Goal Is No Móre Extinctions,o New york Timcs, November13, 1990. 2ZFood and Agriculturat oqganization,Forcst ResourcesAssessment: Tropical Cownrnes, Fo(estry Paper No. I12, Food and Agricuhre Organizatisn of the United Nations, Rome,1993. 23. Ryan (1992)24' Edward B- Barbier, Janes C. Burgess,and Carl Folke, Paradise Lost? TlzeEcological Ecorwmicsof Biodiversity (ondon: Earttrscanpublications,Ltd., 1994),p. 3. 25' ruCN JNEP/WIilF' Cuingforthe Earth A StrategyforSustahable Living(Glan4 Switzerlanú ruCN, 1991). 26. Rachel carsorg sìlcnt spring (New yorlc Houghton-Miflin ,1962)27' Legislation passedduring the 19?0sto protectlan4 air ana waterresources included the Clean Air Acts of 1970 and 1977,the Federalwar€r pollutiou Control Act óf 19,12,the EndangeredSpeciesAct of 1973,theToxic Substances ControlAct oÍ l976,the ResourceRecoveryand ConservationAct of 1976and the NationalEnergyAct of 197g.Most of these actshave sincebeenamended 28' Population ReferenceBureau, 1991 Population Dara ^Strer (Washingtorl D.C-: 1991),U.S. Bureauof the Census. 29' World Banh World DevelopmentReport 1992:Developmentand the Erwíronment (New Yorlc Oxford Universitypress,Inc.,1992),p.29. 30' Nicholas Lenssen'"ProvidingEnergy in DevelopingCountries," ia State of tIrc World 1993(NewYork W.V/.Norron& Co^,1993),p. 106. 31. Brown andposrel(198?),p.5. 32. Intemational Instinrte of Apptied SystemsAnalysis, '"Ihe price of pollution ,,, Opriozs, September1990. 33' United Nations Food andAgriculture organization as cited in World ResourcesInstitute, world Resourceslggz-1993 (New york oxford universiry press, 1992), pp. 118-119. 34. Lester R- Brown, "A New Era unfolds,- in stúe of tlv wrlL /9g7 (New yorlc \V.W.Norton & Co., 1987),pp.5-6. 35' H. Dregne et al-' "A New Assessmentof the 'World Statusof Desenification Desertifrcation Corurol Bullctin, No. 20, 1991. ,O .,i 5:.": Itartc, ry,I.A.Haverkaurp, and W. Chapman"Ercding Soils:Tlu Aff-Farm Impac* (washington, D.c.: The conservationFoundation,r9g5). 37' Marc Ribaudo' Water Quality BenSts fiom the Coruematìon Resente progran (washington, D.C-: U-S- Departmentof Agriculhrre, Economic ResearchS"*i"., February 1989). 38' $/illiaur Cline' Global warming: Tln Ecorwmic Status(washington, D.C.: Instinrte for Internationallssnsmics, 1992). 39' From ThomasCrocker,University of Wyoming, as describedin JamesS. Cannon,

l-

hnpo

of Nafural Resourcesand Environrnetrt

The Health costs of Air poilution (New york AmericanLung Association, r9g5). 40' united Nations Food and Agrinrlture organizatioo i in rÀ/orldResourcesInstitute, wortd Resources1992-1993(New y"r*, "itea &i;Júinity hess, lgg2), p. r79. 4r. Lester Brown, '"TheArar sea Going, Going-,, woiu watch (washington,D.c.: WorldwarchInstirure,January/Februaryfgl), pp. 2(-:n. 42. Tom Horton and Mlliam M. Eichbaui,furnng the Tidc: Savìngtttc Ctwsapeahe Bay (Washington,D.C.: Islandpress,l99t)43- JoshFriedman'"Burgaria'sDeadlysecret,-Newsday,April 21, l99o 44' chrystiaFreelan4 "f,sssians Doomedfor Next years,2i Financiat Tbrus,october g, tggz. 45' william K' Reilly, statementon ozpneDepletion(washington, D.c.: April4, 1991). 46. Milton Russelret al.,'The u-s- tlazardouswaste *à"*,, Envircrunznf, rury/August 1992. 47. Mlson (t9y2). Agriculurre,"in Stateof the Wortd,/9g7 (New 1. ricultural,lrarrsrlcs (Washington,D.C.: U.S. iordon SloggetgEnergyard A-5.Agiculrure: .C.:U.S. Governmentprinting Office, l9St. cultural and.Food prcùtctio4I950J5 (Unpr 52. Julian Simon, The Ultimate Resource audJulianL. SimonandHennanKahq eds.,Z well, 1984). 53. F-H. Borman, 'aJnlimited Growth: Growing, Growing, Gone?, Bioscicnce zz, no. 72 (1972):7o6-709;and HermanE. Daly, stea@-itate Ecoiomics,2nd ed- (washingon, D.C.: Island Press,lgg2). 54. Ilarcld J. Barnett andChandlerMorse

hess, l99l), p'p.3-4.

rstnnz',ed- (New yorlc Columbia University Economicsas if people Mattered(New yorlc Ir., For tlrc Cortmon Good: Redírectingthe tt, and a SustaínableFuture (Boston,Massa_

CHAPTER

Economicand Financial Conceptsin Resource Management Tlu goal of the economist is not merely to train a new generation in his arcane mystery ít is to understand, this economic world in which we live. -{EoRcE J. Srrcr-nn,t9g7

atural and environmental resources are utilized in the production and consumption of goods and services (commodities). House_ holds' firms and governments produce commodities from natural or environmental resources and consume the amenity services provided by these resources.hoduction and consumption generateeconomic value in the form of income and employment and generate residuals that are either recycled or released to the environment. Releasing residuals to the environment can degrade the quality of natural and environmental resources and reduce the amenity services that they provide. Economic theory of natural or environmental resources utilizes several tey concepts: namely, consumntion and demand, b) production and supply, c) marlet equiiurium ano 1) d) present value. This chapter explains each of ttreie concepts in narrative, graphical and mathematical terms. The concepts are used in later chapters

Consumption and Demand Theory Households indircctly coruiume natural and environmental resources when they purchase a house containing wood, plastic and metal products and use electricity, oil and natural gas to heatiool 41ta Ugnt the house. Households directly consume natural and environmental ."*o*."* when they breathe air, drink water, or use a forest for outdoor recreation. Consumption generates residuals that can degrade natural and environmental rcsources. The income that households use to purchase commodities is earned by selling natural and human resources, such as land and labor to firrns and the govemment. Household savings

28

Natural Resourcc and Environmental Economics

are a sourceof capital that fimrs and governmentsuse to finance production activities. Consumptionand demandtheory explains how an individual decides what to consume,how much to consume,and 6o* ssasrrmFtionvaries with commodity prices, householdincome andother socioeconomiccharacteristicsof the household. Four key assurnptionsunderlie householddemand.th"o"y. Hrst, commod.itiesprovide utility or satisfaction to households.Second,the objective of householdsis to selectcommoditiesthat maximize their utility or satisfaqtion.Thirù total household expenditure on commodities is limited by income and.commodity prices. Fourth" householdconsumFtiondoesnot affect theprices paid for (households "o**oditiés are price takers).

UTILITY FIINCTION AltD INDIITERENCE MAP. Household preferences for commoditiesare representedby a utilìtyfwrction- This utility function ranks the household's preferencesfor all commodities. Consider a household that receives utility or satisfactionfrom consumingtwo comrrodities, X and y. The utility function for the householdis: U= F(X Y). This function statesthat total utility (U) is a firnction @ of the quantities of X and Y consumed-Changesin preferencesfor commodities alters the utility function. The utility firnction hasfour.properties.First, it 'rssingle valued, which means that specific values of X and Y result in a unique level of utility- Secon4 utility is at irrcreasingfinction of X and Y, which means U increases(decreases)as more 0ess)X and/orY areconsumed-Thir4 the utility function exhibits diminìshing marginal utiW for X and Y. Diminishing marginal utility requires that the increments in total utility becomeprogressivelysmalleras equal incrementsof X are constmrcd and cons'mption of Y is held constant.Likewise, incrementsin total utility become progressively smaller as equal incrementsof Y are consumedand consumption of X is held constant-Fourth, the utility function is ordìrnl.An ordinal utility function ranks different commodity bundles accord.ingto the household's preferences.A commodity bundle is a particular cómbination of X and y, such * fo* units of X and six units of Y- Ordinality requiresthat if commodity bundle c is more eess) preferred than conmodity bundle a, then c provides greater (less)utility than does a The utility function is representedgraphically by an hdffircrce map bke the one shownin Figure2.1. In this figure,the quantity consumedof X is measuredon the horizontal axis and the quantity consumedof Y is measuredon the vertical axis. Every point betweenthe Y axis and X axis representsa commodity bundle. Commodity bundle a consistsof X; units of X and Y. units of Y and commodity bundle $ gbntaihs\ units of X andyo units of y. Supposecomurodity bundlesa and b provide the samelevel of utility- All commodity bundlesthat provide the sameutility as bundles a and b lie on the fudffirence cun)e Ut- Total utility is constant along an indifference curve. Moving up (down) an indifference curve showsconsumptionof Y increasing(decreasing ana consumptionof X decreasing(increasing).A collection of indifference curves from the sameutility function is called aa indífferencenuzp.An indifferencemap contains

2- Eeononic and XlnancialConcepts

29

a very large number of indifference curyes. Three indifference curves (u,, u, and UJ are shown in Figure 2.1. rties. First, an indiffereuce curye is convex marginalutiliry for X and y. Diminishing creasinginctemenB of X are needed.to o: down the indifference curve (b to a). Secr lzg becausettre utility function is single valued. If indifference c'nres inùersected, then the sarte commodity bundle would provide two different levels of utility, which is not possible when the utility function is single valued. îhird, indifference curves are tnonotonícally increashg, which-meansutility incneases by moving to a higher indifference cruve. This property follows from the assumption that the utility function is increasingin x and y- In Fignre 2.1, bundl. oo-u, is p.r.rrea to bundles a and b on u, becauseu, > u,. sinilarly, bundles"on u3 are preferred to bundleson U2 andU1 becauseU3> U2 ) Ur. coNsTRAIlfTs. Household consumptionof X and Y is constrainedby household income and market prices of X and y. Apart from borrowiog, houseloH ex_ penditrre on X and Y cannot exceedhouseholdincome. In addition, the household

C@suryrÈioa

of

y

ConsrqlÈLon

Fig're 2.1. rndifference map for commodities x and y. = u utility.

of

I

30

Nahrral Resource and Environmental Economics

must pay the market prices for X andY. Constraintsare imposedon the household's purchasesof X andYby income and priccs as illustrated Uy Oe budget set andbudget line in Figrrre2.2.The budgetssl gsatninsall commoditybundies, ,u"h as d, e and f, that the householdis ableùopurchasewith a given inóme and marketprices, The budget line, labeledB2, containsall combinat'ronsof X and I' that exha'st the household's income. For example, commodity bundles e and f gqarain different amountsof X andY but they cost the sane aÍiount and utilize all of thefiousehold's income. - B2correspondsto a householdincomeof $100,a price of X of $le and a pnce of Y of $20. With this budget conshaint, the househola-canpurchasea maximum of l0 uniB of x ($lo0/$10) and a maximumof five units of y ($l0o/$20). Therefore, the X intercept of the budget line is 10 units and the Y intercept is five 'nits. Becausea householdcannotinfluencemarket prices, the budgetline is linear. The most ef,Ecientcommodity bundls lie on the budget line. Why? Consider bundle d. This bundle is in the budget set but below the budget tine. ú the household choosesbundle d, then there is unusedincome becausebundle d is below the budget line- When utility is'an increasingfunction of X andy, unused.income inrplies that the householdcan increaseutility by consumingmore X and/ory. Therefore, moving from bundle d to any bundle on B2 increasesutility and exhausts the household'sincome.

Consu4lÈioa

of

y

ColrsnrylÈLoa

tlgure 22. Budget set and budget line @) for commoditíesX and ywhen household income is Slffi; price of X is S10and price oty ís S20.

2. Economicend XinancialConcepts

EoUSEHoLD EQIJILIBRIUII{. A householdachieves equilibrium by choosing a comurodity bundle on the budgetline tnut r*i-iro utility- stated differently, equilibrium is achieved by selecting the bundle on the budget line that is on the highestindifference curve. The equitibrrirrmbundle is found at the pornt of tangency betweenthe indifference curve and the budget line, namelv, i*Í-" ri, tt* t.r. For bundle f, X = 6, Y = udlity is u, and Èouseholdexpendinre is Br. tt! house?: hold is in equilibrium with bundle f becauseutility is ma,ximizedand all income is spenL EouseholdDemandcurve. T}.e householddemandcune for (D,) x is defined T ttt" relationship between the equilibrium quantities and correspondiogpi"". or { when the price of X income and the utility firnction (pnefereniesfor-cómmodities) are held constant. D, is illustated in vertical axis and consumption of X on th, 2.3, X = 6 when p. = $10, pv = $20 anr titylrice combination X = 6 and p* = $l( Let p. increasefrom $10 to g20, as_shownin Figure 2.5. The higher price re_ ducesrhe X interceptof the budgettine from l0 ($tOò'1S10) ($fdlSZ0'), to 5 which caus€sthe budget line to rotate clockwise from B2 to 8,. Household equiuúriun is re-establishedat bundle i, whele budgetline B, is tangent to indifference curve Ur.

CoasuqlÈ:lon

of

y

.10 gar'qsrylLoa

Figure 23. Eousehold equilibrium when howehold incone ---- is $lfi|; price of X is Sl0 and price of Y is $2O.& = budget line; and Uz = utitity.

of

X

QteaaÈlÈy

Figure2.4- Househorddemand curreforx. D = demand.

CoasuqlÈíon

of y

Consuqrtion

t_0 of X

Flgure 25. Effects of an increasein the price of X ftom S10 to S20 on household equilibrium. B = budget tine; and U = ntitity.

2.

Economic and Finansial Concepts

33

Notice that the new equilibrium occurs on a lower indtfference curve (ur < ur. At the new equilibriurg x = 3 md p* = $20,which grvespoint h on D*. connecting points g and h grvesthe householddemandcurve ior x-'ro-e demandcurve shown in Figure 2.4 is called a Marshallian demandcurye.Along a lvrarshalliandemand curve' householdincome and prices of all other commodities are constant Dr is downwardsloping'becauseof diminishingmarginalutitity forX. Therefore, along the demandcurve' an increase(decreaseJinp* results in a decrease(increase) in consumption of x- Hence, quantity oemandeà and price of x are in_ versely related- The demand curye for Y is aerived in a simitar rnanner by connecting the equilibrirrm qrranlilies associatedwith virious prices of X holding the price of X andhouseholdincome sslsrnn[ Elasticityof demand for a commodit tity demandedcorrespondingto a I percr holding otherpricesandincomeconstanl atively sloped,the elasticity of demandit is greater0ess)than 1 in absolutevalue,oemanais said tobe elastic(inetastic).lncreasingthe price of a commodit]r whosedemandis elastic (inelastic) causeshouse_ hold expenditureon that commodity (price times quantity purchased) to decrease (increase)'Conversely,when demandiselastic (inelastic), lowering the price ca'ses householdexpenditureto increase(decrease).Commodities consideredto be necessities' suchas basicfood and.clothing, have inelastic demands. Lessessentialcommodities' suchasluxury homes and fancy sportscars, have elastic de,mands. The relationshipbetweenquantity demandedand household incorne when all prices are held constantdetermineswhethera commodity is a twrmal goodor aninferior good The demandcurve for a normal (inferior) good shifts upward (downward) from D,r to D*, @.2 to D*,) when householdincome increasei, as shownin Figurc 2.6. rf X andY are substitutes(butter and margarine),then the depand curve for X shifts to the right (left) when the price of Y inlreas"l1d""r"*es), holding price of X and householdincone constant.Conversely,if X and y are complem.ents (bread and butter), then the demandcunre for X srrifts to the Ieft (right) *i"o thc price of Y increases(decteases),holding price of X and household income constanl

Production and Supply Theory Firms usenaturalandenvironmentalresourcesto pro_ duce commodities-crude oil is extacted from unoergound. resenroirsand refined into petroleumproducts,such as heating oil, gasorii"e *a;", fuel. Expenditures made by firms on nafiual or environmental resources are a source of income .o those, suchashouseholdsand governments,who own the resources.production activities generateresidualstha! when releasedto the environment, can degradenatural and environmentalresources.An oil spill caused by a mptured pipeline or tanker is a threatto ecosystems.The burning of fossil fuels such as oil, natural gas and coal producescarbon dioxide, which is tne primary causeof global wanning, and sulfi.ndioxide, which contributesto acid rain. The theory of production and.supply explains how individuat firms determine

u

Natural Resourceand Environmental Economics

rigure 2-6. Effectsof increasein househordincomeon demand fur a normar @) good(Dp to Do) andon dernanflfor an inferior good(Do DxJ. to th9 most efficient quantitiesof inputs and ouputs in production and how changesin prices and technology influence input and ouput Èveb. An input refers to a resource usedin production, and an outprrt refers to thc comnodity that results from production-Three key assumptionsunderlie the economictheoryof production and -à supply. Firsg firms auempt to maximize their own profits. Secón4 fir;r,,, ability to convert inputs into ouputs is determinedby technology,which, along with marketprices of inputsandouQutsandthe firm's costbu-dgJt,determines the most economically efficient ievels of inputs and outputs.Thirù-under pure cornpetition, tbe firm cannot influencethe prices paid for infuts or the prices received fòr ouquts.

PRoDUcrroN x'uNcrroN aI{D rsoeual\rr MAp. Theproduction reh-

nologies available to a finn deterrninethe ouerutobtainedfron differcnt combinations of inputs. consider a fimr ttrat utilizes two inpuB ,2, and.4, toprodgce one 9utrlt, Y The ptodnctionfiurction shows the relationshipbetween mrDdmumprcduction of Y and useof Z, arrdZ.": Y = G(ZIZ). Maximum production for any given combination of Z, and zais rchteved by employing the most efficient technology.

2.

Economic snfl trinancial Concepts

35

íoperties.First, it is singte vatue4 which esult in a unique level of production. Sec_ tctíon of Z, andZe.TJhrsmeansthat y in_ lsreases(decreases).Thirq the production eturnsfor inputs Z, and7a.'Whenproduc_ turns, equal incrementsof Z, result in proing Z, and the production function (tech_ nology) constanl Likewise,equalincrementsof 74r"rott in progressivetysmaller increments in Y houin gz, andthe production function constanl Fourtta a production function exhibits corLrtr-rn) returns to scale. Retuns to scalerefers tc

/ greater(less) than the changesin inputs, o scale.For example,if all inputs are dou_

doubres,increasingreturns,"::ff ;nffiJffiò'"'"#$",#T.tff:::Hlr.::

creasingrehrrns to scalewhen production lèss than doubles.A production function can exhibit more thanone type of returnsto scale, suchas increasingreturnsto scale followed by decreasingreturns to scale.Fifth, the proaucdon function is cardinal cardinality meÍrnsthat specific amountsof Z, and i resutt in a measurableouput The production function is representedgraptricairy by an isoquantmap likethe one depictedin Figure 2J.The isoquantmap consists of individual ísoquantsyr, Yz and Y3. Each isoquantssltains all input bìndles thai provide the samelevel of output.An tnput bundleis a specificcombination of z, andzz-For example,bun_ dle a contains 2,. of 21 and T-^ of Zr, whereasbundle L contains26 of z, and,Tnn of 74' Both bundlesgive-ttresameoutput, namely, five unis. changesin production technology alter the production funct-ronand the isoqrrant trtap. Isoquantshave threeproperties.Firsg isoquants^rnìon r*(U) to the origin be_ causeof dininishing marginalreturnsto inputs fhe latter implies that progressively larger increments of z, arc requiredto offset equal decrementsin zi when moving up an isoquant (a to b). conversely,progressively largeriucrementsof Z, areneeded to offset

equaldecrements in Z, whenmovingdo* * ilo"-l,t,T.J,-a",

ample' if increasinlzr from one to two units, two "*to three units and three to four units causesY to inclreaseby six, four and three units, respectively,then there are diminishing marginalretumsbZt. Secon4 isoqt"nls arenonùttercectingbecausethe production function is single valued' rf isoquantshtersected, then one input bundle results in two different outputs' This is not possiblewhen the productioi function is single valued. Third, 3, which means that output increaseswhen Figure 2.7, input bundlec on isoquanty2 I a and b on isoqr.antY, (yr> l.J. Simirgreaterouq)ut thaninput bundleson isoquantsy, and y, Cy, > yz > yJ. coNSTRaIDrrS' The firor'* selectionof efficient inputs andoutputis influenced by the production function, the cost budget for inputs -d p.i"", of inputs and out_

t6

Uee of

laguÈ

Naturaf Resource and Environmental Economics

21

Figure 2.7. Isoquant mrp forinputs Zr úùT2.y

= outpul

puts-InPut prices and the firm's cost budgetare combinedinto the firm's cost set,as showu in Figrue 2.8- The cost set containsall input bundles,such as d and e, which the firm canpurchasewith a given cost budget at given input prices. The maximum combinationsof Z, and Z,rú*the firm can pgrchaselie on the isocostline labeledcr. rf the firm's budgetis $go, the price of Z, is $16, and the price of Q is $10, then the firm can purchasea maxinum of five ,nits of Zr ($80/$16)anda maximumof eight unitsof ($80/$10). Therefore, theZlintercept Q of the isocostline is 5 and thezrintercept is g. when the firm cannot influence input prices, the isocost line is a straight line. Changesin the.firm's cost budget and/or input prices alter the position of the isocostline. Increasingthe firm's costbudget *hil" nótaing input pricìs constantresults in an outward parallel movementin the isocost tine. e d""rc*" (increase) in e isocostline to increasc(decrease),hold: of 7a. Similsxly a decrease(increase) in e isocostline to increase(decreasc),holdof Zy *All efficient input brmdleslie on the isocostline. A bundtein the interior of the cost set' suchas bundle d, is not efficient becauseproduction can be increasedwithout exceedingthe cost budgel

37

Usa of

laDut

Zr

Uss of

Figure2.E. Costset,isocosttine (C), isoquant(yJ andfim equitibrium (e)when the costbudgetis S80;price of Z, is Sld; and price of 22 is $lO. EIT'ICIENT II{PUT USA The efEcientinput bundlefor producing a given level of outputis the input bundle that minimizes the cost of producing that level of output SupPosethe firm wants to determinethe most efficient input bundle for producing Y, (15 units). The efficient input bundle is given by the point of rangency betweenisocostline C-zandisoquantYr, which occursat bundlee whereZr=2 and 4,= 4-8-Ernploying any other combinationof Z, úd74on the isocostline results in lessprtrduction,which is inefficient.Hencq Zr=ZúdZ2= 4.g is the most efEcient input bundle for producing Yt. Also, Y, is the maximum ouq)ut the firur can producewhen the cost budgetis $80, the price of z, is $16, and the price oî Z.-is

sl0.

The efficient input bundlesfor producing different levels of ouput lie along the eryansionparlrshown in Fignre 2.9.1\e expansionpath is derivedby connecting the points sf tangencybenreenthe isocostlines and the isoquantswheninput prices and the productiou funetion are held constanl When input prices arc constangincreasing(decreasind the firut's cost budget from C, to Ct to C3 causesthc isocost line to shift outward (inward) in a paratlel fashion Therefore, moving up the expansionpath requires successivelylarger cost budgets.The efficient inpui bundles a1slo\, a1il lo), for five units of Y, z2)r and z@z for 15 units of y, and zF)r and Z
I frfiuÈ

Zz

3t

Use of

IagrÈ

Nafural Resourceand EnvÍronnental Economics

Zr

E:<Pansi611

zrt,,

Figure 2J.

Expansion path fory. C = isocostline; and y = ouerut.

FIRM'S NPUT DEll{At\tD CtlRYE. The firm's demand.curve for an inpur $ow-s the quantity demandedof an input at various prices when the production function, cost budgeL and Pncesof ottrerinputs are heid constanl Efficient useof 4!or a costbudgetof $8o, a price of Z, of $16, anda price of z2of $1o is givenby point e in Figure 2.10 (which is the sameaspoint e in Figure 2.S).at e, effióient use of Z, is 4.8 andoueut is 15.Let the gnceof Zoincreasefrom $1Oto $16.The higher price reducesthe Z, intercept of thé isocostline from g ($g0/$1O) ro 5 ($gOXSlO, which makesthe isocost line rotate clockivise from C, to Cr. The new equilibrirrm occurs at point f, whe,rcisocost line c, is tangentto isoquant Y'r. At the new equi_ librinm, 4=2 andY= 5. Hence,ahigherprice forZ! reducesboth the effi.cientuse of.7a andouput The demandcurve for zo @ò is determinedby plotting efficient use of e againstthe price of Tawhenthe productionfunctioo, budgèt and price of 21 are held constant,as shown in Figrrre 2.11. points g and"ori h on p," correspond to points e-aiia.r,rcspectively,in Figurè 2.r0. connectinÉ *d h give.sD=. Therefore, efris cient input trseis inversely related to input pnce. UtasActtyof delttandfor an input measur:s the rcsponsivenessof quantity demandedof the input to a chrangein the price of the input when all other input prices and the cost budget are held The demandfunction for an input shifts to the right (left) when the prodgctivity "o*t*r of input the is increased(decteased)by a changeiniechnology.

I Ues of

Iulnrt

Figgre 2.10. Ef.*t"_gf increasein price of 22 from S10to S16on efficient use of Zo C = isocost tine; and Y = oufiluL

Price

t2 10

Qnraatity

F"rgure2.11. Ilemand eurve for input Z, holding the production function, cost budget and price of Z, constant.

22

40

Natural Resourceand Environrnental Economics

Efficient input useby a firm occurs wherethe price of the input (po) intersects the demandcurve for that input For exarrple, whenthe price of Zeir*f|2, efficient use of Q is 3.87,as shownin Figure2.11. EFT'ICIENT OUTPUT. The traditional criterion for detenxrining the efficient output for a firrr is to maximize profit subject to theproduction funcfiorr, the prices of outputs andinputs,and the cost budger An importantdistinction is -uA" benryecn short-run and long-run profit maxirnization. Short-run Qong-run)profit maximization is based on the short-run (long-run) production function. Ttie short-run production function includes both variable inputs and,fuedinputs- Variable inputs can be change4 and fixed inputs cannotbe changed,in the short run- In the short run, a mining company can increasethe of coal that is mined uy in"."*infú" "mount number of laborersworking the mi16, but it cannotvary the equif,ment and stgcnrres in the rnine-Labor is a variable inpu! and equipmentand s6uctures are fixed inputs, in the shortrun- The long-run production function includes only variable inputs. In the long run, the mining company can changeits use of laboi, equipment, structuresand all other inputs. Short-RunProfit lV[aximization. LetZl be the fixed input and.Z2the variable input- The amountof Z, availableto the finn is 2.6inthe shortrun. Then the shortrun production function is: Y = G(Zp7) whercZr 1Zn If an ouqputof Y1requires2,, units of Zl,then thefixed input 21 is not a constraint on production as long as y S yr. Shon-run margírnl cost (SMC) is the changein total cost of production associated with a changein output when there is uil"a.t one fixed iniuu For y. yr, SMC is detenninedby the retuns to scalein the productionfunctiòn ana *tepi"ei of Z, emd74.If the production function exhibits constant,increasing or decreasing retrrns to scale, then SMC is constan! decreasingor insreasing, iespectively, as shown by the segmentof SMC for y < yr in Figure2.12. For Y > Yr, the fixed input Z, iS being fully utilized and increasesin output can only be achievedby increasingft. When Q is increasedwhile holding Z, constant atzb production is subject to diminishing marginalreturns.Hence, for y > y6, increasingoutput by equalincrementsrequiresprogressivelygreaterincrernentsnZ4. when this qgsws,sMc increaseswith output asshownin Figrrrc 2.12. The equilibriuur condition for slonlw prortt maximizatíon is to equate the price of ouQut to short-run marginal cost (py = SMC) on the increasing pàrtion ot tne,ftvtc curvc- short-run profit maximiz.ation(rccursat y*5 in Figurel,.ì2. ror y 'Y*t, p.r > SMC' which implies that raising ouput causestotal revenue to increase moFethan total cost Profit increasesby raising oueut. conversely, when t pv < SMC, which implies that a lower ouput reducesùotalcost more "*r, than it" reduces total revenue-Profit increasesby lowering outpul Hence,y*s is the most profitable level of output in the short run The fitut's shon-run supply curle gves the quantitiesof the commodity that the firm is willing to supply at various prices in the short run. As mentioned earlier,

2. Fronomic ald

Value per

ancíal Concepts

4l

Uait

SrenÈity Fìgure 2.12- short-nm marginal crst (sll,fc) curve forywith6xed inpul rRs = increasing returns to scale; CRS = constant r€turns to scale; DRS = deàeaSng rrchrns to scale;and py - price of Y.

there are two kinds of costsin the shortrun, variable cost and fixed cost-TbaI varíable costis the anount of the variable input used by. the firm times its price. Total fued cosr is the cost of the fixed inpur Averagefaid cosr (AFC) is toral fixed cost divided by outpul Averagevaríablecosr(AVC) is total variablecostdivided by outpuL Average total cosr (Af,c) is the sum of AFC and AVC. AFc, AVc, Af,c and SMC are shown in Figure 2.13.Becausetotal fixed cost is independentof the level of ouput' AFC is a decrcasingfunction of outpul When thereis increasingmarginal retums followed by decreasingmarginal rettIrns îo the variable iopot, tnJAVC ana ATC curves are U-straped-Af,C reachesa minimum at a higher level of output than AVC becauseAFC decreas€swith respectto ouqrut. fhe short-nrn supply curyeis the SMC curye aboveininimumAvC. Stppose ouFut pnce is below minimum AVc (Iry, < min AVc), as shown in Figr'e 2.13. 'When producÉonis zeio, lossesto the fmr equal total fixed cost When proauction is nonzero,however, lossesto the firm equal t"tA n*ea cost plus total vafiable cost rninss total revenue.Becauseto'tal variable cost exceedstotal rcvenue when py < min AVC, the loss with production exceedsthe loss witbout p,roduction.Therefore, the firm minimizes losseswhen p, < min AVC by producing zero ouq)ut.

42

Value

per

Natual Resourceand Environnmtal

Economics

llait

$rartiÈy

Figure eB. Short-nrn cost curves and supply curve.aFC = ayerage fixed cost; AVC = averagevariable ctst; ATC = ayeriagetotal cost; SMC = short-nrn marginal cosq and p, = price of Y.

supposepr is betweenminimum AVC and rninimum Af,c (min AVc ( pvz ( min AIC). In this case,if the firm producesY*, where py2 = SMC, then total revenueexceedstotal variable cost.The excessof total revenueover total variable cost can be used to Pay some (but not all) of the fixed cost. In this case,lossesare minimized by producingY*2. Finally, supposept exceedsminimurnAf,c (pn > min Af,c).If the firm trrodrrcesY*3 wherepy3= SMC, then maximum profit is earned.In sgmmary,the finn rninimiz-eslossesor ma:dmizesprofits in the short nrn by selectingthe level of output for which Py = SMC, provided py S rnin AVC. If p" < min {\/Q, then the firrr minimizes its lossesby producingzero ouqrut.Therefore,the short-runsupply curve is the SMC curve aboveminirnum AVC. :j Changesin tecbnology arid input prices causethe firm's supply curye to shift to the left or righr Improve, entsin technology,which increasethc productivity of the variable input, and lower input prices causethe short-run supply curye to shift downward- Increasesin input prices carse the short-run supply curye to shift upward. Long-RunProfitlVfaximization. Becauseall inputs arevariablein the long run, the long-nrn production function is:

2, EconomicandlìnaneialConcepts

4

Y = G @y Z), with no restrictions onz, îndz2. I-ong-rw tnarginal ca.îr (LMc) is the change in total cost of production with respectto a changein output when alf rnputsare variable- The shapeof the LMC curve is determinedby the returns to scalein the longrun production firnction. As shown in Figure 2.L4,LMC is: a) a decreasingfunction of output for increasingreturns to scale(Figire 2.14a);b) a constantfunction of ouput fó, rehrrris to scale @gure 2.1.4b);and c) an increasingfirnction of ouput for decreas"o*aot ing reh[ns to scale(Figrue 2.14c). The'long-run production functión can exhibit a combination of rehrrnsto scale.For example, when the long-nrn production function exhibits increasingreturns to scalefollowed by decteasingreturnsto scale, thc LMC curye is U-shaped. The equilibriuln condition for rong-rwt proftt maximizationis equaritybetween price of output and long-run marginal cost (p, = LMC) on the increasingportion of the LMC curve. Equilibrium is not achievedat p" = LMC under i".rea*iog returns to scale' as demonstratedin Figure 2.14a, becauseprofit increasesas outfut rises. 'when there is constant returns to scale and pv < LMc, as with LMC2 in Figure 2.14b, no level of oulput is profitable.when py > LMC, as with LMcr, the firm has an incentive to inmeaseoutput becauseit increasesprofit There is not a rrnique output that maximizes profit when pv = LMC under constantreturns to scale. Finally, under decreasingreturns to scale,profit is maximized at y*a where pv = I-lvIC, as. shown in Figure 2.14cLong-Run suppty Curve- As already shown, long-run equilibriuur does not exist' an4 therefore,the long-run supply curve is not aenneaforincreasing and constant returnsto scale-When the long-run productionfunction exhibits dareasing returns to scale, long-run profit maximization occurs where pr = LMC. Because all inpuB are variable in the long nrn, points along the LMC curve give the lowest averagecost ofproducing any given level ofoutput Therefore,underdecreasing returns to scale,the long-run supply curve equalsLMCThe firm's long-run supply curve is affectedby changesin technologyand input prices- Improvementsin technology that increasethe productivity of one or more inputs and reductionsin input prices causethe long-run supply cgrve to shift downward. The long-run supply curve shifts upward whÉn input prices increase.

Market Equilibrium ',;

Tho preceding sections on coruiumption and dErnand and production and supply describe the economic theory underlying a household,s demand curve for a commodity and a firm's demand curve for an input and supply curve for a commodity. Market equilibrium is determined by the tnarket denand cun'e and market supply curve for a commodity. This section explains the market demand and supply curves and explains market equilibrium-

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MARKET DEMAND AI\[D SUPPLY. he marketdemandcurae for a comrnodit-y is determinedby summing the householddemandcurvesfor.rhat cornmodity, as illustratedin Figure2.15. Whenthereare n householdsand.the price of y is pvr, the quantity demandedis q(t)r, for householdl, qe)y1for household2 aú, nt.lYr ror householdn. summing the quantities demandid by all householdsd pv, gives a market quantity demandedof Qyr that correspondsto point a. Similarly,-wÀen the price of Y is p.rr, quantity demandedis zero for househàld1, qrzl* for úousehold2

2.

Economic and Ftnancial Concepts

and q(u)r, for household n. Adding together the quantities demandedby all households at pvz glves a market quantity dernandedoì that corresponds point b. to Q", connecting points a and b gives the market demand curve for xìamery, br. ne_ causethe householddeuund curvesare negatively slope{ D, is negatirretystopeA.

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46

Natural Resource and Environmental Economics

The market supply cune is derived by summing the supply curvesfor individual frrms' as shown in Figure 2.16.When m firms produceÍ and the price y of is pyr, the quantity suppliedis q(t)r, for firm 1, q€)r, for firm 2 andq(.)"ì for firur m. Summingthe quantitiessupptisdby all firms atpy, gives a rnarket d.-',iqy supplied of Qr that correspondsto point c. similarly, when the price of y is pri quantity

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Xlnandal Concepts

47

supplied is zero for firrr l, qzlnfor firm the quantities supplied by all firrns at p, that correspondsto point d. The markei sì necting points c and d. S., is positively s curyes are positively slopedQornfining the rnarketaemanacurviefrom Figure z.l5 andthe marketsupply cunrefrom Figr[e 2-16gives Figure2.r7.a\e ^orlrt equilibrtwt price and, market equilibrtwn qnntity of Y occur at poif e, where qu*úry demanded equalsq,rentity supplied. why is point e an equilib1q? wnen the price y of is pr,, q*tity suppliedis Qrtt and q'an1i1t demandedis which resultsin a d$citof Qavr_ Qavr, Q.vr. To eliminate the deficiq price mustir quantity supplied is e.r, and quantity den of Qyz- Qd,2.Eliminarion of the surplus P*v, Qav= Q"y = Q*y. As long asthe marl changed' the equilibriy staysat p*v and e*v. A similar procedureis used to de_ termine market demandand supply curvesand market equilibrium for X.. Factors that shift household demandcurves atso ìrun the market demand curYe'Increases(decreases)in householdincomesand prices of substiurtesand decreases'(increases) in the prices of complernenf5garrssttre martet demand curve to shift upward (downward). In addition,increases(decreases) in the numberof households cause the market dernand c'rve to shift upward (downwardl. a" ,prrrra (downward) shift in the denand curve is known Íui an incrcase (decrease)in demand-

Price

Q*rr

Qsvr

Figune2.17. ndark* equilibrium fory. py = price y. of

Qe.r1 Q"s,

Qreantity

4t

Natural Resource and Environmental

Economics

Likewise, the factors that shift firrr curve. Improvementsi4 technology and market supply curve to shift downward. market supply curve to shift upward. Ar number of firms producing the commodity causesthe market supply curye to shift downward (upward).An upward (downward) shift in the supply curve is known as an increase(decrease)in supply. when the market dernandcurye increasesand/or the marke, ..rniil curve decreases'equilibrium market price increases.Conversely,when the market demand c9rve decreasesand/or the market supply curve increales, the equilibrium market price decreases.Increasesin demandand/ to increase.Conversely,decreasesin den quantity to decrease.Increasesin dernanr equilibrium price to increasebu! in gene librium quantity.Likewise, decreasesin, causeequilibrium price to decreasebut, in general,have an indeterminate efrect on equilibrirm quantity.

EXAMPLE Ox' MARKET EQIIILIBRIIIN'L Market equitibriuur price and qt'4ntity can be deterrrined for particular market demand and supply curves. For exarqple,supposethe market dernandand.supply functions for y *'^ follows: Pa= 50 - 0.5Qo Demand p s=5 +0 .5 Q"

Supply

The constantterm (50 in the demandfunction and 5 in the supply function) is the intercept on the price axis or the price at which quantity aemandedor supplied is zero- The coefficients of quantity demanded(-o.t and iuantity supplied.?ó.sl ur" the slopesof the demand and supply curves,respectively. The-stopemeasgresthe changein price associatedwith a one-unitchangein qu.t úty aemanìea or supplied. The dEmandand supply functions are illustrated in Fìgure 2.1g. rn market equilibriurn' price 1s such that quantity demanded equals quantity s"oplied- The equili-bri"rn quantify is determio"à by setting the demandpnce (p) supply price (p) equal to eachother and solvinjfor quantity. The dernand 1nd price is the price on the demand curve and the supply is price *re on the supply Iri"" curve' Equilibri'm price is determined.by subitituting the equilibrium quantity into either the demandor supply function andsolving for irice. Equatingpuuod p" gives: ,

50-0.5Qd=5+0.5q.

Setting Qa= Q., which is required for equilibrirrm, and solving for e gives an equilibriun quantity of Q*v = 45. Substituting into either trt a"rLl Q*y function or supply function yrelds an equilifuiqm price ol p"" = Tl.5-

2-

Economic and Financial Concepts

49

Prica

Ps=5+0.sQs

(Supply)

P Y =27-5

Pa=50-0 - 5Qa

(Deurand)

QuanÈiÈy

Figure 2-lt-

Ilfiarket demand and suppry frrnctions for y py - price y. of

Present Value Present value is the present worttr of monetary values that occur over several time periods. Present valuJs are used in determinini tne efficient allocation of natural and environrnental resources over time (Chapters 7 and 8); efficient levels of pollution or portution abatement (chapter 9); and the economic feasibility of resource investments that generate benefits and costs which occur over several years (Chapter ll). kesent value is the opposite of compouding. compounding is what happens to a fixed amount of money when it is placed in L interest-bearing savings or investment account- Supposea pres€nt amount of money (A) is deposited in a"savings account that pays interest annually at the rate of r percentIn this case, the savings grows in value in discrete time intervals, namely, yeri$. ryolnt The future value (FV) of the account is A(l + r) at the end of the firsi ye"r; A(l + r)(1 + r) = A(1 + r)2 at the end of ,Ée second year, and so forth. In generar, the futrue varue of A at the end of period t is: FV,=A(1 +r)t. The term (l + r)tis the discrete compound interestfacr,on ForA= $100, r = g7o and t=5:

50

FV5= $100(l + 0.08)5= $146.93.., The interestmfc r must be expressedih decirnalform, not in percent4geform (O.08 insteadof E%). What is the prcsent value (PV) of a future amount of money? Since a present value is the sameas a presentamount,A cagbe replacedwith PV in the FV,formula to obtain: FV,=PV(l + r)t. Solving for PV gives: P V =F V (l +r)* . When r appearsin a presentvalue formula, it is called the discount rate- The term (1 + r)* is called t}re discrete díscornt factor Hence, PV equalsFV, times the discount factor Consider the present value of the benefits provided by a parlc Benefits are $500,000in year 1, $800,000in year 2 and$1,000,000in year3. If the benefitsare received at the end of eachyear, then the lrresentvalue of benefitsfor the park is: + $800,000(1.08f2 + $ 1,000,000(l.Oglr PV = $500,0O0(1.0S;-t = $462,963+ $685,871+ $793,832 =$1,942,666. Eachtem on the right-hand sideof the equality is the be,uefittimes the discount factor for a particular year, which is called the discottntedvahte of the benefit In discrete time, present value is a sum of discountedvalues. As the discount rate incr€ases(decreases),presentvalue decreases(increases).The presentvalue ofpark benefitsis $1,867,017for a 10percentdiscountrate and $2,073,692for a 6 percent rliscountrat€. Presentvalues arecalculateddifferently when the interestrate or discount rate sfoeng€scontinuously ratber than discretely over time. Future value of a present amountof money with continuouscompoundingis: FV(t) =Aert wheree is the baseof the natural logarithm, namely,2-718,and ett is the continuous compound btercst factor For example, if the park provides an iniÉal benefit of $500,000and the benefit grows continuously over a three-yearperid, then the fun1e value of the park at the end of year 3 is: = $635,500. FV(3) = $50O,000e(ooEX3) The presentvalue of the park with continuousdiscounting is: PV = FV(t)e-É,

5l wheree-Éis the contínuousdíscowttfauor.T\ercfore, the presentvalue of the park is: PV = $635,500e(-{.orx3) = $500,000.

Summary Determiningthe economicaly efficient useof naturar or environrnentalresourcesinvolves the appticationof economic and financial concepts,including consumptionand demandùeory, production and supply theory, and present value. Consumption and derrand theory explains housenotà igrchases of commodities in terrns of the household'sutility function and.budgetìet A utiliry function ranks corrmodity bundlesaccordingto householdpreferelces. It is an ordinal' single-valued function that exhibits diminishing marginal utility for individual commodities-The utility function is graphically representedby an indifference map that consistsof a set of indifferencecurves.Each indifferencscurve is convex, nonintersecting and monotoilically increasing. The budget set includes all commodity bundles that the householdcan purchasewith a given income.A household is assumedto purchasethe commodity bundle that maximizes utility and uriìizss all of the housghold'sincome. This bundle is determinedby the t-rg"o.y between the budgetline and the indifference curve_ Householddemandexpressqsquantity dernandedof a commodity asa function of its own price while holding constantthe prices of other commoditiesand household income-Becausethe demandcurve is downwardsloping, qrrantitydcmanded is inversely related to price. Responsiveness of quantity demandedto changesin the price of a commodity is measuredby the elasticity of demarrdfor a commodity. For a normal good' insreasesin householdincome *Olo, the price of substinres shift the demandcunre to the right. Conversely,decreasesin householdincome and/orincreasesin the price of complementsshift the dernandcurve to the left. Production and supply theory explainsa firm's selection of inputs and ouputs in tenns of the production function and cost set. The production function indicates the maximum output resulting from different input levels. It embodiesthe most efficient technology available to the finn- Aproduition function is a cardinal,singlevalued function that exbibits diminiShing.*g"A reùrrns in the short run, and in_ creasing,decreasing.orconstantreturnsto scalein the long run. In the shortnrn, at least one input is fixed. All inpua are variable in the long run. The firm's cost set containsinput bundles which can be purchased.for the samecost. An isoquant map is a gpPhical representationof the firrr's production function, which consistsofja set of isoquants.Each isoquantis convex,nonintersec"ng and monotonically increasing. The firm is assumedto maximize profit within the limits imposedby the production function and the cost set.In the shontrun, the most efEcientinput buudlesfor producingdifferent outputsare given by the points of engencybetweenthe isocost lines andthe isoquantsup to the level the of fixed input. Îhese input bundles are usedto derive the short-run-marginalcost cuve. The short-

52

Natural Resourceand,Environmental Economics

run supply curye for the firm is the short-nrn marginal cost curve above minimum averagevariable cost. In the short run, the fiÍn maximizes profit by selecting the output where price intersectsthe firm's short-run supply curve. The expansionpath defines the efficient input bundlesfor producing differenr outputs whcn all inputs are varied simultaneously.It is derived by connecting the points'of tangencyberweenthe isoquantsand the isocostlines. rnput bundles on the expansionpath are dsed to derive the long-run marginal cost curve. Tre laÉer is downward sloping with respectto output for increasingrehrrnsto scale,constantfor constantrehrrns to scale,and upward sloping for dec_reasing returns to scale. The firm's long-run supply curve eeualsthe long-nur marginal cost curve when there are decreasingreturns to scale.The long-run supply curye is not defined for increasing returns to scaleor constantreturns to scale.The firrr maxinizes profit in the long run by selectingthe output at which commodity price intenece the long-run supply curve. The f,rm's input demandcurve indicatesthe relationship between quantity demandedand price of an input when prices of all other inputs and the production function are constant The elasticity of supply measuresthe responsivenessof quantity suppliedof a commodity to its own price when all other input prices and the pre. duction function are held constanl The rnarketdemandcurve for a cornmodityis de,rivedby summing tbe demand curvesfor all householdsthat are likely to purchasethat commodity. Likewise, the market supply curve is found by srrmming the supply curves for all firms that are likely to producethat commodity.In market equilibrium, quantity demandedequals quantity supplied.Equilibriumprice occursatthe intersectionof the market demand. curve and market supply curye. Above the equilibrium price, there is a surplus of the commodity becausequantity supplied exceedsquantity demanded.Below the equitbrium price, there is a deficit of the comrnodity becausequantity demanded exceedsquantity suppliedkesent value is thq presentworth of monetary values that occur over several time periods. It is the opposite of compounding.The presenrvalue of a series of monetary valuesis the sum of the discountedmonetary values.A discounted value is the original value muttiplied by the discount factor that is (1+r)* in discrete time and e{ in continuoustime, wherer is the discount rate and t is the designation for time period. Presentvalue increase.is (decreases)as the discount rate decreases(increases).

Questionsfor Discussion "

1. Discussthe relationshipbetweenan indiffercnce map and a utility firnction and betweenan isoquantnvtp and a production function. 2. E:rplain a) why the tangency between the budget line and indifrerence curve is an equilibriun for a householdand b) why the tangencybetrnreenthe isocost line and isoquantis an equilibrium for a fi.rm. 3. Use an indifference map and budget line for commoditiesX and Y to illustratewhat happensto householdequilibrium when the price of Y decreaseswhile holding the price of X and householdincome constanl

2, Ecouomic andlinancial Concepts

53

4' How is ptnduction technologyaccountedfor in determiningthe efficient use of inputs by a fir:rr? 5' Identify the kinds of inputs that are likely to limit the generationof electricity from solar energyin the short run. 6. Explain how the demandcurve for an input is derived. 7' Describe the relationshipbetweenthe èxpansionpath and the long-run marginal cost curve. 8. Supposethe demandfunction for an input is: Pa=24 - 2Qd where pu is the price and ea is the quantity demandedof the inpul Graph the input demandfunction and determitr. input use when the marketprice "quitibtium of the input is $6. 9' calculate future valueat the endof the fifth year of placing $100in a savings accountthat pays4 percentannualinterest. 10' Supposethe costs of protectingwildtife habitat in a national refuge is $10,000in year l, $15,000in year 2 and,$25,000 in year 3. calculate the present value ofcosts using an annualdiscountrateof l0 percent.

Further Readings Baumol, wiliam J. r97'r. Economic Theory and operations Anarysir, 4th ed. Englewood Cliffs, New Jersey: prentice_Hall, lncHenderson' James M.' and Richard EQuandr l97l- Microeconomic Tlrcory: A Mathematical Approach,2nd ed- New york: McGraw-Hill Book company. Leftwictt' Richard H- ln6. The Price systemand Resource Allocation,6th ed-Hinsdale, Illinois: The Dryden hess. Nicholson, Walter. lg7g. Microeconomic Theory: Basic Pirrcìples and Enensions. Hinsdale, Illinois: The Dryden press.

Solberg' Eric J' 1982-IntennediateMicrceconomics.plano, Texas: Businesspubtications, Inc. to$"" GeoreeJ' 198?.The Theoryof Price,4th ed-New yorlc Macrnillanpublishing ao. varian" Hal R. 1984-Microeconomic Analysis,2nded-New york w. w. Norton & Co.

CHAPTER

Historical Views of Nlatural and Environmental Resource Capacity A great change in our stewardshipof the Earth and the life on it is required if vast hwnan misery is to be arcided and our global home on this planet is not to be irretrievably mutilated -Uvrox or CoNmxm ScmrnsrC f9g2

he roots of natural resource and environmental economics can be traced to concerns about the capacity of natural and environrnenhl resources to sustain economic growth and to the value of conserving natural and environmental resources. Natural resource limitations on economi" gto*rh were addressed by classical economists. Debate on limits to growth continues 1s this day. The capacity of environmental resources to assimilate residuats from economic activities, and the desirability of protecting nonuse values of the environment, such as solitude, beauty and biological diversity, have become just as limiring to economic activity as has depletion of natural rEsources- This chElter discusses the relationships between natural or environmental resource capacity and economic activity in terms of classical ecorwmics, neocLassicaleconomfcs and conserttationism; it also evaluates conteÍflporary views and indicators of natural or environmental resource capacity.

Economic Views Natural resourcecapacity was first discussedin terrrs of resourcescarcity.Economicconcemaboutresourcescarcityandits effectson human welfare was expressedby classicaleconomists.Neoclassicaleconouristsgenerally downplayed the.idea that natural resourceswould limit economic growth. Conservationistswere generally concernedabout slanaging natural resourcesfor the benefit of humankind and aboutprotecting the resourcebase. CLASSICAL ECONOMICS. Classical economics was concernedprimarily with the effects of population growth and land use on resourcescarcity, economic

56

Natural Resourceend Envimnnental Econonics

gowth and the quality of life. Of particular interest was the .'msaîs of raising the physical productiviry of labor and expanding the total volume of economic activity."r Economists making important conributions to this sulject include Adam Smith, Thomas Malthus, David Ricardo, John Stuart Mill and Williasr Stanley Jevons. Adam Smith statedthat the natural pice of a comnodity was determined by the amount of labor comrftinded in the markel This naturalprice wasÉamore relevant indicator of wealth than were market prices. Smith aryuedthat suppty-side factors in the agricultural sectordo not conEibuteto economicstagnationbecausecapital accumulation in agriculnue raises labor productivity. Agricultural products becomerelatively scarcebecausedemandeventually exceedssupply, resulting in a whole host of social problerrn that lead to economicstagnation.2 InAz Essayontlrc Prtnciple of Population,ThomasMalthus3arguedthatpopulation grows at a geometricrate and human subsistence(food suppty) at an arithmetic rate, causing the human condition to decline over time. This is referred to as the Malthusian trap. ln Principles of Palitical Econonry,aMalthus solidifies the concept of absolutescarcíryof land by arguing that geometricgrowth in population in combination with a fixed supply of land increasesthe intensity of land cultivation over time, resulting in diminishing per capita returns to land and higher food production and labor costs.The relationship betweenpopulation and food-production capacityof land is depictedin Figure 3.1. As long as the level of population remainsbelow the maximum food-produc-

PoDulaÈiotr'

TÎ

Figure 3.1. Maltbusian rnodel of absolute scarcity showing relationship between population growth (P) and food-production capacity of the land (L*).

3. HstoricalYiews

g7

tion capacity of the land @ < L*), thereis sufficient food to maintain per capita food consumption. As soon as the level of population exceedsthe maximum r*o_pr* duction capacity of land (p > L{,), however, additional growth population in then causesper capita food consumptionto decrease.If reductionsin per caiita food consumption slow down the ratg of popuftion 8tofih, then populationgrowth is likely to follow the logistic growth curveafter T*, as shown ii Égrne li.nthis figure, population increasesat an increasingrate up to T*. After T*, ma:rimum food-p,roduction capacity of the land is reachedandpopulation increasesat a decreasing rare. ln summary,Malthus's absolutescarcity_resr.ritr *h.o geomeric growth in population eventually overtakesthe capacityof the land to ,"!pry food. David RicardoFagreedwith lvlalthusrcgarding rapù populationgrowth, rising production costs and declining profits. Ricardo ditrered with-Malthus-regaraing the timing of both diminishing returnsto land and rising production costs. Malthus argued that returns to land would not dirninish until thJabsolute limit on land availability is reached-Ricardo believedthat averageand marginal productivity of land desreasesalmost imrnediately becauseexpànsionin food production takesplace on land of decreasingfertility. This conceptis known as ,lotíu, scarcity. onl consequenceof relative is that proportionately more labor is required per unit of larcity land' resulting in higher wagesandeconomic rent. Economicrent, whic[ is central to Rjcardo's macro@onomicanalysis,equalsthe dtfference betweenprice and averagecost of production. The implications of Malthusian absolute scarcity and Ricardian relative Pornalatl.ou,

F"tgure32.

Logistic growth in population.

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Natural Resource and Environmental Economics

scarcity for marginal costs of food production are illustrated in Figrge 3.3. q7ith absolute scarcity, margiqal cost is constantbelow an output of e*1ut increasesbeyond Q*. Relative scarcity implies that marginal cost increaseswith the first and successiveunits of ouput as less fertile land is brought under cultivation. Ricardo subscribedto the labor theory of value Qaboris ttre measgrcof all economic value) and consideredtechnologicalchangeto be cost redrrcing.Malthus rejectcd the labor theory of value and believed that technologicalghangeincreasedoutgÉ Economic stagnationfrom absoluteor relative scarcity is delayed through the substitutionof capital for labor, technologicaladvancementsand slówer population growth- Substinrtion and technologicalprogressincreasethe marginal productivity of labor and decreasemarginal production cosL Slower population gro;th reduces total demand for food, provided there is not a compensatingincreasein food demand causedby income growth. Jobn Stuart Mill believed ttrat economic growth was limited by the agount of Iand,rliminishingmarginalproductivityof land, andincreasesin poiulation spurred by growth in indusnial production. MiU postulated that technoiogical progress is sufficient to offset rriminishing retums to land. He believed that diminirhiog-n"tlro, in the mining of exhaustibleresources,such as coal and metals,increasethè cost oi producing thesercsources,regardlessof technologicalprogress. Mill appean ùo be the earliest economist to addressother values associated with the environnent, such as solinrde, natural beauty and the provision of habitat for flora and fauna Mill's philosophyregarding anenity valuesof the environment is similar to the philosophy espousedby conservationistssuch as Henry David Thoreau and John Muir. Regardingsolitude, Mill obsenre4 'solitude in thc presCosÈ per

IIaiÈ

Relative

ScarciÈy

Absolute

ScarciEy

Quntl.ty

Egure 33- lìfiarginat production cost with lvfalth$ian absolute scarcity and Ricardian relaúive scarcity.

3. Historical Views

59 ence of natural beauty and grandeuris the cradle of thoughts of aspirationswhich are not only good for the individual, but which ro"i"ay .oold ill do withoul-.

Nl-EoclAssrcal EcoNoMrcs- Folrowing classicaleconomics, develop ment of resourceeconomicsproceeded

along *Jtirr"ineoclassical economicsand institutional or land The transition from classical to neoclassical eco".ooolrri"rnomics occured in the late ninsleentfrand early twentieth centuries. Neoclassical economic uttavql,s is based on marginat anatysis, *rri"n assumesthat economic agents(householdsand finns) make individuali""irioo, by comparing incremental changesin satisfactionor revenueto incremental cosi In neoclissicJ economics, the price of a product or service is determined by market equilibrium betweendemand and supply.Market price.reflectsa commodity's scarcity value. rvilliam stanrey Jevonszarguedthat dependen'ce o' oo*n"wable encrgy re_ sources'notably coal, posed a seriousthreaito oonoJ" growth in industrialized countries' such as Britain- He arguedthat unlimir"d gn"*,h in coal consumptionresults in the exhaustionof coal reserves.As coal".J*", are depleted,rower grade depositsare mined, causing mioirg cos-tsand coal prices to increase.prices would eventually increaseto a point where British coat wouu no looger be competitive in world markets' Jevonsfeared that Bri-tain'scoal martet and economymight be devastatedby higher domestic coal prices "*p"i Jevons systematically rejected the possibility that this dilernma would be re_ solved by substinrtion of petroleum forìoal, *írr"r"sydniven decreasesin coal and transportation costs, and the importing orlour 3**g from other countiesJevonsfailed to understandthat higher coalprices *óUa stimul216developmentand use of petroleumproducts' and that technotàgical uorr*"", reducecoal mining and transportationcosts. The cornerstoneof neoclassicalmicroeconornics was laid by Alfred Ma$hall. other neoclassicaleconomistsmaking significant contributions include JohnMaynard lGynes in macroeconomicsana vimeao Pareto,eè. in werare economics'Despite his seminalcontributiorrs rigou and Ronaldcoase to neo"lassicaleconomics, Mamhall did not make a major contribution ,o ouru,J resour.e e-conomics.He agreedwith classicaleconomiststhat land is subject to diminishing marginalreh'ns and believedthat land prices rise in responseto tcreasing land scarcity.He argued, however, that land scarcity is not a linit to prices for land would causefarmersto seek ""oooJ"-srowth becausethe higher new knowtig" and better mÍrnagement tecbniques,which incleases agricultural productivity.-ú..n"n:* optimisrn forrned the basisfor the cornucopian view that technological progressand the substitution of manufacn[ed capital fol capital pr"r"it tn"iun", from constrainingeco.. rytryl nomic activiry Nahml capital refersto the iuanuty anan"*tt of nah'al resources. Marshallrecognizedthat the environmentprovides not only reso'rcesforpro. duction, but also "free gifts of nature," such ai ;;;'beauty; scenery fresh air, light and fresh water. Marshall observedthat the *services which land rendersto man, in grving him spaceand light and air in which to live and work,, are t*ically undervaluedor not valued at alln the marketplace.r while neither a classical or neoclassicaleconomist, Karl Marx lines up with the-neoclassicalphilosophy that natural resources o" noaa constraint to economic activity's lVranc'slabor th.ory of value explains tn" of the labor classby "*pioitution

60

Natural Resource and Enviroumental

Econornics

capitalists.This theory is quite different from classical and neoclassicaltheories of value. Basedon the labor theory of value,Marx concludedthat "things supplied by nahrre'gratis' andthe servicesof capitalproper have no value."t0In a Manrian view of the world" value is crcated only when a nahral resourceis combined with labor.' Mant recognized that nature ÍN well as labor contributed to wealth. He also provided what turned out to be an asùrterationale for why privately optimal rates exceedsocially optimal rates of soil erosion.Specifically, economic lpcentives for making long-term capital itrvestmentsin soil conservationare lacking. This lack of incentivesis perpetuatedby the price systeinInstitutional economicswas pioneeredby R T. Ely, in collaboration with President Van Hise and J. R Commonsof the Univenity of Wisconsin. Ely, along with Henry C. Taylor, Benjamin H. Hibbard, GeorgeC. Wehrwein and Lewis C. Gray, formed the core of the land economicstradition that evolved at the University of Wisconsinin the 1920s.Land economicsfocuseson the role of institutional factors, such asprivate property, public policy andpublic action, in the rnaoagementof renewable natural resources. Early land economists studied land tenure (property rights) in agriculture, grazing and forestry.The institutionalist tradition at Wisconsin continuesin the present-daywritings of Daniel Bromley. Institutionaliss generally associateenvironmental problemswith econornicgrowth and arguethat social costs of environmentaldegradationrequirc appropriatepublic action.

Consenationism Concern about the depletion and degradation of America's natural resources has been voiced by many conservationists. The abundance of flora and fauna that existed at the time of the Lewis and Clark expedition was substantially reduced with the settlement of America Native Americans criticlzrd the profligate use of natural resources by white people. A classic exarnple of this problem is the senseless slaughter of bison on the Great Plains for sport, which accompanied the westward expansion of the railroad. For decades, hunting and trapping took place without restrictions, resulting in the decimation of beaver in the Rocky |vlsuntains. While some restrictions were eventually placed on resource use, extraction was accelerated by widespread mining of energy and precious rninerals, livestock grazing and the damming of rivers to supply water for irrigated agriculnre and commercial development. While taking a serious toll on natural resources and the environment, resource exploitation made possible the settlement and development of frontier regions in the United States. It is not practical to trace all the contributions made to the philosophy and prac, 'tice of conservationismin the United States.Fortunately, the thrust of the early conservation movement is capnrred in the lifestyles and achievements of a few noteworthy individuals. According to G. Tyler Mller, early actors in the conservation movement can be distinguished as being either scientific conservationists or preservationists. He asserts that "scientific conserrrationists see public lands as resources to be used now to enhance economic growth and national strength. They must be protected from degradation by being managed efficiently and scientifically for sustained yield and multiple use. Prcservationists emphasize protecting large areas of

3,

oricalYiews

61

public lands from mining, timbering, and other forms of developmentso they can be enjoyed by presentgenerationsandpas.sedon unspoiled to future generations.,,u GeorgeP Marsh (1801-1882)was a scientistand vermonrò""il*-i* *0. laid much of the foundation for noderu conservationism.rn his influential book Man and Nature, Marsh expressedthe diverse and cornplex interactions benveen hum415and nature(environment)in terms of a "nature{nan continuum-,'Along the continuun' humans affect nature and nature affects humans. In other words, there are feedbackloops. Marsh contendedthat humans'cornplex dependence on nature extended far beyond the classical economicsconcept oi ai*ioirting ,o-girrur ,.tums to agriculnrral land and mineral developmenl Nature can support hrrmanactivities indefinitely, provided the ecologicat irrpacts of those activities are not excessive' Marsh arguedthat humansand the environmentneeded to be in balance.r2 His viewpoints representan early manifestationof the ecological concept of environmental carrying capacity,which is gen conternporaryeconomists.Marsh'sconce tween furrrnansand the environmentis ecl servationistssuch asWendellBerrJ,and\ Iohn Muir (183s-1914) was one of the prernierpreservationists in the united States'Muir received his motivation and rt"ogtn ,n*ìgn a close relationship with nature' while a successfirtfruit fanner in California's Alharnbra Valley, Muir,s first love was the shrdy and preservationof the wilderness.His writings extol the ..gle ries of nature" experiencedduring his many modest(stale bread Àa tea; but ambitious treks through the SierraNevadamountains,Alaska and many other parrsof the United States-Muir devotedhis wildernessodysseysto collecting field data for his ilrany scientific investigationsand enjoying nu-tor".H" is credited with discovering new species of plants and animals and the importance of glaciers in forming Yosemite Valley in central California Muir was instrumental in the l7-year sb:uggleto establisha nationat park in Yosemite valley -9 u national park systemin the united states. Both efforts were successful' He received major ctedit for preserving the Grand Canyon. John Muir was the founder and first presidentof the Sierra club, an activist grassroots organization starùedin 1892-His biggest defeat was the unsuccessful carrpaign to save Hetch Hetchy valley in YosemiteNational Park from b.irg flooded to form a water supply reservoirfor San Francisco.r3 hesident TheodoreRoosevelt(1858-1919)wasthe first active conservationist in thewhite House'During his administration(1901-1909), Rooseveltinitiated numerousprograms to consenreAmerica's natural resources. In 1903,he astablished the nation's first federal wildlife refuge to prot€ct Florida's brown pelican. During his administation, the size of the national forest reserve Eipled. In 1905,congress creaÎedthe United StatesForest Serviceand hesident Roosevelt appointedGifford Pinchot (1865-1946)as its first chief. Pinchot usheredin the era of scientific re. sourcemanagementbasédon multipls sss_s,s5teined yield managementof national forest reservesoatter re-named national forests). pinctrot espousedthe philosophy of managingnatural rEsourcesfor the greatestgood of the greatest number of people for the longesttime. In contrastto John Muir, Pinchot supportedthe flooding of the Hetch Hetchy valley.r+ Aldo Leopold (188G1948) operated in the same tradition as John Muir. Leopold received a college educatioì in-resource*ug"-"nt (forestry and game management)and worked for Gifford Pinchol Leopold-is best known for his land

62

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Econornics

ethic, which views land as a community of soils, water, plants and anirnals worth presenringand humansasresponsiblefor land stewardshipas an "ecological necessity." The land ethic doesnot require that land resourcesremain idle. Use is allowed as long as provision is made for the continued exjstenceof land, *an4 at least in spots, continued existencein a natural state." This latter èoncept spurred Leopold and Bob Marshall to establishthe WildernessSociety in 1935. Leopold consideredit inappropriateto baseland conservationde4isionssolely on economic criteria He arguedthat many seryicesprovided by the land arc esseutial for its proper functioning, even though such serviceshaveno coulmercial value. He wanted land managersto have an 'ecological conscience"that causesthern to take personalresponsibility formaintaining the healthof theland. Leopold reasoned that land rnanagersneededto put aside the narrow mindset tlat "economics deterrnines all lan&use" and embracewhat is ethically and aesthetically right for the land. This required preserving the land's integrity, stability rind.beauty.rs

Contemporary Views Prior to the l4te 1960s,the position that resourcedepletion and environmentaldegradationmight limit long-term economic growth received little support for three reasons.First, Malthus's dire prediction that population growth would eventually cause economic stegnation did not rnaterialize. Seconù neoclassicaleconomicsprovided a convincing argufnentthat a well-functioning price systemtriggers higher prices for depletedresources,technological innovation and resourcesubstitution, all of which sustain econornic growth. Third, benefits of economic growth seemedto ounnreighthe resourceand environmental costs. Spurred by the birth of the environmentalmovementin the late 1960s and the concept of sustainabledevelopmentthat gained popularity in the late 1980s,scientists, policy-makers, govenrmentotEcials and the generalpubtic becameconcerned with the human and environmentalcosts of unbridled economic growth- This concem was heightenedby the lntential environmentalimpacts of adding anotherbillion peopleto world populationin 10 years(seeTable1.1)and the slowing of technological progressin many.developedcountries,such as the United States.The remaindersf this sectionreviews someof the moreimportant contemtrrcrarystudies about the relationship between natural and environnental resource capacity and economic activity.

tnnts TO GROWTET ln TheLimits to Growth,Meadowset al.r6 useda dynamic simulation model to exanine the potential environmental consequencesof population and economic growth. Their simulation model indicated 1) that if presentworld trendsin population,industrializ2lgisll,pollution, food production and resourcedepletioncontinue,limits to growth would be reachedin 10Oyerirs (between 2020 and 2100); 2) that presentnends can be alteredto achievea sustainablebalancebetweeneconomicand ecological systens thatis adequateand equitable for all peNorls; and 3) that the sooner society begins to work toward sustainability, the

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yiews

63

greater the likelihood of achieving ir The World3 model used in The Limits to Growth study assumesexponentialgrowth in population, industrial production, pollution and consrrmFtion,and fixed quantitiesofland and exhaustiblerqsources. In the sequeltoThe Limits to Gruwth entitledBeyondthc Limits,Meadows et al'rTobservethatl)manyresogrceandpollutionflowsnowexceedthe limitsof sustainability and' if unchecke4 will evennrallyreduce food and industrial production and energy use; 2) economicdecline can be avertedby adopting policies to reduce growth in population and consumptionand by increasingthe of resource "ffi"i"o"y use; and 3) in addition to incrtrasedproductivig and uèrcr technology, achieving sustainability requiresman'ity, compassionand wisdom_ The pessirnistic conclusionsof the limits-to-growth study have beencriticized by Solow and othersrEon severalgrounds.Firs|tectrnological innovation causes more or less exponential growth in the productivity of natural resources. Second, greater scarcity of exhaustibleresourcesincreasestheir prices as well as the prices of commodities that utilize theseresources.hice increasesreducenesource use and stimulate development of substitutes.Third, as countries become more affluent, population growth decreases;hence,population growth is not exponential. Fourth, industrial pollution does not have to increasein airect proportion to indusrial production- Pollution can be reduced by such things as-emission controls, effluent chargesand taxes. Of course,regulationsand financial disincentivesfor reducing pollution divert resourcesfrorn production of commodities. Hence,p,ollution reduction involves a real social cost. In support of Solow's viewpoints, Kransberglecontendsthat technological in_ novation helps to sustain economic growth. He aqguesthat resourc" ,upflio ur* augmentedand food and energyproduction are increasedby technologicJchange, both of which tend to moderatethe effectsof resourcescarcity. Several other studieshave addressednatural and environmentalresource limits to economic glowth- Among the works zupporting natural limits to growttr are the Global2o0o Repon by Barney,Healing *i pt*tirby Ehrlich andEbrlich, Beyond OiI by Gever et al., andSteady-State EconomicsbyDaly.D Studiesthat reject the notion of resource-basedlimits to growth and thai embracethe cornucopian view include Thz ResourcefulEanh by Simon and Kahn, The Global possible by Repetto and,TheNen 200 Yearsby Katrn.zr

Other f,'actors Resource development directly affects nanrral and enrrironmental resourcecapacity.Acomprehensivl economic approach to resource development requires tharia proposed activity not be undertaken unless it is economically feasible (benefits exceed costs, including resource and environmental costs). In an economic-based approach to resource development, nahrral and environmental resources are used in a socially efficient manner when resource prices reflect the full social cost of production. Resource development is, however, affected by factors other than economics- Legal, political, ethical, religious and sociological factors are especially importanl Consider the role of law and politics in government-funded projects such as

&

Natural Resource and Envir:onmental Economics

consEuction of hydroelectricpower plants. Project selectionis basedeither directly or indirectly on authorizinglegislation, which evolvesfrom interaction and lobbying among executiveandlegislative branchesof government,special interest groups and the generalpublic. The resulting legislation is a political compromise in which economics often plays a minor role. For example, the EndangeredSpccies Act of 1973 prohibits considerationof economic criteria in developing and implernenting programsto protect threatenedand endangeredspecies.Inthe early l9gs, this stipulation resulted in a major clash betrveentimber companieswho wanted.to harvest old-growth forests and environmental groups and federal agencieswho wanted to protect the habitat of the northern spottedowl in the northwestemUnited States. Even when resourcedevelopmentactivities mustpassthe test of economic feasibility, politics influencestheeconomicanalysisof benefigand costs.When Jimrrry Carter becamePresidentof the United Statesin 1977,he proposed increasing the discount rate usedto evaluatethe benefits and costsof waterresourcedeveloprnents in the western United States.At ttle [ime, a low discountraùewas being used-Many resourceeconomistssupportedCarter's proposal becausethey believed the discount rate was too low, causingCongressto approvewaterrcsourcedevelopment projects with short-term economicbenefitsbut long-term environmentalcosts- A good example of this is the developmentof hydroelectric power facilities (rtarns uid ,r".voirs) on the ColumbiaRiver.The higher discount rateproposedby president Carter would have disqualified many water resource developmentprojects (costs would exceedbenefits).Politically powerful interest groupspersuaded. the Carter administration to drop this proposal. Another way that resourcesare misallocated is as a result of potitically based decisionsto subsidizecertainactivities. For exarnple,the World ResourcesInstitute claims that motor vehicle transportationin the United Statesis subsidized to the tune of more tlmn $1,000per penion aboveand beyondwhat each person directly pays for motor transportation.zWithout thesesubsidies,the use of motor vehicles would likely be much lower, as evidencedby the more energy-ef;Ecienttransportation systemsthat haveevolved in westernEuropeJudicial and adminisEativelaws are also important in resolving legal conflics between opposingpartiesand in establishing and protectingpropeÉy rights to natural resources.koperty rights specrfywho has the right to usèa fattitufar resource. For exanple, under the prior appropriation doctrine, westernwater users with earIier rights are given priority in water allocationChangesin political partiescan have positive and/ornegativeeffects on the environment- In the united States,the Democratic party is more qrmpathetic to environmental protection than is the Republican Party. Greenparties and green politics in many developedcounEiesemphasizegrassrootsdemocracy,social r"pooifulity and nonviolence, positionsthat align closely with the deepecology movémenta ., EQdly significantis the growth in green businessesand the greening of businèsses.In 1990, the world market for environmental goodsand services amounted so$20Obillion. By the year20OO,this rnarket is projectedto gr,owby 5Opercenr In October 1992,the chairmanand chief executive officer of Dow Chemical Company announced his belief that chernical prices should reflect environmental costs.a These and rnany other examplesportend a "new" gre€nrevolution that aspiresto achievea balancebetweeneconomicdevelopmentandeuvironmentalqualit Other examplesof eventswith negativeenvironmentalconsequences include the defoliation of vastportionsofthelandscapefromextensiveuseof napalmduringtheViet-

3. HistoriealVi

65

nam War and arr, w^ater,and land pollution resulting from the conflagration of oil wells in Kuwait during the l99l pèrsian Gulf War.

Indicators of Resource Capacity

tosustaineconomicacti'ityff ;lt::n:TT3"#AHSilff

ì:[,:::

ton generally fall into two categories:physical measures and economic mqrs'res. Typical physical m3alures_include pro;ecteaproduction, u-o*, of theresource discoveredper unit of effort (banels of oil discóveredp", i*, [meter] of well drilled), the amount of labor and capital required to extract àne unit of the resourceand the energ'yprofit ratio' common economic mquures include unit extraction costs and prices. Each m",*ure of resourcecapacrtyhasshengths and weaknesses. PEYsrcaL MEAsrlREs' Most physical measuresof resourcecapacity have been applied to exhaustiblenesourcessuch as energy and minerals. The most fatheoretical projections of oil and natural gas-production Polt are basedon Hubbert's bell-shapedcurve developedin 1956.2s ceuerit al. updatedHubbert,scurye using morc advancedstatisticaltechniquesand more t"""*ta.r*-*,i.*il tt*ure 3'4' Both the original and rcvised curves indicate that oil and gas production grow slowly at first, increaserapidly, a peak and then decreaie*!iory. rrr" -yach decline phase o""utt--bTause the quality of pàttot"o- dir"oueries decreasesover time' Predictions by Hubbert and Gever et al. proved to be very accuratein projecting the l97o pakin oil production and the rr?: peat inìaaral gasproduction that occurred in the united states.Hubbert's projections indicate that united Statescapacity to produce oil,and naturargaswiilìi*rip"t, bv trre year zo2o. Fossil fuellroduction capacity,especiallyt"t and coal, has decreasedon a worldwide basis,asshownin Table3.1.bil production "il increased from 1950to l9?9 but decreasedfrom 1979to lggz.coal trnoductionincreasedfrom 1950to 19g9,but decreasedfrom 1989 to 1992-Naaual gas production increasedthroughout the l95o-l992periodother physical measuFes of oil and gasproduction capacityare consistentwith Hubbert'scurve-Discoveriesof cnrdeoil p.t f*t;f *"ll driued followed a downward trend from l93o to the mid-1980s.^À.aoitioo, proven to reservesper foot (or meter) of well driued showeda marked downward. trènd from 1945 to 1956, increasedslightry from 1957to !974, andfelr sharpry from 1g75to 1gg5.using dara Table 3.1-

tn

of fcsil fuet, U)ft-1992

Growth P€riod Fuel

oil Coal Natural

r9sGly/9 195Gr989 l95Gl9E2

PercentAnnual tó.4 +22 +6.2

Soarce: Lester R- Brown,-A O.""4" Iustitute, July/Aug 1993), pp. 19_26.

Decline Period PercentAffual

Years t979-tW2 198 1992

-{).5

<).6

ffi

tur.al Resource and Environmeatat Economics

(t

a

H

o A o

À o h H 6

tr É o

Yl F{

Ft

Ì{ E

rigure 3'4. Actual and projected oil production in lower 4E súatesby HubbeÉ curye (dashedllìze), Kaufuann (r99r) (sotid-Iine)and actual values (open cùcbs). SoURCE: John c-Évq. et.al- Bqond oX The Thrust to Food dnd Facl h tlu coning Dccada(Nirroq Colorado: University of Colorado, l99l), p. xxxi

for the 187È1957 period Barnettand MorseP6determined that there w:rs a fourfold decreasein the quantity of labor and capital required per unit of resource exmcted in the agricultural, mineral or fueli, forestry and fisheries sectors. Physical effi.ciency of energyuse has been measuredusing the net energy ra_ tio, net energ} return on inves- ent and energyprofit ratio.u While these measures can be applied to several typesof resources,they are rnost often applied to energy resourcessuch as coal, oil, natural gas, hydroelectric power and soiar energy. Net energyreturn on investrnentis the energycontent of a product minus all the energy required to produce that product including the energy'embodied in the capital and 9," 3Y materials usedto producethat producL For eÉmple, if 25,000 barrels of oil equrvalent(boe) are requiredto produce75,000 boe from an oil shale deposig then the netenergyreturn on investrnentfor that deposit is 5O,000boe. production of the resourceis enerry efEcient (inefficient) when the net energyreturn is positive (negative). Net energ)/ratio or energyprofit ratio is the ratio of the energ-ycontained in a product_tothe energyrequiredto produceir A ratio greater Qess)tn- f implies energy efficiency (inefficiency). The net energy ratio for the oil shale i" 3. "*uo,pL

3.

cal Views

Geveret al'8 determinedthat theenergyprofit ratio for cnrdeoil decreased slowly from27in l9r9 to rg in 1955,in"t"*"iìo n;;l;6?, anddecreased ro aboutlg il 1982'The long-terrndownwardtend in the eiergy p."n.-rrr" il;;nt with Hubbert's curve and the downward Eend in both discoìeries of cnrde oil and addi-

tions to proven reservesper foot (meter)of well drilled.

EcoNoMrc MEASURES. Nordhausexaminedthe changes in mineral prices relative to wagesin the manufacturingsector.Nordhaus concludedthat mineralsare becoming less scarcerelative to labor basedon declining relative mineral prices from 1900to l97o''9 In addition to theirphysical rneasure of resourcecapacity,Barnett and MorseSoevaluatedthe prices ofixtractive resources (agricultural products, minerals, fuels, forcst products and fish) relative to pric"s for nonextactive resourcesduring the 187G1957 period-Relativeprices oi agricultural andnineral resourcesshowed a downward trend d.uringthis period, indicating reducedscarcity, yhereas relative prices for forest productsand dsh .ose in the early 1930s, indicating increasedscarcity. Johnsonet al'3r uprúatedthe original Barnett and Morse study by extendingthe databasethrough once agern,prices of agriculturat proaucb, minerars, 197?and fuels declined' indicating reducedr"*_ìity. compLo J,rt m" increasingprices and greaterscarcityfound in the original 187È1957 period, prices or rorestióducts decreasedfrom 1962to 1970,implyrng lessscarcity.Fish irices continuj theupward nend that had begun in the early 1930s.Smitht exaiinea resourceprices using more advancedstatisticalmethodsand morerecert data than Barnett andMorse. He determinedthat trendsin resourcepnces dependon the time period selectedand that Barnett and Morse'5 sgaglrrsionthat r€sourcesare not becomingmore scarcecannot be supported. cleveland33examined three economic indicators of petroleum scarcity: real well headprices of crudeoil and nahrralgas,capital andiabor (unig costper unit of extraction, and averagetotal cost of extraction.near oil prices followed a ushapedtime path' Pricesfell from 1860to 1890,remained "ruJe relatively consrrntfrom 1890to 1940'roseslightly frorn 1940to themid-1970s, and increasedsharplyfrom the mid-1970s to the early 1980s-unit cost or p"t oi*m fell throughthe early 1970sandincreasedthrough lgST.Averagetotal cost decreasedfrom the mid-1950s to the early 1970sand increasedvery r4pidly from the mid-r970s tbrough19g7. Norgaardr argues that resource scarcit5rcannot be determined by studying in resourceprices becauseof a logical iau"y. He points FTd* out that the theoretical modelsdevelopedby Ricardo and Hotelling start *itt tn" rnajorpremise..if resourcesare scarce"' and the minar premise*if resource allocators are inforrned of resor[ce scarcity," and conclude that "then economic indicators will reflect this scarcit5/'"The logical f#l":y ,h"j empirical studieshave reasonedin an opposite it manner' Norgaard contendsthat the model usesresource scarcity ioaàii, ttt" conclusion) to determinewhether resourcesarc scarce(the major premise)and ig_ nore whether resourceallocatorsarc informed (the minàr premise). Ratherthan reRicardo's predictions of increasing rcsourc" ,"ur"iay, empirical studiesshow T,iog that the assumptionof informed resourie uuo"uao..i, iur"". rf the th"ory is accepted' then resourceallocators are infonned about *"*"i,y and resourcescarcity can be determinedby simply asking them whether resourcesare scarce.

68

Natural Resour.rce and Environmental Economics

Physicaland economicmeruiurcsof resourcecapacity have certain drawbacks. Although the effects of'diminishing suppliesarecounteractedby increasesin petroleum prices,judging the adeq"acy of petroleumreservesbased on the number of years until exhaustionignores this facL On the demandside, higher prices for petroleum and penoleum-basedproducts would increaseconservation. Events of the mid-1970s and early 1980sbear this out. On the supply side, higher petrolegm prices would stimulate petroleum exploration;use of totnrotogies ttrat*rcrease the efficiency of petroleum exploratiorl developmentand p.o""rriog; and replacement of petroleumwith substitntessuch as solar energy.Infening resource capacity timits from economicindicators might be misleadingbecauseótpri"" and cost distortions causedby federal price controls, depletionallowances,import restrictions, international cartelssuchas the Organizationof PetroleumExporting Countries, wars and other factors.

EIYVIRONMENTAL RESOIIRCES. M"ny resourcespecialise believe that the capacity of the environment to assimilateresidualsfrom production and consumption is a greaterconstraint to economic activity than are nanral resource depletion and exploitation. Unfornrnately,physical and economicrneÍNuresof natural resogrce capacity do not adequatelyreflect the impacts of resourceextaction, processing,transportation and useon environmentalqualiry Burning of coal hascreatedair quality problems, such as global warming and acid rain. In order to reduce dagages from acid rain, the 1990amendmentsto the CleanAir Act limit enrissionsof sulfur dioxide from power plants.Reducingcarbondioxide emissions,which are the major culprit in global warming,is more difficult due to the global natureof the problem- The environmentaldamagewroughtby theF.nonValdezoil spill in 1989was not reflected in oil pricesdue to the competitive natureof the oil market-This incident did, however, bring aboutfederally mandatedsafetystandardsfor oil tanker construction and transportation. Extraction and use of natural resoltrcesdeplete and degrade other natural resources.By the late 1970s,2,350 mi2 (6,087hn2) of various ecosystemsin the United Stateswere convertedto drilling pladonns, pipelines,refineries and other facilities that supportpetroleum use."Petroleumextraction and other industrial activities have claimed more than 10O-iz (?591m2) of wetlands in Louisiana prior to the push for environmentalprotection legislation in the late l960s, envilonrnental costs were generally external, meaning they were not reflected in costs of production and the prices of goods and services.Legislation, such as the Clean Air Acf CleanWaterAct and EndangeredSpeciesAct,hashelpedto internalizs many environmental costs. "j

Sunmar5r The capacityof ndturat and envirorunental resources to support economicactivities is a major concernof resourceeconomistsi conservationists and others. Economic concernover resourcecapaciry and its effects on

3. HistoricalYiews

69

economic activity was first expressedby classical economists. Thomas Malthus and David Ricardo argued th,at growth in population combined with a limited land base would eventually result in economic stagnation in the forrr of declining per capita food production- Malthus claimed that the marginal productiviry or raúj declines when the absolute land limit is reached (absotute r.*.ity;. In contast, Ricardo believed that the marginal productivity of land declines atmost immediately (relative scarcity). Both Malthus and Ricardo contended that economic stagnatioi could be delayed through the substitution of capital for labor, technologi"il udy*"emen* and slower population growth. John Snrart Mill recognized that the environmenr provided natural services such as solitude and beauty. Neoclassical economists generally sounded an optimistic note regarding resource scarcity. Mlliarn Stanley Jevons claimed that dependence on exhaustible energy resources leads to economic stagnation. Alfred Marshall, the father of neoclassical economics, argued that increasing land scarcity causes land prices to increase, which stimulates farmers to seek new knowledge and. betteui*ug"ro"nt techniques- As a result agricultural productivity increases. Marshall believed that technological progress and the substitution of manufactured capital for natural resources eliminate natural resource constraints to economic activity. Institutional economists focused on the role of institutional factors, such as private property, public policy and public action in the ilnnagement of rural, ,"n"*àbl" natural resources. conservationists like George P. Marsh posited that people's dependence on nature extends far bey_onddiminishing marginal retums to agricultural land and mineral developmenl He argued that nature can support human activities indefinitely provided the ecological impacts of these activities are not excessive. other conservationists such as John Muir, Theodore Roosevelt, Gifford pinchot and Aldo Leopold contributed to th"ory and practice of natural resource management and the protection' Aldo Leopold developed a land conservation ethic and empf,asized the ecological necessity of land stewardship and the protection of natural areas. In the past 20 years' Polar views have developed regarding the relationship between natural and environmental resource capacrty *J*onomic growth. At one exheme is the neo-Malthusian view that resource capacity limits eco-nomic growth. At the other extreme is the cornucopian view that technoiogical progress and operation of the price system are sufEcient to remove natural and environmental rcsource conshaints to economic growth. Falling between these two extremes is the material balances and ecological economi"r (discussed in Chapter 4), "pprou"hes which provide an analytical frarnework for undèrstanding the relationship, ùar"""o the economy and the ecosystem. Development of instiruitional mechanisms for resolving resource conflists involve legal, political, ethical, religious and.sociotogical considerations. various physical and economic indicators of rcsource capacity have been employed" including projections of production (Hubbert's curve), amount of the resource discovered per iinit of efforf aÍlount of labor and capital required to extract one unit of the rEsource' net enerry ratio and energy prcfit ratio. Economic indicators include unit extraction costs and prices or r"ro,u"es. physical and economic indicators of resource capacity are imperfect and.often give contradictory evidence regarding the extent to which natural and environ-"otil rcsource capacity constrains econornic growth. Support is growing for the viewpoint that environmental resource capacity has become a greater potential constraini on economic activity than have narural resource depletion and exploitation.

70

Natural Resource and Environmental

Economics

Questionsfor Discussion 1- Supposethat insteadof growing at an inc:reasingrate, as depicted in Figgre 3-1, populatiotr grows at a decreasingrate after T", wheÉ T" < T*. urn.t are the im_ plications of this changein population growth for the Malthusian hypoúesis that, over tine' land becomesincreasingly scarce and per caplta food iroduction decreases? 2- Marshall conceptualizedthat technologicaladvancementsincr#se the marginal productivity of labor, which offsets the effectsof increasing land scarcity. Resource economistshave pointed out that agricultural technologies have increased. the intensity of land use,thereby acceleratingsoil èrosionand dependenceon fossil fuels- In particular,substitutionof machinerypower for animal pd*, increasedsoil erosion on cultivatedland and boosteduse of fossil fuel per unii of agricultural production- Do technologicalimprovementsdelay the effecù of hnd scarcity at the expenseofincreasedland degradationand higher energyuse? 3- Aldo Leopoldmaintainedthat land nunagersneedto develop a land ethic to Preservecertain noneconomicbenefits of the land suchas keeping a wetland in its natural staterather than converting it to cropland. Someresourceeconornistshave estimatednonmarketvaluesof different land usessuchas the recreational and,water quality benefits of a wetland. Is the detenninationof nonmarket values of land usesinconsistentwith Leopold's land ethic? 4. If, as someeconomistsargue, the assumptionsmade by proponents of limits to growth are faulty, then do their conclusionshaveany relevancefor natural and environmentalresourcemÍrnagement?Explain. 5- How irnportantare noneconornicfactors in detcrmining resource develop. ment and use? 6- What arc someofttre advantagesand disadvantagesof using physical versus economicmeasuresof natural resourcecapacity? 7- Is environmentalresourcecapacity or naturalresourcecapacity likely to be a greaterconcemin developedor in developing countries?Explain.

Further Readings Castle, Emery N., et aL 1977. 'Nahtral Resource Economics, lg4G.7S-A Suney of Agriculural Econornics Literature, Vol. 3, Economics of Welfare, Rural Developmer4 and Natural Resources h Agicalture, 1940s to 1970s. Lee R Martin, edMinneapolis, MinnesoE University of Minnesota hess. Hall' Danvin C- and Jane V. tlall. 1984. 'toncepts and Measures of Nanrral Resource Sqarcity with a Summary of Recent Ttends.- Joumal of Ewironnental Economics and Management 2:363-379. Kneese' Allen IC, Robert U. Ayres and Ralph C. d'Arge. l97o- Ecorwmics atd ttg Envíton'rnent: A Maerial Balances Approach. Baltirnore, vruiyr*a, nt; irft"r Hopti"s u"iversity Press. Myers, Norman and Julian L Simon. 1994. Scercity orAbwda4ce? A Debate on the Envircwncnt. New York W. U/. Norton & Co. Pearce' Daviù Anil Markandya and Edward B. Barbier. l9B9Blucpint for a Grcen Economy. London: Earttrsczn publications Ltd-

3. HistoricalYiews

7l

Tannet îrornas, ed- 1982.Ardo l.eopord: TheMan arú Hk Legaq,Ankeny, Iowa: soil ConservationSociety of America

Notes l- Hla Myint, ."The Classical View of the Economic problenL,, in Essays in Economic Thought: Aristotle to Marshail, Joseph J. spengler and w. R. Arlen, eds. (chicago: RandMacNally, 1960), pp. 451452. 2' Adam Smith' An Inqtiry into tle Signtftcance and Causes of tttc Wealth of Nations (I-ondon: J. M. Dent & Co., l9l0). 3. Thomas R- N{althus,An Essayon tltc pinciple of populatio4lst ed- (London: J. Johnston' 1798)' and rhomas R. Malthus, An Essuyon tt ertitpte of populatioa 2nd ed(London: J. M. Dent & Sons, l9l4). " 4' Thomas R- Malthus' Prirciples of Potìticat Econonry: Consídercd with a llìew to Their Practical Applbation (London: John Murray, 1g20). 5. David Ricardo, The Principles of Political Economy (London: J. M. Dent & Sons, 1973). 6' John Surart Mil\ Princíples of Politícal Economy with Sorne of Ttuir Applícation to social Philosoprry,srh ed-, vol. II, book rv (Londoru parker, Son and Bourn, lg62), p.3zs. 7- viilliam gtenrsy Jevons, Thc coar euestion: An tnqu;by concernhg thc pigrcss of tle Nation and the Prcbable Exhanstion of our Coal Minei (London: Macmillan, 1909). 8' Atfred Marshall' Pinciples of Econornics: An Introductory Vohnu, gth ed- (London: Macmillan, 1945), pp. 13&-139. 9' Kart Marx' Cl4ital: A Critique of Politicat Economy, vol. I (Harrrondsworth, England: Penguin Boolcs, 1976)_ 10'' Nicholas Georgescu-Roegea The Entropy l^svv aÌtd ttu Ecorcmic process (Cambridge, Massachusetts:Harvard University ness, ig7t), pp. 2gE_2E9. 11' G' T$er Mitler'lt., Resource Corsertatìon and twarragemcnt (Belmont, Califomia Wadsworth Rrblishing Co., 1990), p. 3g. 12- George p- MarstL Man and.Nawe (New yorrc charles scribner, 1s65). 13' Ed\r/in ll/ay Teale' The Wildemess World of JotnMzúr @oston: Houghton Miffiin Co., 1954). 14' Frank Graham'Man's Domhiat The Story of Conserttation inAnuríca(New york: M. Evans, l97l). 15' Aldo Leopold' A Sand County Atmanac with Essayson Consemgion fiom Round Rrver (New York Ballantine Books, 1970). 16' D- H- Meadows et al-, The Limits to Growth(New Yorlc Universe Books, lnz). 17' Donella Meadows, Dennis L. Meadows and Jorgen Randers, Bqond tlw Limits: Cor{tontíng Global Co_llapse,Ewisioning a Sustaùuble fwure(post Mills, Vermonu Chelsia Green Rrblishing Co., 1992),pp. xii!-rvi 18' Robert M- soloq'Ts the End of the Ìv'ortd at Haod?' nTlre Economic Growth Cont'?olÌersy,Andrew weintrarb et al., eds. (New York Intemational Arts and Science press, ln3), pp. 3f61. 19- M- Kranzberg"'Can Technological Frogress Continue to provide for the Fuh'e?, The Economic Gtowth C,ontlversy, Andrew v/eintranb et al., eds. (New york Intemational Arts and Science Press, Ig73),pp. 62-gl. 20' G' o' Barney' The clobal2No Repon to the Prcsídent ttrc of United States,2vols. (Oxford, England: Permagon Pre$s, 1980); paul R. Ehrlich and Anne H. Ehrlich, Healing the Planet (Reading, Massachusetts:Addison-wesley, 1991); John Gever etal., Beyond,oil: The

72

Natural Resourceand Environmental Economics

Thread to Food and Fucl in the ComingDecades(Niwot, Colorado:University press of Colorado, 1991); Herrrau Daly, steady-stateEconomics,2nded. (washingtoo, p.c., Island Press,1991). 21. Julian SimonandHermanKahrL TheResourcefalEartbr A Response to Gtobal 206p (oxford' England:Basil Blackrvell, 1984);Robert Repetto, d., The Globat possíble: Resources' Developmentand tlu New Cenfiry (New Haven, Connecdcutr yale University Press, 1986); Herman Kahn, The Ner 200 Yearc:A Scenarìo Anerica and -the -- World for (New Yorlc William Morow, 1976). *)22. EdAyers,'BreakingAway" WorldWatch(Washington, D.C.: Worldwarchlnstiture, JanuaryrFebruary 1993),pp. lO-18. - in Amerban 23- BiU Devall, 'Deep Ecolog5rand RadicalEnvironmentalisrn Envircnmentalism: The u.s- Ewircwnental Mwement, Ig7ÈIgg0, Riley E. Dunlap and.Angela G. Mertig' eds-(washingon,D.c.: Taylor & FrancisInc., 1992),pp. 51-62. 24. ChristopherFlavin and JohnE. young, ..TVillClintor, ói*re Industry a GreenEdge?, Worldwach (Washington" D.C.: WorldwatchInstinrte,January/February t-ggg),pp.26;31. 25. M- IC Hubbert,"Nucleat Energy and the Fossil Fuels,' Drtiltng ana-prcduction Practice (washington, D.c.: American petroleum Institute, l95O; R K- Kaufrmnn, ..oil hoduction in the Lower 4{l Sutes: Reconciling Curve Fining and Econome6ic Methods,Resources and Energy13(1991):lll-127. 26- Ilarold Bamett and ChandlerMorse, Scarcityand Grcwh: The Economìcsof Natural ResourceAvailnbilitX @altimore, Marytand: JohnsHopkins University prress,1963). 27. HowardÎ Odum,Envirunnent, Power and Society(NewYork John Wiley & Sons, l97L); CharlesHall, Cutler Clevelandand Mirchell Berger,"Yield per Effort as a Function of Tlme and Effort for United StatesPeEoleurn"Uranium and Coal," rn Energy and Ecological Modellíng,W.J.Mitsch,R. W. BossermanandJ. M. Klopatelqeds.(New iork Elsevier, 1981); and John Gever et al., Beyond.OíI: The Threat to-Food and, Fuet in tlu Coming Decades(NiwoL Colorado:University pressof Colorado,1gl). 28. Geveret al. (1991). 29. W. D- Nordha's, '-fhe Allocation of EnergyResources,'Brcokhgs papers on Economic Activity3(1973):52*57 O. 3O.Barnet and Morse(1963). 3l- Manual IL Johnson,Frederick W. Bell and JamesT. Bennett, "Nanrral Resource Scarcity: Empirical Evidenceand Public Policy,- Joumal of Envircnnental Economicsand Mong emcnr7(I 980):256-n t. 32-V- Kerry Smith,'The Evaluationof Nanral ResourceAdequacy:Elusive euest or Frohtier of Fronomic Analysis?"Land Economr'cs56(1980):257-298:V.f"rw Smirh, ..Measuring Nanfal ResourceScarcity: T?r.b.y and Practice," Journf,l of Envircnntcntal Economics otd Managemenr5(1978):150-171.; andV. Kerry Smith, ..NaturalResourceScarcity:A statisticàt Analysis," Reviewof Economicsand statiitics 6l(1979):4?s.a27. 33. Cutler J- Cleveland,*An Exploration of Alternative Measurcsof Natural Resource Scarcity:The Caseof PetroleumResources,"EcologicalEconomicsT(1993):lZ3-lSZ. 34. RichardB- Norgaard,'Economic Indicatorsof ResourceScarcity:A Critical Essay,o rournal of Ewircnmental Economícs and,Managenuntl9(1990):lg-25.

CHAPTER

4

Economyand Environment The capacity of the environmentto rearrange matîer (Jreeeneryy), as well as the stock of mutter (resources). . . ari both irrevocabry used up

in theec7nomic pnocess. Reptenishment of the,r;í"j

!r::j,y,

"r*

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ur understandingof the relationship betrreen the economy and the environment has \-t evolved from the classical economic view that natural iesource capacityis a constraint on economicactivity to the neoclassical position that a well-functioning market and technologicalinnovation eliminate natural and envhonmentalresourceconstraintsoo r"oooìuic growth. Critics axgue that the neoclassicalparadigm epitomizes the fallacy of misplaced concreteness. This fallacy occurs when abstractionsare used to draw conclusions about reality without considgrhg the limitations of those abstractionsand the validity of the resulting conclusions-r One way to deal with this criticism is to employ a holistic model of the economy ùd environment that reflects the interplay be-trveeneco. nomic activities' resourcedepletion and environmentaldegradation. This chapter discussesthe relationshipsbetweenthe economy and the environment in terms of the chcalarflow of economicactivíry,materìal balances,ecological ecorwmics and susnirnb le develop ment

Circular Flow Econony science utilizes models to describe and predict the behavior ofphysical and behavioral sysr sentation of a sysùem.Thc languageof r The complexity of a model dependson t the consequencesof making a q/rong lrre a model to determine whether a nuclear reactor is safe to op€rate should be fairly complete to ensure that it accurately simulatesthe reactor's operation- Completenessis Pararnountbecausethe potential human and enviroo*otut consequencesof inaccuratemodel predictionsof reactor safety are simply too greal In cornparison,

74

Natural Resource and Envimnnental Economics

a model to predict soil erosionin a field of soybeanswould not have to be as complete becausethe socioeconornicconsequencesof an inaccurateprediction are relatively minor. Economists use models to explain and predict economic behavior of households and firms and the economyas a whole. Beca,rseeconomicsdealswith behavior, economicmodels tend to focus on behavioral relationships.The circular flow economy,illustrated in Figure 4.1, representsthe traditional explanation of how firms and householdsinteract in a market economy. The model consistsof a physical flow in the inner loop and a mopetary flow in the outer loop. In the physical loop, firms employ resourcessuppliedby households (A) to produce commodities(B) that are sofd to households.fn tft" monetary loop, householdsmake expendinrreson commodities (C) using income_@)derived from selling resourcesto firms. Incomeis in the forrr of wagcs,salariesand rents- Household expendituresequalhouseholdincome (C = D) and expend.itures made by firms equal revenuesreceived by firrns in a closed economy.While the completenessof the model canbe enhancedby adding governmentand import-export sectors, such additions do not changethe basic sructure of the rnodel. The circular flow model capturesthe salient behavioralfeaturesof production and consumptionin a market economy.Unfornrnately, it ignores s",v"al important relationships.Firsl it does not take account of the physical realities of proàuction and consumption.The model implies a circular flow of resourcesand commodities betweenhouseholdsand firms. Physical laws dictate that energyand materials are transformed and degraded(entropy), which suggestsa unidirectional flow rather than a circular flow of resourcesand comnodities. In additiorl production and consumption result in by-prodrrctsand residuals. Second,the model does not distinguish between natural and hunan resourcesand betweendifferent b1pesof natnral

Figure 4.1.

Circufar flow model of econo'ny.

4. Economy and Environment

75

resources-frrmping natural resourcestogether glossesover the important distinction between the depletion of exhaustibleresourcesand the overexploitation of renewable resources- In addition, the model ignores the satisfaction received by householdsand firms from cons,ràingorpresenringthe option to consume amenity servicesprovided by natural and environmentalresources. ftir4 depicting monetary flows in a circular manner suggeststhat the economy cÍrn gow indefinitely. In fact, neoclassicaleconomicsÍrssrynesthat maximizing economic output is an appropriategoal of the economy.This goal is consistent with thè human-centeredorientation of neoclassicaleconomics,but it contradicts the growing body of evidencethat unbridled economicgrowth adversely affects natural and environmental resourcecapacity.The circul* noro model abstracts from the physical and biological seningin which the economy operatesand ignores the principles governing the use and transformationof material and energy. ùre material balances,ecological economicsand sustainabledevelopme", discussedin the remainder of this chapterattempt to integrateeconomic, "ip-*ies physical and biological proiesses.

Material Balances fte materiar barances(I\B) model provides a more comprehensivedescription of the relationship benreen the economyand the environment by considering natural resourcedepletion and pollutioo of environrnental resoluces.A simplified MB modelthat accountsfor the flàws of material and energy I'lthu the economy and benveenthe economy and the environmentis depicted in Figure 4.2-Theleft side of the diagramillusuaies the interactionsbetween firms and householdsand is identical to the circular flow model shownin Figure 4.1. The right sidg of the diagrarn depicts the environrnentalsector,which incorporatesrresiduals, assimilative capaclty of naturalsystems,recycling and enviroo*"ot t pollution.z Finns use material and energ-yin the forrn of huuranand naturalresources(A) to producecommodities that are sold to households(C). production activities generatematerial and energyresidualsthat are releasedto the environrnent(B). Households satisfy their wants and needsby c firms and environmental and.amenigrsen vices include such things as purification c tection from uluaviolet flfV) radiation Amenity services include outdoor recre placeto live. Consrmrptiongeneratesresidualsthat enter the environment(E). Residuals are storcd,dispersed,recycled or assimilatedby the naturalsystems.Recycling of residuals (F) extends the resourcebase.Natural resourcescan bé oepfeted ol ou"r*ploited. Use of exhaustiblepetroleurnresourcesdepletesthis resogrce. Renewable resourcessuch as soil are overexploitedwhen rates of use exceedratesof regen€ration- Pollution of natural resourcessuch as air and water occurswhen the flow of residualsinto ttre environmentexceedsthe rate at which natural systems can assimilate thoseresiduals (G > 0). Pollution decreasesthe capacity of natural systemsto

76

Natural Resource and Environmental Economics

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assimilab residuals (rD and results in resourcedegradation (Í). For exarnple,high nitrate-nitrogen concentrationsin runoff fro* ugti;ultura fields can impair reprodrrction and growth of plants and animalsin rivérs and lakes and can gspraminzf6 drinking water-Amore completedescriptionof the of the material balancesmodel is containedin Chapter9."or.iron-"","i;;;;;t \\e prirciple of rnaterial balancesstatesthat in a closed economy (no imports or exports) and in the absenceof accumulationof stocks of buildings, equipment, inventories and consumerdurables,materialand energyused in production andconsumption equal material and energyin residuarr,ouÀLty, A + D = B + E. The first two laws of thermodynamics,a branchof physics,form'th" theoretical basisfor the material balancesmodel- The first law of-therrnodynamicssays matter and energy can neither be creatednor destroyedQawof conseriation of matter and energy;.r1r, other words, the amount of energyand matteris constanl Implications of the first law were illustrated by Boulding.a He uSeda word pic_ ture of the earth as a self-containedspaceshiphaving an initial stock of resources and a limitless external supply of solar energy.If the spaceship's internal resources and residuals are not managedin a sustainabl"-*o"i, then Àe spacemeneventually die when natural resourcesare depletedand environmental resourcesare degraded' If the spaceship'slimited resourcesare used in a sustainablemanner,however' then life on spaceshipearthcontinuesindefinitely. The messageof Boulding,s metaphor is that the earth is a closedsystemwhose ability to support life depends on minimizing rather than ma,ximizingthe throughput of material and energy. The secondlaw of themrodynasricsstatesthatintropy increasesovertime- Entropy is the aurount of unavailableenergyand disord.er-in a system.Available energy is high (low entropy) in fossil fuel deiosits.These sources of energyareof high quality b'ecausethey can be usedùodo useful work. unavailabte energ! inqeasesas available sourcesof energyare usedup. when coal is burned i" . óo,optunq it generatesheat that is used to produce steam.Residuals from coal comlustion include heat' carbon dioxide, sulfur dioxide and particulate matter that go up the smokesraclqand coal ash, which accumulatesat the bonom of the boiler. The enerÉlycontent of the useful heat is eventually dissipated, and the energy content of residuals is irrmediately dissipated(high Entropy increasesas coal and "otropyj. other fossil fuels are burned.In this regard, tn"ànrv ouy ió reduce éo*opy is to reduceuseof fossil fuels. "o"rgy While the secondlaw is formulatedin terms of energy,it has beenextendedto material by Georgescu-RoegenA more generaleconomicintelpretation of the second law implies that economic activities transform useful (low entropy) material and energy into rrseless_ (hrsh enhopy) material and energy.As Dalys points oul 'Ttre throughput flow [of material uod maintains or increasesthe order "rr"rgy] within the human economy'but at the cost of crcating greaterdisorder in the rest of the natural world' as a,result of depletion and po[uúon.- people use material aud energy from the naturàl world (environment) io produce goods and servicesthat raise living standards.unfornrnately, goods*"* òog servióes uo r"o"r,roiof, li energy dissipates' placing further demandson natural systems.An important distinction exists be{een material entropy and energy while someresiduats can be recycled (aluminurn cans;glass bottles uJJ rr"*rpapers), "oópy. energ.yresiduers, such as waste heat from a power planE cannotbe recycled. Recycling extendsthe life of the natural resourcesusedin production.

7t

Natural Resource and Environmental

Economics

Ecological Economics costanzaet al.óhavedefined.ecological economicsas "a new transdisciplinary field of study that addresses the rehlonships tenveen ecosystemsand economic systems in the broadestsense."Ecological economics a more comprehensive view of this relationship than do neoclassicaleconornFk"t ics, resourceeconomics, environmental economi"r-* egglogy. Neoclassical economicsviews the satisfaction of human wants "oou"ntional as the ortffiul-go.r ot economic activity- Natural resourcesare not consideredto be a constraint on ec*nomic becauseof unlimited potential foi technòlogical innovation and rerywttt sourcesubstitution.Environmental economicsdealsprimarily with the management of environmentalresiduals and the valuation of u-i"ity servicesprovided by the environmenl Natural resourceeconomicsconcentrateson efficient allocation of renewable and exhaustibleresourcesover time. Conventionalecology is that subfield of biology that deals with the interrelationships betweenorganismsin a particular location. Ecologists focus on the productivity, stability and'resilience of natural ecosystems.Humans are just one of many species;however, unlike other species,they have the unique uUifity to manage the environmentfor personalgain. As Odumzpointsout, the exploitaúon of the environmentby h'rmans is *iucreasingly disruptiog, deshoying, the biotic componentswhich are necessaryfor ttheir] physiological "u"ocxistencé." So*" ecologists study human-pert'rbed ecosysterns.,r"È * ugrú"ory.tems. In termsof the relationship betweenecosystemsand.economic systems, which is at the coreof ecological ecouomics,Ebrlich andEhrlichEidentify severalways an ecosystemsupports the economy, including the following: a) by maintaining at_ mospheric quality by regulating gas ratios and fittering dust and pollutants; b) by ssntrolling aud amelioratingclimate tbroughthe carboncycle and effecf of vege_ tation in stimulating local and regional rainfall; c) by reguluai"g tetn-ater roppUo and controlting floodins; d) by generatinganOmaintaining soils through the deposition of organic matter and the relationshipsbetweenplant roots and mycorrhizal ltgtt e) by disposing of residuals, including domesúc sewage and.by-products from industrial and agriculturar production, anl rycring of nutrients; D úfcoorotling pestsand diseases;and g) by pollinating crops and-usefuIwild plant speciesUy insects,bats,hurnmingbirdsand otler pollinators.s Ecological economicstakesthe holistic view that humans,culturc and biological systernsco-evolve. Co-evolution implies that the cultural objective of rnaximizing short-term economic ouQut be madc subservientto long-terrn biological constraintson economicactivity. Constraintsincludethe capacity Jf nanrrat ,yr*." to assimilateresid.als, ethical concetnsfor ftrture generations(intergenerational eqoity)' and the survival of nonhumanspecies(biodiversity). Ecological economics :e-ws the economy as a subsysternof a laqgerfinite anà noog-irrrg ecosysîÉm. slhile neoclassicaleconomicshas a human.centered(anthropocentricj perspective of the economy'ecological economicstakesabiologically Uasea @iocenfoc)orece logically based(ecocentric) view. Adistinguishing fgaturc of ecological economicsis thepurposety conservative assumptionthat technological innovation doesnot eliminate resource constraintsto economicgrowttr"This assumptionis consistentwith a no-regretspublíc polícy for dealing with specific environmental problems. Consider a no.rcgrcts poticy for global warming-Thepolicy requiresdevelopmentof cost-effectiu" ttn ,oìogies and

1, EconomyandEn

ent

79

pricing policies to reduceglobal emissions of carbondioxide.Global warmingis attributed primarily to emissionsof carbon dioxide. If thepolicy is carried out and the threat is real' then the severity of the threat is reduced. There is no regret beca'se the policy reduced-the likelihood of global warming. r u" policy is not pursuedand the threat is real, then action could have reduced the tbreat.There is a regret for not taking action- of course,a nG-regrctsp?li"y has to ro*rr, the t1ryesof technorogies and pricing policies to be undertaken.The .o*"*itirr" ùechnologyassumptionof ecological economicsis quite different from the optimistic assumptionof neoclassical economics that technologicalinnovation is sufficient to ensurethat nan'a] resourcesare not a constrainton economic growth. A major goal of ecological economicsis to determine ways to maintain longtelrt sustainability of the integrated ecological-economic system.Achievement of this goal requires establishing the optimum scale of ,lr" ecosystem and implernentingpolicies and institutions "ooo*y relative to the that rnaintain the optimum scale' Dalyto definesoptimal scalein t"_-t: of the piyri"ur ri;;f ,h;Ji capitar stock' which includespeopleand their physical *dfú. The latter includes serviceyielding capital assetssuch

capitar .to"kisdirectry pro

f#tt

itrHilj;*S artifacts (inflow) and inven rcople and depreciation of artifacts (outflow). Maintair requires balancing inflow Jù;;or-^*.-*o"igy in the *ooo-""conomy choice""d of optimalscaleis subjectiveanddifficult becuos. it entailssocial,ethical and moral considerations.Daly opts for a scalethat achievesa sufficient Ievel of wealth to be sustainablein the l,ong run. sustainalitity requires the rate of throughput flow (depletionof natural resources and pollution) to be within the assimilative and regenerativecapacitiel of th9 Because.throughput flow representsa cost' it should be minimized subject ""o.yri.* to the constraint that tle optimal scaleof the economybe maintained. Ecological economictheory differs from neoclassical economic theory in rwo respects' First' neoclassicaleconomic th"ory is not concenredwith the optirnum scale of the economy-The only place neocrassical theory addressesoprimurn ssar, is in terms of the optimal scarcóf the physical facilitiesihor"o by a firm. Second, neoclassicalmacloeconomicsadopB the Lverall goJoi-*i-izing gross uational product (GÌ'IP), which is consistent with ttr" pniìosonit *, more is besl lvfaximizing GNp implies maximizing the flow of rnaner *i orny' This objective contradictsthe goal of ecological "o"rgy through the econ_ economics,which is to minirnizs ths cost of the throughput flow of matter and energy needed.to sustain the optrmum scale of the economy-Ecological economics embracesthe philosophy that enoughis bestThe economy does not automatically achieve an optirnum scale. As Dalyu points out "' ' ' just asthcre is nothing in úe pri"" ,yst"- that can identify the best distribution of ownershif according i9 criteriì of jritice, neitner is-trere'*r*o* that allows the price systemto determine the uotlur" or ttnougtput accordingto ecological criteria of sustainabiliry.-Th3refgre, an optimal scarerequires that specific actions andpolicies be undertaker.Thi;;; o"ry ffioses three policies or institutions for this purposq:stabilizilg the population'*a stoct of physicat arttfacts; keeping throughput flow below tionit ; ,no controlting the degreeof in""oÉgi"ul equality in the dishibution of services Írmongpeople.

80

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Economics

Population can be stabilized by transferable birth quotas (as first suggested by Boulding), raising educational and income levels of women in developing counties (which reduces fertility rates), farnily planning, and providing financial disincentives for increasing family size. Keeping throughput of matter and energy below ecological limits can be achieved by imposing severancetaxes on, and/or auctioning depletion quotas for, extraction of exhaustible resources; imposing taxes on renewable resources that take effect when the rate of use exceeds the rate/of regeneration; setting harvest quotas or limitations on exploitation of renewable resources; limiting disposal of residuals and potential pollutants; taxing emissions of potential pollutants; protecting critical habitats of rare and endangered species; and others. Inequities in the distribution of services among people (disributive justice) can be alleviated by tax policies designed to redistribute income (alrea.dy done in many countries) and international aid from developed to developing countries. Ecological economics is sirnilar to the material balances approach. Both approaches account for the two major linkages between the economy and the environment; namely, the environment supplies the economy with productive natural and environmental resources and amenities, and the economy generates residuals that enter the environment. Material balances and ecological economics approaches are compatible with the first and second laws of therrnodynamics. There are two fundamental differences between the two approaches. First, ecological economics views the economy as a subsystem that is capable of exceeding natural and environmental resource capacities. Ecological economics supports actions and policies to keep the economic subsystem within the biophysical limits imposed by the parent ecosystem- Second, ecological economics is concerned about the optimal scale of the economy and development of nanual and environmental resource accounts that trace the adverse effects of economic activity on natural and environmental resources. Neither of these issues is addressedin the material balances approach.

Sustainable Development The'sustainable development approach attempts to balance the cornucopian view that continued economic growth is essential andpossible with the neo-Malthusian view of ecological limits to economic growth. The cornucopian element recognizes that economic growth is needed to increase per capita household incomes and living standards in the face of population growth. Economic growth appears to be essential in developing countries because of their generally low incomes, substandard living conditions and rapid population growthThe neo-Malthusian element qf sustainable development acknowledges that ecoiomic growth typically results in the degradation of natural and environnental resources, which, if unchecked, reduces long-term prospects for economic developmenL Because developed countries account for a disproportionate share of natural resource use and environmental degradation, global sustainable development addresses sharing of benefits and costs of reducing global environmental impacts between developed and developing countries. Sustainable development originated in 1968 with the Paris Biosphere Confer-

4, Economy andEnvironnent

8l

ence and the Conference on the EcologrcalAspects of Intemational Development held in Washington,D.C.r2Both conferencespointed our that policy ptanning and development generally ignore environmental inpacts becauseof lack of interest and/or limited financial and technical resources.Sustainabledevelopment is an integralpart of theV/orld ConservationStategy, which prornot€sthe .lnaintenance of essentialecological Processesand life-support systems,the.preservation genetic of diversity, and the sustainableutilization of speciesand ecosystems.',r3 Economists have criticized the definitions and objectivesof the World ConservationStategy for being impractical and for not paying attention to tradeoffs betweeneconomic and conservationobjectives.t+ The concept of sustainabledevelopment achieved prominence during the United Nations Conferenceon the Human Environrnentheld in Stockùotm in Lg72. It was finnly establishedas the focal point for international developàeoiUy ,n" United Nations Conference on Environment and Development neia in Rio de Janeiro in 1992-The most often quoted definition of sustainabledevelopment appears in the Brundtland Comnission reportls "sustainable developm"oi i, development that meetsthe needsof the presentwithout compromisingtire abitity of future generationsto meet their own needs." The definition impúÉs a balanling of resource use between current and future generations.The gruìaUana report iiaicatesthat sustainabledevelopmentrequireskeeping consumptionlevels qfi*,in ecological bounds,ensuring increasedproduction potentiA and equity, protecting lifesupport systems, using nonrenewable resources at rates below the limits of regeneration and regrowth, depleting exhaustibleresourcesat rates that minirnize foreclosure of future options, and mininrizing adverseimpacts on environmental quality- The Bnrndtland Commission's definition of sust"rnabledevelopment has been endorsedby the World Bank While theBmndtland Commission'sdefinitionof sustainabledevelopment has broad-basedappeal, its implementationis no simple matter.For exampll, what is meant by mceting the needsof the current generation?How is it to be deternined whether the ability of funre generationsto meet their own needsis being compromised? These are difficult questions. Pearceet al-r6believe that sustainabledevelopmentshouldbolster indicators of economic development over time. Typical economic developmentindicators include rising levelsof per capitaincoml, higher levels of educationalattainmenL improved health care and nutrition, a more equitable distribution of income, ild gfowth in personalfreedoms.According to pearceet al.,lz a necessary condition for sustainabledevelopmentis that the current level of natural capital stock (defined as the *stock of all environmental and natural rcsourceassets")be rnaintained. Maintaining the current level is preferableto achievingthe economically optimal level of natural capital stock-which is likely to be lower--$ecause of thi m-ultiple usesof natural resources' uncertainty and irrcversibilities regard.ingthe cons{uences of natural resource'depledionand environmental degradation,and the nonefficiency benefits of natural capital, suchas provision of life-support systemsClugstontt statesthat (sustainabledevelopmentàoesnot endangerthe atrnosphere, water' soil' and ecosystemsthat support life on earth.It is a Oy-narnic process in which resource use, economicpolicies, technorogicardevelopmlng popìhtio1 growtb" and institutional stnicturesare in harmony,contributing io both tt pr*"oa and future potential for hrrmanprogress."He also points out that sustainability " im-

n

Natural Resource aud Environrnsqtn I Econonnics

plies a deep ethical and moral connectionto all of creation. Clark has identified three obstaclesto sustainabledevelopment.reFirst, a tagedy of the corrìmonsoccurs at the international level becauseindividual countries are often unwilling to cooperatefor the puq)oseof alleviating global environmeatal problems, such as climate change and ozone depletion. Wttit" there have been successesin international cooperation,fruskationr Luu" been more courmon. A successfulinternationalugt""^ot is the 1984Montreal protocol, c/hich estab. lished targetsfor reducing emissionsof cholorofluorocarbons(CFCs), the primary chemicalagentin ozonedepletion.Incontrasf the lgg2United Nations Coùerence on Environment and Develolment (Earth Summit), which focused on sustainable development,left much to be desiredin the areaof climate changeand.biodiversity. The Earttr Smmit's agreernenton climate changedid not include specific targets and timetablesfor reducing carbondioxide emissions,and the treaty io protect biological diversity was weakepedby lack of support frorn the United Staies.m These events underscore the difEculty of securing international agreernent to alleviate global environmentalprroblems. Second'uncertaintyregardingthe environmentalbenefitsof reducing pollution stymies the willingness of countriesto take appropriateaction. president Bush was unwilling to agree to specific reductions in carbon dioxide emissions at the 1992 Earth Summit becausethe cost to the United Stateseconomywas thought to be too high and the benefitsof reducingglobal warming, too uncertain.william Nordhaus estimatesthe worldwide cost of controlling global warming to be $25O billion per year.2lAccording to Flavin andLenssen,zimplementingtechnologiesto reduce carbon dioxide emissionsin the United Statescould cost betweenseveral hundred billion dollars and $3.6 trillion. Third' calculating the presentvalue of a resourceinvestment using a high discount rate (as opposedto a low discount rate) could lead to a shift in resource use from the funrre to the present,provided ttrat it doesnot renderthe investrrenr economically infeasible. If this shift occurs,then the welfare of the present generation increasesand the welfare of funue generationsdecreasesbecausethe rèsource is used up more quickly. d'Arge8 arguesfor "exceedinglylow, if not zero,,'discount rates in casesinvolving intergenerationalchoices.Relative to a high discount rate, a low discountrate generallylengthensthe time period over which natural resources are used' which benefitsfuture gerierations.A low discountrate can, however, also increasethe economicfeasibility and selection of resourceinvestnents that have a high initial capital cost andeconomicbenefitsspreadout over severalyears, such as developmentof water resourcesfor hydroelecúic power generation.Should this occur, the presentgenerationbenefitsat the expenseof funue generations.It is, therefore, diffiicult to generalizeabouthow different discountratesinfluence resourceuse and intergenerationalequity. ,, Howarth and Norgaardz+suggestthat the d.ileurmaregarding intergenerational consequencesof different discotrntrates can be hvoidedby assigning future generations specific rights to naturalandenvironmentalrcsources.Tntheiricherne, future generationsare given a right to specific qrrenliliss and quatities of fossil energy, minerals and water resources,as well as environmentalresources.This .ppro*Èi. quite similar to the way by which individuals are protectedfrom criminal acts. Ail individuals, regardlessof generation,have been grantedrights of protection from thieves and rnurderers.Levels of protection are ooi burcd on the presentvalue of future benefitsand costs,but rather on the d.ecisionthat suchprotéction is a right.

4, Economyand Environment

SUSTATNABLEREsouRcE UsE

E3r

while thereis broadsupportfor susrain-

able development' there havebeenfew atteu.rptsoutsideof nanrralreso'rce and.environmental accounting (sec chapter 10) to àevelop an economic framework that incorporatessustainableresourceuse.This section di""orr", sucha framework and its practical implementation. sustainability implies a balancingof economic and environmental objectives.The economicobjecùve can includJseveral suchas income, emplolmrentand inflation-The environmental "o*poo"no, objective reiects the quality of air, soil' water and wildlife resources.Therefore, amuùple objective decision-makingframework is well suitedfor evaluatingsustninable rcsourceuse. In a multiple objective frarnework, resourcesari aevoteato the achievement of economic and/or environmentalobiectives. Resourcesare denoted by the vector x' The elernents of x include naturalresources,labor and manufactured capital- Becauseresources are limited, x is finite which constrainsthe attainmentof economic and environmental objectives-For a grven technology and finite resources,allocating more resources to attainmentof the econornic (énvironmental) objective eventually curtails attainment of the environmental (economic)objective. 'The relationships betweenattainment of economic (EC) and environmental (EV) objectives and resourceuseare as follows: EC = EC(x"q) and EV = EV(xgv), where xr. and xEv are the resourcesallocated to achievement of economic and environmental objectives, respectively,and r-c * xEv = x. EC (EV) incrcaseswith re_ spectto xec (xev). Given these production relationships, mathematical optimization techniques can be used to deterurinethe effrcient allocation of resources to the economic and environmental objectives-Efficient combinationsof objectives lie on the efficiency frontier illustrated in Figrrre4.3.ÉThe frontier is concaie (bowed outward) because allocating more resourcesto achievementof the economic(environmental) objective decreasesachievementof the environmental (economic) objective The combination of economic(Ec) and environmental @V) objectiveschosen by anindividual dependson that individual's preferencesf,ortrre nvotbjectives. The tetm indíviùtal'is usedherein a geireri" r.*é. It encompasses a wide range of economic agents including businesses,consutne{s, govemment and.public interest grouPs'The relevant point hereis not who the individual is, but rather that ind1viduals have different preferencesfor objectives. Supposethe satisfaction that individual i and individual j receivefrom the economic and environmental objectives can be representedby the following utility functions: Ur = Ur[EC(x), EV(x)] Uj = UjtEC(x), EV(x)1. Correspondingto eachutility function is an indifferencemap. Superimposing the indifference mapsfor individual's i andj on the efEciency frontier, and locating 1fostan$encybetween.theefficiency frontiei and the highest indifference curve for eachindividual' grve the equihbriashownin Figure 4.4.-Individual i selectsEC, and E\/t and individualJ-t"t:tt EC, and H/.i of thetonomic ana environmentalobjectives, respectively- In this example,inalviaua i's preferences favor the economic

Figure 43.

Efficiency firontier for economic (EC) and environmental @V) o;bjectives-

EC

El/i

Eivj

= economic Figure 4.4" Equilibriun choice of objectives for individuals i and j. EC objective; EV = environmental obiective; and U = utilit5r-

4. EconomyandEnvironment

t5

objective and individual j's preferencesfavor the envirormrentalobjective. Therefore, individual i selectsrelatively more of the economicobjective and individual j selectsrclatively morc of the environmentalobjective.For eachcombination of objectives on the efficiency frontier, there is a unique and efficient allocation of resourcesthat achievesthat combination. Sustainabletesourceuse can be consideredin the context of the examplejust describedby posing the following question.Are the combinationsof objectives and . underlying resourceallocation that maximize utility for individuals i andj sustainable? The answer requires specifying those combinationsof objectives that imply unsustainableuseof resources.For example, cornbinationsof economic and environmental objectives that trnovidehigh (low) achievementof the economic objective andlow (high) achievementof the environmentalobjectivemight be considered unsustainàble-This would eliminate, for example,combinationsof objectives above the upper sustainability contour (Cu) and below the lower sustainabilit5rcontow (CJ in Figrne 4-5.Deterrrination of the sustainabitty contoursis not a sirnple matter. Ideally, it should be basedon feedbackfrom scientists,policy-makers, government, businessand the generalpublic. For the placementof the sustainability contoursshownin Figure 4.5, neither individual i's norindividual j's equilibrium combinationof objectivesis sustainable. The segment of the efficiency frontier between the sustainability contotrs (AB) contains the efficient and sustainablecombinationsof objectivesand corresponding

EC

Figure 45. Sustainableand efficient conbinations of econonic (EC) and environmental (EY) objectives.

t6

Natural Resourceand Environmental Economics

resource allocations. Therefore,the extent to which sustainableresource use constrains the choice ofobjectives dependson the natureofpreferences and the availability of resources. Except when segmentAB is very short there is still a need to resolve r€source use conflicts between individuals. For the sustainability contours given in Figure 4.5, individual i would prefer to be at A and individual j would prefer to be at B when choices are constrainedto the sustainablesegmeqtof the efficierlcy frontier. Becausethere is still a relatively large discrepancybetweencombinations A and B, conflict resolution would be neededto determinea compromisecombination of ob jectives. This conceptualframework provides a basis for imFlementing sustainableresource use.The three major elemenB of the franrework are the efEciency frontier, the sustainabilitycontoursand individuals'preferences.The efficiency frontier can be determinedfor given technologiesand resourceendowments.For example, Xu et a1.26estimatedan efEciency frontier for farming systemsthat achieve three objectives: maximum profit, minimum soil erosion and minimum nitrate leaching through the soil. Deterrrination of the sustainabifirycontoursis not a simple matter becauseit involves considerationof the long-term economicand environmental impacts of different patternsof resourceuse. Conceptsbeing applied in natrual resourceand environmentalaccounting,such as adjustnentsto GNP for depletion of exhaustibleresources(seeChapterl0), would be useful in evaluatingsuch consequences.Finally, preferencesfor the multiple objectiveswould ultimately detersrine which of the sustainableand efficient combinationsof objectives and underlying resourceallocations would be preferredby different individuals.

Summary The traditional circular flow model of the economy does not account for biophysical limits to economic activity. Extensions of the circular flow modei based on materiai balances and ecological economics offer a more integrated view of the economy aid the environmenL The material balances model focuses on the depletion of exhaustible resources and exploitation of renewable resoruces in economic production and consumption, as well as residtrals and pollution generated by natural resource use, production and consumption. Ecological economics views the economy as a subsystem of a finite and nongrowing ecosysùem, which implies that economic growth is constrained by the capacity of nabrral resources to support ecodomic activity and of environnental resources to assimilate rcsiduals, Ecological economics is concerned about the optimal scale of the econbmy and accounting for resource d'epletion and degradation in rneasuring economic progress. Sustainable development attempts to balance the economic benefits with the resource and environmental costs of growth. It is achieved when the needs of the current generation are met without compromising the ability of funlre generations to meet their own needs. Sustainable development requires keeping consumption levels within ecological limits, ensuring increased production potential and equity, protecting life-support systems, using exhaustible resources at rates below the lim-

4.

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Economy and Environment

its of regeneration and regrowth, depleting nonrenewableresourcesat rates that minimize foreclosure of future options, and minimizing adverseimpacts on environmental quality. Achíevement of sustainabledevelopmentis often thwarted by discounting, a procedurethat reducesthe value of futurc benefitsand costsfrom the developmentand use of natural and environmentalresources.An alternativeto discounting is to give futrne generationsrigbts to a minimum quantity and quality of natural and environmental resources.

Questions for Discussion 1. The circular flow model of an economyis suited to conditionsin a frontier economy,which has a relatively small population, primitive technologyand abundant suttlies of natural Fesources.The model is less appropriatefor an industrial economy, where population and resourceuse are high relative to ecosystems,and technologies have a greater capacity to degrade natr.ualand environmentnl resources.Are you in agreementor disagreementwith this statement?Explain. 2. Would someonewho embracesthe conceptof ecological economicsbe content with the material balancesapproach?Explain. 3. Are the following activities sustainable:a) imposing a tax on the saleof petroleurrrproducts and using the tax revenueto develop a substitutesourceof energy and b) hanesting timber at a rate that exceedsnew tree planting and natural regrowth? Explain.

F'urther Readings Costanza, R. and H. E- Daty. 1987. '"Toward an Ecological Economics." Ecological Modelíng 38:l-7. Dorfotan" Roben and Nancy S. Dorfuan" eds. 1977. Economics of tlrc Envitonment, 2nd ed. New Yorlc W.]È/. Norton & Co. Kneese, Allen V., Robert U. Ayers and Ralph C. d'Arge. ITIO. Economics and the Envircrunent: A Materials Balance Approach. Washington, D.C.: Resources for the Future. Kneese, Allen V. 1977. Economics otd tlu Envirowncnt. New Yorlc Penguin Books. Olson, Richard IC, ed- 199'2. Integrahg Sustainable Agiculrure, F*ology, ond, Envírcnm'ental Poliq. Binghamton, New York Food Products Press. Pearce, David W. and R Kerry Thnrer. 1990. "Ihe Circular Economy." Chapter 2 in Economícs of Naural Resourr'esand the Envircnncnt. Baltimore, Maryland The Johns Hopkins University Press, pp.294z.

Notes 1. A. N. Whitehead.Processand Reality(New York Harper, 1929). 2. A- Myrick FreemantrI, RobertH. HavemenandAllen V. Kneese,TlrcEconomicsof EnvircrunentalPolicy (New York JohnWiley & Sons,1973),pp. 11-16.

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Natural Resourceand Environmmtal Economics

3. Nicholas Georgescu-Roegen, The Entropy lait and tlu Econornic Process(Cambridge, Massachusetts:HarvardUniversity Press,190). 4. KennethBoulding,'"TheEconorúcsof ComingSpaceship Earth,- ia Envimrunental (Baltimore, Maryland: Jfts J6hnsHopkins Quality in a Grcwing Econonry,Henry Jarre$,ed. Univenity Press,1966). 5. Herman E. Daly, 'Entropy, Growth and the Political Economy of Scarcity," in Scarcity and Growth ReconsideredKerry SmittL ed (Baltimore, Maryland: The JohnsHopkins UniversityFless,1979),p.76. € 6. Robert Qe6tnnz4Herman E Daly and Joy A Barttrolomew,"C:oals,Agenda, and Policy Recommendations for EcologicalEconomics,"in Ecological Economícs:TheScíence and Mougenrent of SustainaAilíry,Robert Costanza,ed- (New York Columbia University Press,1991),p. 3. 7. Eugenep. Q(lrrm,Fmda nentalsof Ecologt,3rd ed- (Philadelphia,Pennsylvania:W. B- Sanders, l9'Il), p.251. 8. P- R. Ehrlich and A. H. Ehrlich, Exthction: Tlu Causesand Consequencesof tttc Dkappearance of Species(New York RandomHouse, 1981). 9. Reed F. Noos and Allen Y. Cooperrider,SavingNaturcb Legacy: Protecting and RestoringBíadiversity(Washington,D.C.: IslandPress,199rt),p. 21. 10. Herman Daly, Steady-StateEcorzomícs,2d ed- (Washington,D.C.: Island Press, 1991). ll- Ibid.,p. 190. 12. Lynton IL Caldwell, '?olitical Aspectsof Ecologically SustainableDevelopmentEnvircrunentaI Consemation 2(1984):299-308. 13. International Union for the Conservationof Nature CIUCIù, World Consemation Strategy: Livhg ResourceConsenationfor SustainableDaelopmezr (Gland, Switzerland: ruCN-NEP-W'WF,1980). 14.Edward Barbier,Economics,Natural-ResourceScarcityand Development:Corwentional and Alternative Vews (Iondon: EarttrscanPublications,Ltd-, 1989). 15. World Commissionon Environmentand DevelopmenEOur CornrnonFzrzre (New York Oxford UniversityPress,1987),p.43. 16.David Pearce,Rlward Barbier andAnil Markandy+ SustainabtcDeveloprment:Economicsstd, Environm.ent intheThirdWorld (London:Earthscanhrbtications,1990),pp-2-3. 77.Ibid, p.l. 18. RichardM. Clugston,"ATurning Poing" Eanh Ethícs (Washington,D.C.: Center for Respectof Life and Environment,Winter 1992),p. 5. 19-Colin Clarh 'EconomicBiasesAgainslSustainable Developmen\"EcologicalEconomics: The Scienceand Managementof Sustahabfliry Robert Costanza ed. (New York: ColumbiaUniversityPress,l99l), pp. 31L330. 20. Robert'W.Fri,'Environment andDwelopment The Next Step," Resourees.(Washington,D.C.: Resourcesfor theFuture,Mnter 1993),pp. lGl8. 21. As quotedin CbristopherFlavin andNicholasLenssen,"S'aving.theClimate Saves Money," WorldWatch(Washington,D.C.: WorldwatchInstitute, NovemberlDecember1990), pp.26-33. 22.F1avenandLenssen(1990). ,ì 23. Ralph d'Arge, "Matking Time with CERCLA: Assessingttre Effect of Time on Damagesfrom HazardousWastes;"chapter12 n ValuingNatural Assets:Tlv Economicsof Natural ResourceDamage Assessmcnt, RaymondJ. Kopp and V. Kerry Smittr, eds-(Washington,D.C.: Resourcesfor theFuture,1993),p.248-263. 24. Richard B. Howarttr and RichardB. Norgaarù t'IntergenerationalResourceRights, Efficiency,and SocialOptimality,"Land,Economics66(1990):l-ll. 25.V. ChangkongandY. Y. Haimes,'The SurrogateWorth Trade-offMethod and Its Extensions," chapter 8 n Multiobjective Decisíon Malcing: Theory and, Metltodolagy (New

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E9

Yorlc Elsevier-NorthHollan4 1983),pp. 352_3g2;J. L. Cohon,Muttiobjecrtveprogmm_ ming and Plaming (New York AcademicPress,1978);J. L. CohonandD. H. Marks,*Multiobjective $sreeningModelsandWaterResourcesInvestment,"Waîer Resources Research 9:(1993):82G836; and Y. Y. Haimes and V/. A. Hall, ,.Multiobjectivesin Warer Resor:rce Systems Analysis: The Sunogate Worth Tradeoff Metho4" Water ResourcesBulletin 10(1974):61fr2426- Feng Xu, Tony Prato and Jian C. Ma, "A Farm-Level CaseSurdy of Sustainable Agricuthual Production,"Jountal of soil and water consewarton50(1g5):39-44.

CEAPTER

5

Property Rights and Externalities A resourcewhose rights are unassignedis likely to be abused --Rrqreno L. Sreoup exo Jorw A. Bnoelr,1983

well-known conclusion of welfare economics is that a purely competitive marketeconomy automatically achievesan efficient use of resources.'Wheremarketsdo not exist for resources,the rnarketsthat do exist are incomplete, or externalitiesare presenf andthe useof natural and environmentalresourcesis not socially efficient. These inefficienciesczn take the forrr of excessive depletion of exhaustibleresonrces,overexploitationof renewableresources,andenvironmental pollution, all of which decreaseeconomicwelfare. 'When this occnrs, the economyexperiencesaloss in economicwelfare.This chapterconsidersthe distinction betweena centralked economyand.a marketecorrorúyand explainsthe role and importanceof fficient property ríghts andtratuaction cosfsin achievingan efficient use of resources.Causesand consequences of market failures, particularly enernalitíes, are discussedFinally, the pros andconsof governmentinteruentinnto alleviate exte,malitiesare discussed.

Markets and Efficient Property Rights II'IARKETS. Whilc it is possible to achieve efficient resorrrceuse without reliance on markets,the informational and computational requirenents aÍe very high. An alternative to a market economy is a cenEally plannedeconomy.Acentally plaaned ecorrotny is a form of economicorganizatiea in which decisionsregardingwhat to produce,how much to produce,whereto produce, how to distribute pircduction,and the level of resourceand commodity prices are determinedby governmentcommittees.EfEcient use of resourcesin a centrally planned economyrequiresinfonnation on input requirementsand output po$sibilities of alternativeproduction technologiesfor all locations and points in time; consumers' willingness to pay for all commoditiesover time and space; and transportation, marketing and distribution requirements and costs. Based on this information, the government committeeshave to determine the production, con-

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sumption and prices for all resourcesand commoditiesfor all regions and time periods. Therefore,a centrally plannedeconomyrequiresthe orchestrationof, literally, thousandsof economicdecisions. Purely competitive rnarkets automatically achieve efHcient resource use through the independentprofit-maximizing behavior of firms and the independent utility-maximizing behaviorof households,provided there exists an efficient set of property rights. Propefi rights are instinrtional rules that govern anú-facilitate the use and exchangeof resourcesand commodities.Efficientproperty rights are a prerequisite for market transactions. Market equilibrium prices and quantitiesareinfluenced by the specification of property rights. This is illustrated in Figure 5.1, which shows the market demand and supply curvesfor an agricultural crop underpure competition. Under pure competition a) thereis a large numberof producersand consumers;b) no one producer or consumercan influence the price receivedor paid for the product; and c) there is no uncertaintyregardingproduction technologres,consumerpreferencesand prices. In Figure 5.1, D is the market demandcurve. It has a negativeslope becausebuyers are willing to purchaseadditional units of the crop Írsthe price of the crop decreases, other things equal.Marginal cost (MC) is the market supply curve that is the sum of the marginal cost curves above averagevariable costs for all firms producing the crop. It is positively slopedbecausesellersare willing to sell more of the crop as the price increases.The profit maximizing level of crop production is Q where P, = MC. Q, is also known as the privately efficient level of production.

QuartiÈf

Figure 5.1. Privately efricient crop prducfion (QJ and price (PJ, ud socially efficient crop production (QJ and púce (pJ' in a purely competitive marhet. D = demand; MC = marginal cost; and MSC = marginal social cosÉ.

5. Property Rights and Extemalities

lR

In selecting the profit maximizing output, firms typically do not consider environmental damages caused by production- For exanple, qunoff from agricultural fields carries sediment, fertilizers and pesticides to nearby streams and lakes, which can result in water pollution. Marginal cost exclud€s damagescaused by water pollution. Adding the marginal environmental damages-from crop production to MC grves the marginal social cost (MSC) of crop production. Thesocially efficient level of crop production is Q. where p, = MSC. When farmers have a right to pollute water, they ignore the environmental daurages from crop production and select the privately efficient level of crop prcduction, which is Q. BecauseMSc > MC, q < e" and p. ) p, production and pollution are higher and prices are lower when producers have the right to pollute water.'When producers do not have the right to pollute water, sociefy has the right to take action to reduce pollution damages.Suppose this action is in the form of a tax on production. Imposition of the tax causes the MC curye to shift upward by the amount of the tax. An increase in MC causes the profrt maximizing production level to decrease. ff the tax equals the difference between MSC and MC, then the market achieves equilibrium where p = MSC and the privately efficient level of production equals the socially efficient level of production.

EXT'ICIENT PROPERTYRIGHTS. Property rights are efficient if they satisfy four basic properties: ownership, spectficrry, transferability and enforceability. Ownership is the legal mechanism for conveying property rights to a resource. It determines who has the legal right to use a resource. In cases where resources are privately owned, ownership is securedbypayment ìn an amountthat is mutually agreeable to buyer and seller. Payment can be in the form of legal tender (currency) or other resources (barter). Several t)?es of ownership are possible. At one extreme is exclusive ownership, which is the most restrictive forrn of ownership. Exclusive ownership of a resource requires that all benefits and costs associatedwith the ownership and use of the resource be borne by the owner. Suppose odor from a pqper mill pollutes the air in a nearby community. If the cost of air pollution is not considered by the paper mill owner, then exclusivity is violated. Exclusíve ownership allows the resource owner to let another party use the resource. For example, an absenteelandowner can lease the farming rights to his or her land to another parry in return for a share of the crop or a flat fee. Leasing of land and other resources involves certain terms and conditions. Violation of these terms and conditions can result in rernedial action, including termination of the lease. At the other exteme of the ownership spectrum is res nullîus, which means that the property belongs to no one. While exclusive ownership allows the resource to be bought and sold, res nullius prevents it Another form of ownership is res communis, which refers to common or conrmunal properry that is owned and/or managed by a grcup of kindied individuals, such as a tribe or clan. Specificity of property rights refers to the bundle of rights that apply to a particular property. It determines what can and carinot be done with ttre resourie. Consider what happens when the cattle owned by a rancher grÍrze on a neighbor's land, causing damages to the land. The neighbor's property rights are being violated if the rancher does not have permission to gl:aa;ec*tle on the neighbor's land- Under this specification of property rights (lack of permission to graze), the rancher is legatly required to keep the cattle off the neighbor's land- If the neighbor's land is desig-

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nated as open range, however, then the rancher has a right to graze cattle on the neighbor's land. Under this specification of properry rights, the only feasible way to keep the cattle off the neighbor's land is for the neighbor to install fencing, which is costly. ffcattle grazing is not covered by a property right, then a conflict is likely to arise between the rancher and the neighbor. Resor:rce conflicts can be resolved when the rights of the rancher and thq neighbor are completely specified. An efficient property right is transferabla which allows resourgtrs to be allo' cated to their highest valued use. For exanrple, in an effort to reduce erosion rates on highly erodible lan{ the United States govemment created the Consenration Reserve Program (CRP) in 1985. The CRP allows the governmeiit to purchase the cropping rights on highly erodible land for a period of 10 yeani. I-andowners who participate in the prograrn relinquish cropping rights in return for an annual rental payment. The CRP was possible because landowners could transfer cropping rights for specific parcels of land to the government. If the cropping rights to land could not be ù'ansferred independently of other rights, then the only way the federal government could have achieved the benefits of the CRP would have been to buy the land outright or to prohibit agricultural production on highly erodible land- The former would be very expensive and cumbersome and the latter very unpopular. Transferability of one or rnore elements in a bundle of property rights makes possible the leasing of private land, creation of utility emements and the existence of restrictive covenants. Ownership, specificity and transferability of property rights are of limited value in achicving efficient resource use without enforceability. Enforceability requires that the property right be enforceable and enforced when there is a violation. A right that is not enforceable is of little value. Consider eutrophication of a lake, which occurs when some of the phosphorus in livestock manure applied to the land surrounding the lake washes into the lake. Even if a phosphorus loading standard was established for the lake (phosphorus loads below the standard do not cause eutrophication), it would be ve-ry difficult to enforce the standard without detailed assessmentsof manure application rates and phosphorus transport to the lake. In contrast, it is relatively easy to determine the sources of phosphorus loading to the lake and to enforce the standard when phosphorus enters the lake througb pipelines connected to industrial facilities. In both cases, enforceability requires that water qualit-y in the lake be monitored for violation of the standard and that sources contributing to ttr. violation be identified. Enforcement requires that appropriate legal action be taken when a violation occurs. For example, offenders (sources vioIating the standard) could be required to reduce their phosphorus loading to the lake or pay a fine. Even when enforceability is feasible, violations can occur. Tbvo types of violations are possible: unintentionell and intentional. An unintentional violation is one _-thatoccurs even though best management practices are being followed- Phosphorus pollution of the lake by nearby farms is likely to occur when there is a heavy rain on the day following application of manrue. This type of pollution is unintentionalPollution of the lake by industrial sources would be intentional when the industy knowingly releases an amount of phosphonrs to the lake that exceeds ths standard. Industrial sources might risk paying the fine when the expectedpenalry Grobabilitf of a being caught times the amount of the fine) is less than the expected benefit or exceeding the standard (reduction in phosphorus disposal costs).

5. hoperty Rights and EÍernalities

95

TransactionCosts While establishment of effrcient property rights is a necessary condition for efficient resoruce use under pure competition, it is not costless. The costs of achieving efficient property rights are called traruaction cosrs. Transaction costs are usually small when only a few individuals are involved and the conflict is minor. However, transaction costs can be high when nuny parties are involved. Consider the tremendous social, economic and political cost incurred.by countries in the former Soviet Union when socialism rr as renounced in favor of catr> italism" The high initial cost of establishing a market-based, capitalistic system was essentially a front-end transaction cost of establishing efficient property rights. In addition, market-based economies incur a perennial cost of maintaining the property rights system once it is established- Perennial transaction costs include the cost of deciding which rights will be deterrnined by market vensus nonmarket (political) forces, resolving conflicts in resource use, and enforcing property rights. The costs of deciding which rights are determined by market versus nonmarket forces or a mixture of the two is illustrated for health care in the United States. Historically, access to health care in the United States is determined by market forces. Persons who have the opportunity and financial mearìs to enroll in private health care progrÍlrrut have greater access to health care than do those who cannot afford such programs. As with all market-based solutions, those who desire and can afford health care purchase it Others either do without or make do with lower quality health-care services. An alternative to private health care is publicly supported health care, sometimes referred to as national health care or socialized medicine. under national health care, the federal gove.rnment has a much grcater role in determining health care rights for citizens and in contolling access to health care providers. Properry rights have been more difficult to establish in health care than in more traditional areas such as national defense, space exploration, social security, national parks and wilderness preservation. Resolving tesource conflicts constitutes a major perennial Eansaction cosl Examples of resource conflicts in the United States include competition between agricultural, energy and urban water uses; accessto and/or use of public lands for grazing, mining, timber hawesting, water supplies, recreation and endangered species; encroachment of prime agriculnrral areas by urban development; pollution of air, soil and water by agricultural, urban and industrial activities; and others. on a global scale, resource conflicts are caused by global warrning, deforestation, ozoue depletion and loss of biological diversity. Finally, enforcernent of property rights entails major costs. Conflicts exist at all political levels flocal, state, regional, national and international) and are increasing due to development, population and environmental pressures; Do the benefits of establishing effrcient property rights outweigh the costs? Even in cases where mArket allocation of resources is desirable, it may not be practical. Returning to the eutrophication example, phosphorus lsading to the lake can originate from any of the land that drains into ttre lakes. This makes it ditEcult to pinpoint each land parcel's phosphate loading to the lake. Under these conditions, it would be very time-consuming and costly for landowners to negotiate efficient property rights in clean water and to enforce those rights. Providing landowners with technical and financial assistance for best management pr:rctices for manure disposal is likely to be a more practical and cost effective than a market solution.

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Market Failures There àre three conditions under which operation of free or incomplete markets fails to achieve efEcient resorrce use:

1 . The market is not purely competitive. 2- The resourceis a common prop€rfy or open accessresource.4r J.

There are externalities.

Each of theseconditionsconstitutesa marlcctfailure.'fue failure does not mean there is somethingmorally or ethically wrong with the markel Rather, it implies that the prices generatedin the market do not provide firms and householdswith the incentives neededto achievesocially effrcient resourceuse.This section considers market failures due to imperfect competition and courmonproperry or open access resources(conditions 1 and 2). The next sectionconsidersmarket failures due to externalities. A market failure occurswhen the market for a resourceis not purely competitive. Supposethere is only one buyer of a resource(monopsony) instead of rruiny independentbuyers (pure competition). The demandcurye for the commodity produced using the resource(D), the marginal cost of production for apurely competitive industry MCJ, and the marginal cost of production for a monopsonist (MC-) are depicted in Figure 5.2. Under pure competition, individual firms cannot influencethe price paid for theresource.Each firm can purchaseas Erany units of the re-

guaatiÈy

Figure 52.

Market f,ailure from rnonopsony.D = demand; and MC = marginal cost.

5. hopeúy Rights and Extemalities

y7

sourceas neededat the market price. Therefore, the marginal costof production underpure competition (MCJ is determinedby adding up themarginatcosr cunresfor all firms in the industry. 'When there is only one buyer of the resource,namely,monopsony,additional units of the resourcecan only be purcbasedby paying a higherprice. The higher price applies not only to the last unit purchased"but to att units purchased.Therefore, MC. > Mc", which causesthe equilibrium price to be higher (p. > p.), and the equilibrium quantity to be Iower (Q- < Q), with monopsonythan with pure competition. Resource use is not efficient with monopsony. Inefficiencies causedby monopsony and other forms of imperfect competition reduceeconornicwelfare.

coMMoN PROPERTYaND OPENaccEss REsouRcEs. Naturatresources can be managed as comÌnon property or open accessresources. Common property resources are resources that are owned in cornmon and managed for a common pu{pose. Owners have exclusive rights to the property but cannot exclude one another from using it. There may or may not be restrictionS on how frequently ownerc may use the resource. If frequency of use is not restricted, as in a city park, then the resource tends to be overexploited, which results in Garren Hardin's tragedy of the corwnoas.r If frequency of use by owners is restricted, as with tribal gazing lands in African countries, then overexploitation can be avoided. Open access resources are not owned by anyone (res nullius). Thus, it is not practical to exclude others fromusing them, and there is generally no incentive for an individual to limit his or her use of the resource.An exanple of an open accessresource is the ocean flsheries. Overexploitation of a common property resource is illustrated for cattle gl:azing on rangeland- The efFcient stocking rate (number of cattle per acre) for rangeland owned in common by a group of ranchers is demonstrated in Figure 5.3. Suppose the ranchers do not control the stocking rate selected by each rancher. This means each rancher has complete freedom to select his or her own stocking rate. Define the marginal net private benefit (MNPB) of cattle grazing as the difference between the price and the private marginal cost of production for cattle. Profit for each rancher is rnaximized by selecting a stocking rate of q where MNPB = 0. At e,' the price of cattle equals the marginal private cost of production. Suppose that when a certain stocking rate is exceeded, namely, Qo, increasing the number of cows grazed in the courmon area reduces the quantity and quality of forage for each cow, which in turn decreases weight gain per cow. In other words, overgrazing occurs. The marginal darnage (N{D) from overgrazing equals the loss in income from grazing an additional cow when the stocking rate exceedsQ5. For simplicity, let MD be a linear function of the stocking rate when the rate exceeds Q5. Because the profit maximizing stocking rate exceeds the threshold rate (e, > eJ, there is no incentive foi an individuat rancher to select a stobking rate below Q5. When each rancher independently selects the profit maximizing stocking rate, namely, Q, darnages to the rangeland are a maximurn This suggests there are potential benefits from joint management of the rangeland- Under joint management, the ranchers agee to a stocking rate that maximizes net social benefit, which equals total profit minus damages from overgrazing, which equals the area between the MNPB curve and MD curve. Consider a stocking rate of q. At this rate, MNPB =

98

Value

Natural Rsource aud Envimnmental Economics

per

Cow

Q' SÈockLag

RaÈc

Figure 53. Privately (QJ and socially (Q) optinal stocking rate for a conmonly owned grazing area. MD = marginal damage; and MIYPB = marginal net private benefiL

MD and net social benefit is greaterthan it is for any other stocking rate. Because Q maxinizes net social benefit,it is the socially efEcient stocking rate- Notice that the socially efficient stocking rate (QJ is less than the privately efEcient stocking rate (Q). There is no guaranteethat the rancherswill agreeto limit the stocking rate to QuEven in casesin which exclusive property rights to a common property resourceare granted, overexploitaúoncan occur- For example,ranchersin the western United Statesare able to secureexclusive grazing rights to specific parcels of public rangelandby paying a grazingfee basedon the nunber of cattle grazed per month.There is considerableevidencethat even this controlled grazing arangement resultsin overgrazing and significantecological degradation. One way to restrict rrccessto a cornmonproperty or open accessresourceis for a designatedresourcenumagerto ration the resource.In the caseof offshore oil, which is a common property resource,the federal or state govemment leasesex'trloration and developmèntrights to offshore areas.In the United States, competitive leasesalesgive qualified companiesthe opportunity to bid for specific tracts of offshore land. If the bid of a qualified company or consortium of companies is accepted,that companyor consortiumis assignedexclusive developmentrights to any oil and/or natural gaslocatedon the tract for a specified period of time. Leasescan be bought and soldThis competitive leasingschemenot only establishesefficient property rights

5. Property Rights and Externalities

99

for offshore oil, but also limits the total area open for development through a congressiortally approved leasing schedule. The schedule indicates when and where lease sales take place and the amount of land offered for lease. In addition to limiting the acccss to offshore tracts, the leases stipulate the safety and environmental precautions that must be observed in developing each lease Eact. Lease terms and conditions are designed to reduce accidents and oil spills. Fish and wildlife are coÍtmon properry resources whose use is controlled by state or provincial governmental agencies. Consider big game hunting. Management agencies convey hunting rights to a particular species through the issuanceof fee licenses that stipulate the terms and conditions for different types of hunting. The license usually restricts the number and/or sex of animals harvested in a given period (day or season), the specific hunting area and the type of weapon. The number of hunters is conrolled by limiting the number of licenses offered for sale or the number of permits issued in a hunting area Some hunting does occur in private game preserves that charge rather high fees for a quality experience. Comrnercial and recreational fishing licenses operate in a similar manner to publicly provided big garre hunting. In the case of open access resources, no one owns the resource and overcxploitation occtu'ìs-A good example of an overexploited open Írccess resource is the harvesting of whales. Because whale products are very valuable and there are no restrictions on harvest rates, whale harvesting exceeds rates of regeneration. As a result, certain species of whale have been almost hunted to extinction, such as the blue whale in the southern oceansofAntarctica.In an effort to pneventextinction, the International Whaling Corrmission succeededin geuing a group of nations to agreeto voluntary restrictions on whale harvesting. While several nations did not sign the agreement, it did reduce the harvesting of whales. Another exarnple of overexploitation of an open access resource is air pollution. As long as air emissions in an airshed remain below the capacity of the air to assimilate enissions, air pollution does not occur. Rapid growth in urbanization and industrial development in several cities in the United States, notably Los Angeles, California, and Denver, Colorado, has increased airpollution, which has conhibuted to health-related problems, ecological and properry damages and reduced visibility. Environmental pollution is typically controlled by restricting total emissions and/or taxing eurissions. The Clean Air Act of 1970 placed limits on air emissions in socalled nonattainment areas within the United States. These are areas in which concentrations of pollutants exceeded health-based standards established by the United States Environmental Protection Agency (U.S. nBA). The Clean Air Act significantly improved air quality in many nonattainrnent areas, although several of these areari are still not in compliance with the standards. The Clean Air Act Amendments of 1990 restricted the amount of sulfrr dioxide emissions in an airshed by issuing permits that restricted emissions to an acceptable level. By attoúring firms to trade emission permis, the target level of emissions is achieved at least cost This is the concept of tradable emissions permits. A rnore complete discussion of methods for controlling environmental pollution is grven in Chapter 9. While schemes to improve the management of cornmon propeny and open accessresources improve the efEciency of resource use compared to what it would be in the absence of management, they do not necessarily achieve socially efEcient resource use.

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property rights to the PIIBLIC GOODS. Apublic good has two characteristics: good are not exclusive; and use of the good by one person does not diminish the benefitsthat the goodprovidesto other persons.The termpublic good is generic and encompassesboth natural and environmeatal rcsouces. A public good is different from a cornmonproperty resource.Use of a courmonproperty resourceby one person decreasesits availability tg other fersons. Examplesof public goods include national defense,interstatehighways,public educationand nationalparksfril/hile these resourcescould be managedby the private sector,it would lead to a more limited supply of the resourceand a higher price. Consequently,net social benefit would be lower than with public management.Society has decidedthat pubtic goods should be managedfor the benefit of the generalpublic rather than for private gain. Think about public goods, such as wildlife viewing in a public park If additional viewers do not diminish the value of the experienceto existing viewers (congestion does not occur), then the marginal cost of wildlife viewing is very low. Under theseconditions,it is inefEcient to chargeanythingother than a very low fee for wildlife viewing. A high fee is inappropriate becauseit excludessome useni without decreasingthe cost of providing wildlife viewing. Hence,the efficient price for wildlife viewing is very low. Becausea low price would not generatesufficient revenueto cover the costsof providing the viewing, aprofit-motivated firm is not likely to be interestedin managingthe park for wildlife viewing. The park is clearly a pub' lic good that needsto be managedby a public agency.Under public management, accessto the park would requirepaymentof a very low userfee. The public agency could recoup the bulk of the cost of operating the park from general tax revenue. Revenuegeneratedby the accessfee would cover some of the administrative cost of public managemenl

Extermalities Of the three sources of market failure just described, externalities have received the most attention in natural resource and environmental economics. An externality exists when the activities of an acting parfy influence the welfare of an affected party and the acting party does not consider how its activities affect the welfare of the affected party. The acting party is the party engaged in the activity responsible for the externality, and the affected parry is the party whose welfare is influenced by the externality. The acting and affected party can be a household or a firm. Hence, externalities can take place between firms, between households, and between households and firms. If the acting party engages in an ac,tivity for the sole purpose of harming or benefiting the affected parfy, theu the activity does not constitute a Eue externality. When an externality is present, the welfare of the affected party is influenced not only by its own activities, but also by the activities of the acting party. Suppose the Cone fanily plays loud music late at night without concern for how the music affects is neighbors. If the loud music prevents the neighbors from sleeping, then

5. hopeÉy Rígbtsand Externalities

101

there is an externality. In this case, the Cone family is the acting party and the neighbon are the affected party. An externality is relevant when the affected party wants the acting pa4y to change ttre activity that causes the externality. The externality is not relevant when the affected party does not care whether the acting party changes the activity cauiing the externality. If ttre neighbors do not care whether the eone family plays loud music at night, then the externality is not relevant. An externality is said to be Pareto relevant when the activity causi.g a relevant externality can be changed so that the welfare of the affected party can be increased without decreasing the welfare of the 'When acting party. an externality is Pareto relevant, modifying the activity that causesithe externality offers a potential improvement in economic welfare. ff lowering the volume of the music does not reduce the welfare of the Cone falnity, then the neighbors would be better off and the Cone farrily would be no worse off. The externality is Pareto relevant.

TYPES OF EXTERNALITES. Not all relevant externalities are of interest from an efEciency standpoint. Of the two types of externalities, pecwtiary external@ and technological erternality, only the latter adversely affects economic efficiency. A pecuniary externality occurs when a company develops a computer software package that significantly reduces the time required for elecEonic communication. Other firms who do business with this company derive benefis from the time savings even though they did not bear the cost of developing the software. Because a pecuniary externality only changes the relative prices and financial conditions faced by affected parties, it does not result in an inefficient use of resources. In this regard, a pecuniary externality is no different than other market forces that influence resource prices. A technological externality affects the level of production or satisfaction achieved by the affected party, which results in inefficient resource use. The ptaying of loud music by the Cone family is a technological externality- There are two forms of technological externality: enernal economies and external díseconomìes. An external economy increases the welfare of the affected party, whereas an external diseconomy decreases the welfare of the affected party. The term external means the activity generating the externality is external to the affected party. Activities that do not generate external or third-party effects are not considercd externalities. Because of their negative welfare effects, external diseconomies are of greater cotrcern than external economies: Externalities can be classified according to whether there is a conflict between the acting and affected parties and whether they cause inefficient resource use as shown in Table 5.1.

Table 5J. Classification,ifexternalitles Tlpe of Extemality ExteinalEconomy Technological Pecuniary

No conflict Inefficiency No conflíct

extematúseconony Conflict Inefficiency No conflict

IM

Natnral Resourceand Environmental Economics

EXAMPLES OX' EXTERNALIIIES. Consider an external diseconomy in which the acting parties are farmers located in an agricultural watershed and the affected party is a hydroelectric power company located dowmiver from the watershed. Crop production by firrmen causes excessive erosion, which generates sediment. Sediment is carried by runoff to the river, which flows into a reservoir owned by the hydroelectric power company-€ome of the sediment becomes trapped in the reservoir- Trapped sediment displaces ìr'ater, which reduces the watd storage capacity of the reservoir and decreaseselectrical generating capacity. Periodically, the power company has to dredge (remove) the sediment from the reservoir to restore water holding capacity to its original level. The cost of dredging constitutes an offsite damags from soil erosion. An external diseconomy is created because farmers ignore the offsite sediment damagesto the reservoir caused by soil erosion. In terms of Figure 5.1, the private MC of production (MC) is less than the marginal social cost (MSC). If sediment deposition in the reservoir is the only offsite darnage caused by crop production, then the difference between MSC and MC equals the marginal sediment damage incurred by the power company. The divergence between social and private marginal costs MSC - MC) causesprivately efficient crop production to Exceed socially efEcient crop production (Q, > q). Hence, the level of crop production is too high in the presence of an external diseconomy. Consider an extetnal economy between a farur operated by Mr. Jones (acting party) and a ranch operated by Mr. Davis (affected party). lÍr. Jones sprays his cornfield with a herbicide to reduce yield losses from weed infestation. Mr. Davis grazes cattle on a pasture located next to the field. Herbicide use reduces the weeds not only in Mr- fones's cornfield, but also in IVk Davis's pasture. As long as Mr. Jones sprays his corn without regard to Mr. Davis's welfare and Mr. Davis is not indifferent to the spraying, there is an external economy. Mr. Davis benefits from improved pasture for his cattle but does not incur any additional cost. The external economy from herbicide use is illustrared in Figure 5.4. Marginal resource cost and marginal private benefit of herbicide use for Mr. Jones are given by MRC, and MB5, respectively. MRC, is the increase in herbicide application cost from using another unit of the herbicide. Because the srarket for herbicides is assumed to be purely competitive, MRC; equals the market price of the herbicide (p). MB; is the increase in corn production from using another unit of the herbicide. Due to diminishing returns, MBr decreasesas herbicide use increases. Efficient herbicide use for Mr. Jones is Q, where p = MB;. Because Mr. Iones selects the level of herbicide use based on weed control in corn production, the weed control in Mr. Davis's pÍuiture is not likely to be as effective as in Mr. Jones's corn. For this reason, the marginal private benefit of herbicide use for Mr. Davis is below the marginal private benefit of herbicide use for Mr. Jones (MBd < MBj). This particular external diseconomy is undepletable. This means that use óf the .r herbicide by Mr. Jones does not deplete (diminish) the marginal benefit of the herbicide to Mr. Davis. In other words, both individuals benefit Èom use of the herbicide, although Mr. Jones receives a higher benefit than does Mr. Davis. Marginal social benefit (MSB) for an undepletable externality is determined by surnming the marginal benefits to Mr. Iones and Mr. Davis. For exarrrple, when herbicide use is Q in Figure 5.4, MSB = MBr + MBr. MBl is the marginal benefit to Mr. Davis and MB2 is the marginal benefit to Mr. Jones at Q. The socially efficient use of the her-

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Natural Resourceand Environnental Economics

rural town surroundedby large farms. To reducepesticidecosts,farmers opt for aerial application of pesticides.On windy days, somepesticide drifts over the crty, increasingthe exposureby and, health risk to, households.There is an external diseconorny betweenfarms (acting party) and households(afFectedparty). The culprit is the particular technologyusedto apply pesticides,not the useof pesticides.Due to the nature of the problem, a solution might be negotiatedbetweenthe town's healtfr departmentand fanners.One possibility is to restrict aerial applicationdrf pesticides to days when wind velocily is low.

Extemalities and Pnoperty Rights An externality results from the absence of efEcient property righs. This suggests that a major way to eliminate or reduce externalities is to establish efficient property rights. If property righs can be established, then normal market transactions can be used to achieve efficient resource use. The classical treatise on this subject was developed by Ronald Coase.2He argued that acting and affected parties have an incentive to negotiate a reduction in external diseconomies provided: 1. tiate an 2. 3.

The economy is decentralize4 rnaking it possible for both parties to negoagreement freely and without government interference. The cost of negotiating and enforcing ao agreement is low. Efficient property rights are established.

Consider applying these conditions to the externality caused when the rancher's cattle graze on a neighbor's prcperty. The first condition is assumed to be satisfied. Because there are only two parties, the second condition is likely to be satisfied. What is the likelihood of the rancher and neighbor negotiating a settlement without the establishment of property rights (third condition)? This question is addressed in terms of the demand and supply curves for reducing an external diseconomy shown in Figure 5.5. D is the demand curve and S is the supply curve for externality reduction. The externality is grcatest at zero externality reduction and is completely removed at tt",ax. Suppose that the neighbor is willing to bribe the rancher to keep cattle offhis properry. If the amount of the bribe decreases with respect to the level of externality reduction, then there are decreasing marginal benefits of externality reduction. Hence, the neighbor is willing to rnake a lower bribe per cow as the nr.tmberof cows on his property decreases when the demand curye fo.r externality reduction is downward sloping. Suppose the rancher is willing to compensate the neighbor for damages fircim the externality and that the level of compensation per co\l, decreases as the number of cows on the neighbor's property increases. In other words, the rancher is willing to provide a higher compensation for the first cow than for the second cow, a higher compensation for the second cow than for the third cow, and so forth. Compensation per cow increases as the number of cows removed from the neighbor's property increases or, equivalently, as the externality is reduced. Therefore, the supply cnrve for externality reduction (S) is upward sloping.

5. Property Rights and Efemalities

105

R*

ffieraa:.ity

Redu".H

Figure 5.5. Equilibrium price and quantity for external diseconomy. P = flsmand; and S = supply.

The efficient quantity and price of externality reduction occur where the demand and supply curves intersect, namely, at R* and p*, respectively. At R*, the bribe that the neighbor is willing to make equals the compensation the rancher is willing to pay-'While the first and second conditions make it possible for the acting and affected parties to negotiate a settlement to the externalitlr, negotiation is unlikely .nlgss propeÉy rights are assigned.It will be very difficult for the rancher and neighbor to resolve the conflict over cattle grazing unless eitber the rancher has the right to gîaa;ecattle on the neighbor's land or the neighbor has the right to prevent cattle from grazing on his land- When all three conditions are satisfied, the two parties can negotiate an agreement. Even if property rights are established and only a few parties are involved, there needsto be agreement on the demages caused by the externality. \Vithout such agreemenl the parties are not likely to reach agreement on the bribe or compensation. "r'

ASSIGNMEhIT OF PROPERTY RIGETS. Does it make any difference how property rights are assignedto the parties?Coaseshowed that the effrcient level of externality reduction is achievedregardlessof the assignmentof property rights, as long as transactioncosts and incomeeffects are zero. TransactioncostsreÈr to all the costs of settling externality disputes,including expensesfor aftorney'sfees and time spentnegotiating a settlement.Low hansactioncosts meanthat the cost of negotiating a settlementbetweenthe acting and affected parties is negligible. Trans-

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Nahral Resource and Environnental Economics

action costs are likely to be low in the cattle-grazing example because there are only two parties. In the example of lake eutrophication from livestock manure, however, tansaction costs are high because of the potentially large number of acting parties (polluting farms) and affected parties, and the difficulty of facing phosphorus loading in the lake to manure application on specific farms. When the transaction costs exceed the benefits of reducing the externality, it is not efEcient to reduce the ex'òs ternality. Income effects eccur when bribes shift the demand curve and/or compensation shifts the supply curve for externality reduction. When income effects ate zero, the demand and supply curvqs are not affected by the assignment of property righs. For example, consider two property rules. Rule 1 legalizss open grazing (which gives the rancher the right to gnze cattle on the neighbor's land), and rule 2 makes open grazingillegal. The appropriate forrrs of settlement are for the neighbor to bribe the rancher with rule 1 and for the rancher to compen$ale the neighbor with rule 2. Rule 2 reduces the income of the rancher and increases the income of the neighbor. Rule I does the opposite. When income effects are zero, such changes in income do not shift the demand and supply curves. If the income effect for each paffy is positive and nonzero, then a lower income for the rancher reduces the amount of compensation offered for a given externality reduction and a higher income for the neighbor increases the amount of the bribe offered for a given externality reduction. Therefore, the demand curye with rule I is below the demand curye with rule 2 (Dr < Dil and the supply curve with rule I is above the supply curye with rule 2 (Sr > S), as shown in Figure 5.6. Therefore, the equilibrium level of externality reduction is greater with rule 2 than rule 1 (Rz > RJ. Equitibrium prices can be higher or lower with rule 1 than rule 2 depending on the relative magnitude of the income effects for the acting and affected parties. Positive transaction costs cause the difference between the equilibrium levels of externality reduction to be even greater than illustrated in Figure 5.6. Therefore, if transaction costs and/or income effects are not zero, which is likely to be the case, the assignment of properry rights to acting and affected parties can influence the lwel of the external diseconomy and possibly the price of removing it Simitar statements can be made for external economies. How difEcult is it to implement property rules? It depends on the nature of the externaliry In the cattle grazing-exarnple, it would be relatively easy to establish property rules because the cause and consequences of the external diseconomy are obvious: lack of fencing around the ranch or the neighbor's property allows cattle to graze on the neighbor's land. Because it would be easy to determine when a violation of the rules occurs, enforcement would be straighúorwardProperty rules have their share of problems. First, they can generate perverse economic incentives. For example, allowing open grazing gives ranchels an incendve to gruzetheir cattle on someone else's tand. This behavior is mtisnal because it 'ieduces the amount of owned or rented land needed to graze a given numbcr of cattle. Unfortunately, it increases the magnitude of the externality- Second, as the number of parties increases, so does the diffrculty of reaching agreement. Third, when the nnrnber of parties is large, a potential free rtder problem can arise, especially in the case of environmental externalities such as air and water pollution. A free rider problem exists when some of the parties benefiting from externality reduction do not have to bear any of the cost of achieving the reduction.

5.

Pnoperty Rights and Externalities

rvl

Rúax

E*tena.J.iÈy.

Figure 5.6. Equilibrium level of externality reductionwith nonzero income efrect for two grazing rights. D = demand; and S - suppty.

Fourth, it is difficult to defineprop€rty rules for open accessresourcessuch as air and water becausemany environmental interestsobject to grving acting parties the right to pollute or otherwisedegradethe environmenl Other interestsobject to giving affected partiesthe right to an unpolluted environmeùt.Finally, societymay be unwilling to establishpropeÉy rules for certainrtsources,suchas national parks, wildlife refuges and wild and scenic rivers, for fear that a rrarket based on these rules would result in insufFcient quantities and excessivelyhigb prices of the resource.

GOVERI\MBNT INTERVEF{TION. Becauseof the limitations of property rules, other approacheshave been used ùoreduceexternal diseconomies,including liability rules, economiéincentives and regulations.Someof theseapproachesbave the samelimitations asproperty rules. 'With a liability rule, the courts establishthat acting parties are legally liable for the damagesinflicted on affected parties. If af, fected parties claim danrages,then the court determinesthe appropriate amount of compensation for the damagesincurred. Economic incentives, such as taxes and subsidies, can bc used to reduce externalities.'Finally, regulations can be used to limit the amount of the externality to some administratively detemined level Es-

ReducÈion

10E

Natural Resourceand Environmental Economics

rahlishment of properfy rules and other mechanisms for reducing externalities usually involves government interttention Only the general pros and cons of this overall approach are discussed here. Chapter 9 provides a more detailed economic analysis of government intervention for reducing environmental externalities. Proponents claim ùat government intervention is needed to reduce economic losses from external diseconomies. Governinent intervention has been the primary means of addressing externalities associated with national securiq4r health and safety, social welfare and environmental pollution. Pigou3 laid the foundation for such intervention when he stated: .*It is the clear duty of Governmen! which is the trustee for unborn generations as well as for its present citizens, to watch over, and if need be, by legislative enactment, to defend the exhaustible natural resources from rash and reckless exploitation." Mishana supported government intervention for certain types of externalities: "With respect to bodies of land and water, extension of property rights may effectively inlsrnalize what would otherwise rem"in externalities. But the possibilities of protecting the citizen against such common environmental blights as filth, fume, stench, noise, visual distractions, etc., by a market and property righs are too remote to be taken seriously." Government intervention has been supported by the general public, as evidenced by the broad range of social, economic and environmental legislation. Under the banners of new resource economics, new institutional economics and free market environmentalism" soàe economists have argued that govennment intervention to mediate externalities is often cost-ineffective, premature, unnecessary and misguided. Castld pointed out "Market failure in-some abstract sense does not mean that a nonmarket alternative [such Írs govemment intervention] will not also fail in the sarne or in some other abstract sense." The new approach attempts to explain government failue in terms of the relationship between principals and agenB and the influence of transaction costs on this relationship. In this approach, politicians and bureaucrats are the agents and citizens are the principals. Efforts to reach agreement (establish a social contract) are thwarted by voter ignorance, imperfect information and special interests, all of which increase the transaction costs of achievjng agreemenl The higher the transaction costs, the greater the likelihood of governrrrent failure. The newer approaches emphasize the forrnation of markets to internalize externalities by establishing effective properfy rights and reducing Eansaction costs.6

ummary Centrally planned econoùies utilize government committees to allocate resources. Market-based economies can automatically achieve socially efficient resource use through the independent actions of consumers and producers. Markets do not function without efficient property rights. Such rights have four major attributes: exclusivity, specificity, transferability and enforceability. Exclusivity allows the resource ov/ner to exclude others from using the resource. Specificity refers to the bundle of rights associated with a particular property. Transferability allows property rights to be conveyed to another party. En-

5. PropeÉy Rightsand Exter:nalities

109

forceability implies that property right infringements can be determined and violators can be prosecuted. Transaction costs refer to the time and money costs of establishing property rights. Free markeB wiil not achieve a socially efficient use of resources if a) the market is not purely competitive, b) the resource has unique physical attributes, and c) externalities exist. Whèn monopolistic elements arc presert in a market, it is not purely competitive. Cornmon property resources and public goods have unique physical attributes that do not permit these resources to be allocaùed by a markeL Access to certain coulmon property resources and open access resources is unrestricted due to a lack of exclusive property rights. Some common property resources, such as offshore oil and big game, have the characteristic that use by one person decreases the availability of the resource to others. The úagedy of the com: mons refers to the tendency for certain coilrmon property and open access resources to be overexploited. Public goods such as national parks, witdtife refuges, and wild and scenic rivers do not have exclusive property rights and, unless congestion occurs, use by one person does not diminish the benefits that the good provides to other persons. An externality occurs when the actions of an acting party have an adverse or beneficial effect on the welfare of an affected party. When the offending action can Ss ghanged so as to increase the welfare of the affected party without decreasing the welfare of the acting party, the externalify is Pareto relevant. Unlike pecuniary externalities, technological externalities influence the efEciency of resource use. Technological externalities can be either external economies, which increase the welfare, or external diseconomies, which decreasethe welfare of the affected party. One way to alleviate externalities is to establish efficient property rights. Economist Ronald Coase showed that in a decentralized economy with efficient property rights, it would be mutually advantageous for acting and affected parties to negotiate a reduction in an external diseconomy, provided transaction costs are low. He also showed that the level of externality reduction is independent of how property rules are distributed between the acting and affected parties, provided Fansaction costs and income effects are zero. Proponents of property rules want to make them more effective by reducing transaction costs. Critics of property rules point to their drawbacks when applied to common property resources and public goods. They suPport alternative approaches, such as liability rules, economic incentives and regulations, all of which entail significantly more government intervention than property rules.

.

Questions for Discussion

1. Conversion of eastern Europe from a communist to a capitalist governrient has involvedjpPlementation of market-based incentives for determining resource use- Why have the costs of converting from state-owned to privately owned propl. erty been so great? 2. Which of the four attributes of property rights appears to be most critical in teras of resolving externalities? Why? 3. Give exarnples of an external diseconorny and an external economy not dis-

u0

Natural Resourcc and Environmental Economics

cussedin this chapùer.How might theseexternal effectsbe resolved? 4. Distinguish betweena common property resource,open-Írccessresourceand a public good. Illustrate with exarrrPles5. When is it in society's best interest to eliminate externalities? è

Further Readings '"The Economics of Resourcesor the Resources of Economics." Solow, Robert M.1974Ancricst konomÍc Revíew 64:1-14. '?roperty Rights: The ReaI Issue." NatStroup, Richard L and John A. Baden. 1983. Managemenr. San Francisco, Caliuml Resoutces: Bwzarcratic Myttts and hvimnmmtal pp-7-27. Research. Policy for Public fomia Pacific Institute '?roperty Rights, Extemalities, and Environmental Problems." îetenberg, Tom. 1992. Chapter 3 tn Envircwtental and Natural Resource Econombs,3rd ed- New York HarperCollins Rrblishers, lnc., pp. 44-71.

Notes '"Tragedyof the Commons,-Scíence,December13, 1968. 1. GarrettHatdin, 2. Ronald Coase,"Ihe Problemof Social Cost " inEconomicsof the Etwironnzent,2nd ed-RobertDorfman andNancy S. Dorftnan"eds. (New Yorlc W.W. Norton & Co.' 1977)'pp.

r42-17r.

3. A.C. Pigo,r, as quoted in J. W. Milliman" "Can PeopleBe Trusted with Nanral Resources?-Land Ecornmics38(1962):199-2184- E.J. Mishan, "A Reply to Professor Woreester,"Jourtual of Economic Literatute fi(7912)259-62. '"The Market Mechanism,Externalities, and Land Economics," 5. F,mery N. Castle, Journal of Farm Economics13(1973):11-14. '"The Stmchrc of a Contractand the Thmry of Non-Exclusive 6. StevenN.S. Cbeung, 'The New Resource,"Jourrul of Lovt,otd, Economics13(19?0):49-70;Terry L. Anderson" ResourceEconomics:Old Ideasand New Applications,- AttrcricanrJouma'l of Agriculnral ''fhe Market Processand EnvironEconomics6a[982):92tt--934; and Terry L. Anderson, mental Arrenities,' in Economicsand thc Envhonment:A Reconciliaion, V/alter E. Bloch ed. (Vancouver,Britistr Columbia The FraserInstiilte), pp. 137-157.

CHAPTER

6

hlatural ResourceDecisions Whenwe try to pick atrythingoat by itself,wefird it hitchedto everythingelse in the wtiverse. -Jornv Mun" l9ll

rivate and public decisionsregardingthe use and managementof natural resourcesand the envimnment are influenced by a varieg of social, economic, technical and environmental factors. Resource decisions can be arrayed in a hierarchy in which the complexity of the decisions increases as more factors are considered. The physical attributes of a resource influence decisions regarding its use and management. This chapter discusses a decisíon hierarchy for natural resource management, the distinction between exhaustible md renewable nanrral resources, market equilibriwr" and startc fficiency (efficient resource use when decisions in different time periods are independent), producer surplus, consuner svrplus and net social benefit-

Natural Resource Management Resourcenurnagementrefers to the decisions made by resourceowners,rnÍInagers,interestgroupsandpolicy-makersregardingthe rate, timing and method of resourcedepletion, conservationand rumagemenr The four major paradigms, or philosophical approaches,to resource nranagementcan be arrangedin a decision hierarchylike the one illustrated in Figure 6.1. Each paradigl corresp,onds to one of the four models discussedin Chapter4: n^-ely, circular flow, material balances,ecological economicsand sustainabledevelopmenl Management decisions become more diverse and complex" moving from lower to higher layers in the diagram. The first Layerconóistsof 16ssimplified circular flow model of the economy. This model concentrateson decisionsthat gov€rn the exchangeof resources,such as land, labor and capital, betweenhouseholdsand firms. Purchaseand sale of resourcesby the governmentand other countries can be consideredby adding government4d import or export sectorsto the model. Resourceuranagementdecisions in the circular flow model rire governedby market prices that are determinedby demand and supply conditions. trf the demandfor a natural resourceincreases,then 111

Natural R,esourceand Environrnental Econornics

1t2

Ecological

SusÈaiaable

Economics

Material

Circular

F"igure 6.1.

DevelopmenÈ

Balances

FIow

Resourrce decision hierarchy.

market price increases until quantity demanded equals quantity supplid as illustrated in Figure 6.2. Market price rises from Pr to Pz and quantity demanded increases from Q1 to Q2 when demand increases from D1 to D2. The circular flow model represents market-based decisions quite well- Not all resource decisions are subject to market forces. Water pollution by farmers is not subject to market forces because there is no market for clean water- In some cases, markets are incomplete, as in the case of recreational hunting, which is managed primarily by the public sector. Limited recreational hunting is provided by private game preserves. The second layer contains the material balances model, which adds tbree new elements to the circular flow model: consuurption of environrrrental services, disposalofmaterial_energyresidualsandassimilativecapacityoftheenvironment. Most household" firm and government decisions related to these elements are not governed by market forces. For exanple, while there are markets for collection and disposal of corrmon household and business refuse, there are no markets, or very limited markets, for disposal of residuats in air and water bodies. In the absence of a mechanism for keeping residuals below assimilative capacities, air and water pollution is likely to occur. The material balances model envisions direct public intervention to reduce environmental pollution. The third layer consists of the ecological economics model and the sustainable development model. All fotu models consider economic efficiency and equitable distibution of income. The material balances, ecological economics and sustainable development models address the uranagement of environmental pollution. Achieving an optimuÍI scale for an economy relative to the ecosystern is a unique concern of the ecological economics model. Frogress in achieving an optimrrm scale is limited by several factors. Firsq the optimnm scale is subjective. Once an optimum scale has been selecte{ however, conventional economics can be used to determine the most efficient way of achieving it. Second, the goal of achieving an optimun scale for the economy is incompatible with economic growth, which is the most widely accepted

6. Natural Resourcellecisions

113

$taatLtlr

Figure 62. Increase in price and quantity demanded of a natural nesourcedue to increase in denand (D). S - supply.

goal of economic developmenl With unlimited economic growth, the scale of the economy wennrally exceedS whatever optimurn scale is chosen. Third, the instinrtional and policy reforms proposed by ecological economists for achieving a balance between the economic subsystem and the ecosystem and an equitable distribution of income are not popular- Examples include govemment auctioning of depletion quotas for nonrenewable resources, limiting household size, and placing uPper limits on household income.l The diversity and complexity of resource managem€nt decisiotrs, consequences of making wrong decisioús and the likelihood of disagreement and conflict increase moving from the bottom to the top layers of Figrre 6.1. It is no big deal when the public decides that llo-llywood's latest movie release is a flop. However, it is a big deal when the hole in the ahospheric ozone layer becomes larger. In other words, the stakes gener,plly increase from the bottorn to the top of the resource decision hierarchy. Sustainable development and ecological economics are placed in the sarhe layer of the decision hierarchy because they have many corrmon elernents and their level of generality is comparable. Both models focus on interdependencies between the economy and the ecosystem. Sustainable development emphasizes conservation of nanral r€sources and the environment as a means of ensuring long-term economi: developmenl Advocates of sustainable development support the short-term

t14

Natural Resourceand EuvironrmenÉalEconomics

goal of economic growth, especially in developing countries, and the importance of having developed countries bear the burden of reducing environmental degradation and financing environmental protection in developing countries. Since ecological economics considers the ecosystem to be the ultimate constraint on ecouomii growth, unlimited economic groy,rth is ruled out. Sustainable develoPment is a philosophy about how developrnent should proceed, whereas ecological ecolornics is a transboundary discipline interested iu characterizing the linkages ffiween the economy and the environment. All four paradigns in the resource decision hierarchy are llseful in understanding and resolving issues related to the development and/or rxe of natural and environmental resonrces. The philosophical basis for this textbook is that a blending of the four paradigns offers a much stronger foundation for evaluating and resolving natural and environmental resource issues than any single paradigrn. This eclectic approach introduces a fair bit of tension into economic-environmental analysis becauseof the inherent conflicts between paradigms. For exarrple, the goal underlying the circular flow paradigm is economic growth. Resources are not timiting in this paradigm because of technological progress and substitution of manufactured capital (structures and equipment) for natural capital (natural and environmental resogrces). In contrasg the ecological economics paradigm is based on the goal of keeping the economic subsystemwithin ecological limits. Technology is not an automatic way to remove ecological limits and manufactured capital and natural capital are treated as complements rather than substitutes. Despite this tension, a blending of the fotrr paradigms holds greater promise than any single paradigm in resolving cornplex natgral resource and environrnental issues. How do the remaining chapters of this book relate to the four paradigms? Chapters 7 and 8 concentrate on the economic principles for determining efEcient use of exhaustible and renewable resources, resp€ctively, from the viewpoint of individuat firrns and households (private efficiency), and society (social efEciency)These principles are the fundamental building blocks of the circular flow andmaterial balancesmodels. Chapter 9 develops econoulic principles for deùermining the efEcient levels of environmental pollution and evaluates alternative policies for reducing environmenral pollution. These principles -and policies lie at the core of the material balances approach. Chapter 1O deals with natrnal resource and environrnental accounting, which is an integral part of both ecological economics and sustainable development. Chapter 11 addresses benefit-+ost analysis of resource investrnentsBenef,t-cost analysis is an application of welfare economics and investment criteria, which are critical elements of all four models- Chapter 12 covers nonmarket valuation of nanrral and environmental resources. Nonmarket resource values are very important in determining efficient resonrce use, developing monetary accounts of ngngal resource depletion and environmental degradation, evaluating resource protection policies, and assessingthe efficiency of alternative resource investrnents- In sununary, subsequent chapters draw heavily from one or more of the four paradigms.

6. Natural ResourceDecisions

115

Typesof Resources Firn and household decisions regarding the use of nahral and environmental resourcesare inffuencedby the physical and biologicat attributes of a resource.Treesand fish have different physical and biological anributes than do petroleum and minerals.These differenceshave important ecónomic implications for the spatial and temporal use and managerneitof natural and envilsamsatal resources.Nahrral and environmentalresourcescanbe classifiedinto trno broad categories: exhaustibleresourcesand,renewableresources-

E)GAI.]STIELE RESOTIRCES. The stock of.exhausrtbkresourcessuchaspetroleum, coal and metals is fixed. Use of exhaustibleresourcesdepletesthe current stock of the resource,which reducesits future availability. The greater the rate of use, the more quickly the resourceis depleted.A simple model can be usedto illustrate the dlmamics of exhaustibleresources.Let Soequalthe initial stock of coal and U,-t equal the total useof coal usedthroughthe endof periodt-1. The stockof coal available at the beginning of period t is deterrninedby the following stock equation: Sr=So-U"t Because Sois fixd the greaterthe use of coal prior to time t, the less coal is available for current and future generations.This simple stock equation overlooks differences in the availability of different qrraliliss of coal (bituminous, subbituminous and lignite). For example,the 1990 amendmentsto the Clean Air Act restrict emissions of sulfir dioxide. This legislation has increasedthe use of western coal relative to easterncoal becausetlie forrner has a lower sulfur contenl As a result, mining of westerncoal hasincreasedrelative to mining of easterncoal and the stock of low sulfur coal is being depletedmore rapidly than the stock of high sulfur coal. An important feature of certain exhaustible resourcesis the uncertainty regarding their iocation, quantity and quality. Locations of resourcessuchas coal and metals are generally known; however,resourcessuchas oil andnatural gas are subject to greater uncertainty becausetheir location must be determinedthrough exploration. If more oil is discovered,then the initial stock of oil is increasedby the amount discovered.Uncertainty regardingthe initiat stock of oil translatesinto uncertainty regarding the amount of oil that wilt be available to future generations. Supposeinitial estimateof oil resources(So) is 600 billion barrels and cumulative use of oil through the beginning of period t (U,-J is 300 billion barrels. If current annual use of oil is 3 billion barrels,then current reservesand the number of vears of oil remaining at current userates(reserttes-to-useratio or R) are: St = 60O- 30O= 3q0 andR = 30O/3= lffi. If favorable discoveriesof oil causepetoleum geologiststo revise the initial estimateof oil resourcesupward to 1,00Obillion barrelsand the current userate re6ains unchanged"then current reservesand the reserves-to-use ratio are: Sr= 1,000- 300= 70OandR =7OOl3=233.

tr16

Natuml Resourceand Envinorunental Economics

In this case, a 67 percent increase in oil resourcesresults in a 133 percent increase in the reserves:to-use ratio. If oil prices decreasein response to the higher estimate of oil resources, annual oil consumption could increase, which would have the effect of lowering the resewes-to-use ratio. The stock of certain exhaustible resources can be extended through recycling. For example, recycling of aluminum reduces the use of bauxite, the mineral from which aluminum is manufactured. Other things equal, recycling lowers*{he rate of use of the resogrce, which decreasescumulative use (Ut-r) relative to what it would be without recycling. Consequently, it takes longer to exhaust the resource when recycling occurs, other things equal. Plrysical exhantstí.onof a resource occurs when S, = 0, at which point the stock of coal is depleted- Economic exhaustion of a resource occurs when the use of the resource falls to zero. Economic exhaustion usually occurs before physical exhaustion because extraction of a resource will be discontinued when extraction is no longer profitable. Both conceps of exhaustion are dynarnic. For exarrple, increases in the price of the resource and/or improverrents in the efEciency of resource extraction irnprove the profitability of resource extraction. This increases resource extraction and shortens the time until the resource is physically exhausted- On the other han{ these sarne factors could increase resource exploration. If new discoveries are made, then the time until the resource is exhausted could be extended.

RENEWABLE RESOTIRCES. Soil, water, crops, fish, wildlife, forests and so' lar energy are renewable resources. Unlike exhaustible resources, renewable re' sources are regenerated through natural growth. The time and space requirements for regeneration vary by resonrce. Soil regeneration occurs at a relatively slow rate. It takes decades, and in some casescenturies, to replenish the soil lost by high rates of water and wind erosion. In arid climates, soil degradation can be irreversible. Other renewable resources,including certain plant and animal species, regenerate in a matter of hours or days. There are nnny interconnections fimong renewable resources. Crops require soil, water and sunlight (solar energy) for growth and development. Forests contain treés, plants, fish and wildlife that require soil, water and sunlight for regeneration. Deforestation (timber harvesting in excess of regeneration) not only increases the land's íulnerability to soil erosion, but decrea.sesPrccipitation, which increases the risk of arid conditions Renewable resources typically have multiple uses.An old growth forest can be managed for cornmercial timber, which means that periodically timber is harvested and used to manufacture wood products. The sarne f,orest can encompass a watershed that provides drinking water for a nearby community, habitat for fish and wildlife and outdoor recreation. Because of their dependence on complex physical, biological and chemical processes,and the multiplicity of uses, renewable resources arÈ generatly more rtifficult to manage than exhaustible resources. Management of fish and animal populations is based on theii age-sex structure, habitat and geographic distribution, all of which are influenced by economic and environmental conditions. Consider a biological resource such as a forest The initial stock of the forest resource is called biomass. Eiomass at the beginning of period t is:

6. Nahrral Resource Decisions

tt7

S,=So-t1-,+G"r-Lr-, where Sois initial biomass, f,I,-r is cumulative harvest, G,-, is cumulative biomass growth, and t,-1 is cumulative biomasslossesdue to natural causessuch as fire and disease.A subscriptof t-l besidea variabledesignatesthe level of the variableas of the end of period t-1. Therefore,forest biomass: decreaseswhen ltr-, > (G,-,- L,-,), increaseswhen Ho, < (G,-r- L"-,),and remainsconstantwhen Hur = (G,-r- L,.-r), where Gu, - L,-1is net growth in forest biomass.A uniquecharacteristicof a biological resource.is that biomassgrowth dependson the curent level of biomass. ChapterE gives a more completeexplanationof the managementof renewableresoutces. Next, consider how the characteristicsof a renewableresource,such as water, influence managemenl Watercanbe managedas aflow resourceor aftmd resource. It is a flow resourcewhen the quantity available in a given period is not directly affected by human activities. A free-flowing river is a flow resource.If the river is darnmedto createa water storagereservoir,then the water becomesa fund resourceConstruction of ú1sdam and reservoir allows the water to be stored for later use. The stock of water in the reservoirat the beginning of period t is: S,=Fr-t-Wr-t-Lt, where F,-1is cumulative river flow into the reservoil, W,-, is cumulative withdrawals from the reservoir and L,-t is cumulative losses from the reservoir due to evaporation, seepage and other causes through the end of period t-1. Without storage capacity, withdrawals from the river cannot exceed river flows in a given period. With water storage, current withdrawals can exceed current river flows because water can be withdrawn from the reservoir. As the seven-year (1986-1992) drought in California dernonstrated, development of water storage capaclty can actually increase a region's vulnerability to drought when that capacity becomes the basis for rapid expansion in agricultural, urban and indusnial activity. Such expansion increases current water withdrawals and increases dependence on storage capacity to maintain economic activity. Solar energy is a unique renewable resource for three reasons. FirsL the accumulation and/or growth of most natural resources depends on solar energy. Fomiation of exhaustible resources, such as petroleum and coal, required solar energy. Second, solar energy is *flow r€sourcethat has to be used when it is available or its value in use is lost Because the amount of solar insolation received by the earth's surface is huge compared with the amount used for photosynthesis, heating, cooling and electrical power generation, most solar energy is not utilized. Third, solar energy is free.

1lE

Natural Resourrceand Environrnental Fconomics

SÉaticEfficiencv This section disgusssseconomic principles for determining efficient use of natural resources with static conditions. The latter exist when resource decisisns in different time periods are independenl If use resource in the current time period does not affect the amount or the price of the resource in future time periods, then resource decisions aré time-independent. The normat$e decision criterion for determining efficient resource use in a static framework is to maximize consutner surplus plvs producer surphx in each period- Consumer and producer surpluses are derived from the market demand and supply curves for the resource. The sum of consumer surplus and producer su4rlus is net social benefit CNSB). The remainder of this section discusses efEcient resource use under pure competition and imperfect competition.

^A.purelycompetitive mmket contains many buyers and P{.IRE COMPETITION. perfect knowledge who of technical and economic conditions. Consider have sellers how the efficient use of land is determined in a purely competitive market. The land market consists of a market demand for land as depicted in Figure 6.3. This demand is determined by the rnarginal productivity of land in the production of a particular commodity. Suppose the commodity is food. Marginal productivity of land in food production equals the increa.sein food production from using another unit of lan4 holding fixed all other inputs used in food production. The law of diminishing marginal productivity says that the marginal productivity of a resource decrèases as more of that resource is used. For this r.eason,the demand curve for land is negatively sloped, which imFlies that the quantity demanded of land decreases as the price of land increases, and vice versa. The market demand curve for land in Figure 6.3 shows that q, units of land are purchased at pr. Total willingness to pay for land equals the area below the demand curve (D) up Qr, which is the mponQr area. Total vrillingness to pay is the sum of the rectangular area mprnQr and the triangular area pùgn. The rectangular area equals total expenditure, and the triangular area equals consumer surplus for Qt units of land. Therefore, consurner surplus equals total willingness to pay minus total expenditure on the resource. It is"a surplus value because it is the value of the resource to the buyers above and beyond what they actually spend on the resource. The market supply curve for land is shown in Figure 6.4. It represents the marginal opporhnity cost of land, or the loss in value from selling an additional unit of land. Selling land involves transferring the right to the land from the current owner to the new owner. When this occurs, the current owner relinquishes the value of the land in its current use. If the relinquished value is pa, then the seller is not willing to sell that additional unit of land fo1 a price less than po. Since the value of land in its nExt best use is likely to increase as less land is devoted to that use, the marginal op porhrnity cost of land increases as more land is sold. Under pure competition, the relationship between the rrmrginal opportunity cost of land and the quantity of land is the rnarket supply curye (S) for land. The supply curve for land is upward sloping, indicating that sellers are willing to sell more land as the price of land rises. Total income from selling Q.units of land is the area tprvQ, and total oppornrnity cost is the area tuvQr in Figure 6.4. Opportunity cost equals the income the land would have earned in its next best use- Producer

QuantiÈy

Figure 63.

Totalwiningnesst to pay (area nponQJ and demand curwe @) for land.

Qrrantity

FÍgure 6.4. hmducer surplus (uplv) and supply curiye (S) for land.

na

NateuatrResourceand Environrnental Economics

surphs equalsthe differencebetweentotal income and total oppornrnity cost, which is the areaup3v.It representsthe surplus value receivedby the seller above and beyond the opportunity cost of the land. The equilibrium price andquantity of land underpure competition is illustrated in Figure 6.5'for the following market demand and supply curyes: pa= 5O- 0.5Qo Demand p ,=5 +0 .5 Q" Supply,

-*r

where pu is the demandprice, Qois the total quantity demandedof land in the markeL p, is the supply price and Q"is the total quantity suppliedof land in the market. The market demandcurve showsthe total quantity demandedat various prices, and the market supply curve gives the total quantity supplied at various prices. Market demandis determinedas follows. The total quantity of land demandedin the market at a particularprice (which is onepoint on the marketdemandcurve) is derived by summingthe quantitiesof land demandedby atl buyersat that price- Other points on the market demand curve are derived in a similar manner.Connecting all the points gives the market demandcurye- The total quantity of land supplied in the market at a,particularprice (which is one point on the marketsupply curve) is de. rived by summing the quantitiesof land supplied by all sellersat that price. Other points on the market supply curve are derived in a similar manner. Becausethe market demandcurve is negatively slopedand the market supply curve is positively sloped, consumer surplus increasesand producer sulplus decreasesas price decreases.Conversely,consumer surplus decreasesand producer surplus increasesas price increases.For example, when price decreasesfrom p1 to p2, consumer surplus increasesfrom pltu to p2tv and producer surplus decreases from ptws to prvs. flence, thereis a tradeoff betweenconsumersurplus and producer surplus. Land is being usedefficiently when NSB (sum of producerand consumer surpluses)is maximized-Maximum NSB occurs at the marketequilibrium price pz and equilibrium quantity Qr; it equalsthe areastv. Market equitibrium price is found by equating the demandand supply prices and solving for Q: 50 - 0.5Qd= 5 + 0.5qand Qo"=q. Equilibrium quantity is Qr = 45 and equilibriurn price is pz=27.5. Becausethe area of a rectangleis the base times the height, and the areaof a triangle is one half of the basetimes the height, in equilibriunu NSB equals consumer surplus (triangle prw) plus producer surplus (triangle kvs). In numerical terms, corisrunersurplusis 418.75 {0-5[(50 - n.r45]] and producer surplus is 418.75 {0-5[(27.5- OaD]]: In this case,consumersurplusis identical to producer strrplus becausethe demandand supply curyes have the sameslope (O-5) and the supply curve has a positiveintercept NSB equals837.5(418.75+ 418.75). To show that the maxirnum NSB occurs at Q2, considerthe NSB at a price above and below the equilibriumprice. If the price of land is pr = 45, then sellers are willing to supplyQr = 80,but buyersare only wi[ing to purchaseQr : 10.There is a surplusof 70 rrnitsof land. Ten units of land are boughtand sold and NSB is 225 (stux), which is lessthan837.5(sW).If the markerpriceis p: = 10, which is be-

6.

Nahrral ResourceDecisions

12!

Ps=5+O.5Qs

gz=27.5

pa=50-0 .5Qa

Qr=10

Qz=45

Q:=80

Figure 65. Equilibrium in Iand market undenpure coimpetition. D = demand; and S = supply. low the equilibrium price, then buyers are willing to purcha-seQt = 80, but sellers are only willing to supply Qr = 10. There is a shortage of 70 units of land. NSB is 225 (stux), which is less than 837.5 (sw). It is no coincidence that NSB is maxirnized at the equilibrium price and quantity (pz and Qt.At the equilibrium price, quantity demanded equals quantity supplied and there is no surplus or shortage of land. Because equilibrium is assuredunder purely competitive market conditions; maximum NSts is automatically achieved. The use of land is said tobe Pareto fficient when it is not possible to increase the welfare of some individuals without decreasing the welfare of at least one other individual by altering the distribution of land among users. In other words, when a ParetocfEcientuse of resources is achieved, the gainers from are-allocation are not able to compensate the losers and still be better off. fn general, there can be more than one Pareto-efficient use of resources in an economy; Pareto efficiency is-not unique. In the land example, the Fareto-efficient use of land changes when the distribution of land among sellers and the distribution of income among buyers is altered. Because Pareto efEciency requires purely competitive market conditions, efficient resource use is not achieved when the market has monopolistic elernents and/or the demand and supply curves for resources do not include all the relevant social benefits and costs of using the resource. This is typically the casefor natural and environmental resources.

guantl.Èy

Nahral Rsburce and Environmmtal Ec.onomics

!22

What happensto resourceuse, resouriceprice IMPERFECT COMPETITÍON. and NSB when the market is not purely competitivgf rmFerfect competition exists when any of the conditions for pure competitionare violated. Supposetlrereis only one buyer of land-This single buyer is called a monopsonist-Under monopsony,the buyer has to pay successivelyhigher prices for land to acquireadditional land. The higher prices apply to all units of land purchased.Hence,the cost of purchasing an additional unit of land no longer equalsthe price of land but, rather,the.rlparginalresource cost (MRC) of land- MRC is the increasein the total cost of land from buying an additional unit of land- The MRC curve, which is illustrated in Figrrre 6.6, has the sameinterceptÍts the supply (S) curve (50); however,the slope of the MRC cnrve is nrice the slope of the supply curve [l = (2)(0.05). The profit-maximizing quantity of land for the monopsonistis found by setting demandprice equalto MRC (pa = MRC) antl solving for Q as follows: 50 - 0.05Qd= 5 + l.Oq and Qo= q. The solution is Q. = 30. Comparedwith the purely cornpetitive solution (QJ, the equilibrium quantity of land with monopsonyis smaller (30 < 45), the equilibrium price is larger(35 > n.5> and NSB is lower (acd= 725 < 837.5= abd).The loss in NSB from monopsonyequalsthe areaabc.Hence,imperfect competition is not socially efficient. Moving from pure competition to monopsony in the land market causiesproducersurplusto increaseand consumersurplusto dectease,which makes the seller beúer off and buyers worse offrelative to pure competition.

so[e

ÈIRC=5+1 .OQs

ps=5+0 - 5Qg

pl'=35

pc=27 .5

D: pd =50-0.5Qa

Qn=30

Qc=45

in land market unden Bonopsony. D - denand; Figure 6.6. Equilibriun = cost; and S = supply. resonrce m3rginal MRC

SuanÈíÈfr

6. Natural ResourceDecisions

123

SurnrngrJt Decisions regarding the managementof nanrral and environmental rpsourcescanbe approachedusing one of four paradigms.Theseparadigms consist of the circular flow model, the material balancesmodel, the ecological economicsmodel and the sustainabledevelopmentmod.el.The complexity and stakesof resourcemanagementdecisionsincreasefrom the circular flow model to the naterials balancesmodel and from the material balancesmodel to both the ecoIogical economicsand sustainabledevelopmentmodels. Nanrral and environmental resourcesare classified as exhaustible or renewable. The stock of an exhaustibleresource,such as petroleum,coal and minerals, is fixed, although the time requiredto exhaustthe stock is extendedby recycling. The faster the rate of depletion of an exhaustibleresource,the more rapidly the stock is exhausted.There is considerableuncertainty regarding the location, qrrenfily 4o6 quality of certain exhaustibleresources,suchascrude oil and naturalgas.The stock of a renewableresource,suchas soil, water, crops, fish, wildlife andiorests, is stabilized by ensuring that the rate of use does not exceed the rate of regeneration. Time and space requirementsfor regenerationvary by resource.Renewable resourcesare generally more difEcult to understandand managethan are exhaustible resourcesbecauseof their dependenceon complex physical, biological and chemical processes,and their multiple and often competing uses. Static efficiency principles are appropriate for evaluating resogrce management decisionswhen usein the current period does not affect the availabinty of the resourcein future periods. ResourceefEciency in a static framework requires maxirni2i11gNSts (producer surplusplus consumersurplus).The condition for static resource efficienry is equality betweenprice and marginal cost under pure competi_ tion or price and marginal resourcecost under monopsony.

Questions for Discussion 1. Why are economists most comfortable with the circular flow paradigm in the resource decision hierarchy dèpicted in Figure 6.1? What arc some of the drawbacks of not advancing beyond ttris paradigm? 2- Conventional economics addressesthe optimum scale of a firm but ignores the optimum scale of the economy. The latter is a primary concern of ecoiogical economics. Why does this dichotomy exist? 3. What is the distinction between exhaustible resources and renewable resources? What is the irnplication of this difference for natural resource uranagement? ,) 4. I{ow does recycling of aluminum products influence the depletion of baurite? [Bauxite is the mineral from which aluminum is made.] 5. Suppose the dernand curve for land in Figure 6.5 shifts to the right so that the new demand equation is po = 60 - 0.5Qd- Determine the new equilibiium price and quantity of land and NSB.

\24

Natural Resourceand Environmental Econonics

Further Readings Pearce,Davr4 Edward Barbier andAnil Markandya 190. 'Discounting the Fufirre-" In SustainableDeveloptnent:Economícsand Environnent in the Thitd Wortd. London, England: EarthscanPublicationsLtd- pp. ?3-56. Randall,Alan. 1987."Cornucopiaor Cate.sEophe?'Chapter 2in ResoarceEconomics: An EcorwmicApprcachto Natural Resounce and EnvironmentalPoticy. New Yorlc John sliley & Sons,Inc.pp. ll-32. *e,

Note 1. Herrran Daly, *The Steady-Stare Economy: Altemative b Growthmani4" stúe Economics,2nd ed (cavelo, califonnia Istand press, l99l), pp. rg0-210-

Steady-

CHAPTER

ExhausÉibHe Resourceuse Unless we find a woy to dramntically change our civilization and our way of thinking about the relationship between humankind and the earth our children will inherit a wasteland,. -Vra

krsnmrr.Ar. Gonr, 1992

he static condition developed in Chapter 6 for efficient resource use. (price equals marginal -8. cost or price equals marginalresource cost) must be modified to take account of market dynamics if it is o be Aptied to ex-

haustible resources.Market dynamicsrefersto the interactionsbetweenthe exrraction and stock of a resourcethat occur over time. Exhaustibleresourtes,suchaspetroleum and minerals, exhibit market dynamicsbecausethe rate of extractionin the current period influences the stock of the resourceavailable in funlre periods.For example,if the current oil reserveis 700 billion barrels (bbl) and 30Obillion bbl are extracted in the next l0 years,then the oil reservefalls to 40O(700 - 300) billion bbl after 10 years. Ifhigher energyprices increaseenergy conservationand reduce óil extractionby 100 billion bbl over the next 10years,then the oil reserveincreases from 400 billion bbl to 500 (700 - 200) billion bbl. Energy conservationincreases the oil resetve by 10Obillion bbl. Therefore,efficient extraction of an exhaustible resourcesmust account for market dynanics. This chapfsl o(amiaes market dynamics and determination of fficíent intunenporal extraction for exhaustibleresourcqs.It also considersthe effectsof various factors on efficient extraction andprices of exhaustibleresources.

Market Dynamics Mùket dynarrics for an exhaustible resourceresult " from changesin resourceprices and extractionover time due to shifts in the suppty and demandfor the resowce. As shown in Chapter 6, market dynamicsare introduced by placing a time index in the fomr of a subscript on stocks,extraction and prices, and other factors that shift resourcedemandand supply. Incorporatingtime indexing in the stock accountingrelationshipfor the oil conservationexarnplein the intoduction gives:

Nafural Resource and Environmental Economics

126

S,=So-U,-, where S, is oil reserves(or stock) in the beginning of period t, Sois initial oil reservesand UFr is total oil extraction through the end of period t-1. For the oil example, So= 700 billion bbl, UFr = 2@ billion bbl with conseryation,and U,-r = 300 billion bbl without conservation.Therefore, S, = 50Obillion bbl with conservation ,à and S, = 400 billion bbl without consenration. While the stock accounting relationship indicates how oil extraction reduces oil reservesover time, it provides little insight about the efficient rates of oil extraction over time. For this and other reasons,a dynamic econodic model of resourceextractionis neededA, commonway to introduce dynamicsinto the oil market is to utilize a nodel that accountsfor changesin dernandand supply for oil over time. An example of a dynamic marketmodel for oil is as follows: Pt = g[Qo,,Qq,-t> RJ Demand Pt = f[Q'n Sn GJ Qa,= Q".

SUPPIY Equilibrium

where:

p, is the price of oil in period t, Qo,is the quantir-ydemandedof oil in period I Qd(t-r)is the quantity demandedof oil in the previous period (t-1), R, is a dernandshifter in period t which includes householdpreferencesand income and the quantitiesdemandedof substitutesfor oil, Q" is the quantity supplied of oil in period L S, is oil reservesin the beginning of period t, atrd G, is a measiureof improvemens in technology and other factors in period tThe demandequation statesthat the price of oil in the current period depends on the quantity demandedof oil in the crurent and previousperiods and on factors ttut shift,the demandfor oil over time, such as changesin preferences,income and tlie availability of oil substitutes.The suppty equationstatesthat the price of oil dependson the quantity supplied of oil in the crurent perio{ oil reservesat the beginning of the perio{ and factors that shift the supply curve for oil, suchas changesin technology.In equilibriurn, quantity demandedof oil equalsquantity supplied. The familiar two-variable demand(D) and supply (S) curves are derived from thesedemandand supply equationsby assigningspecific valuesto the demand and

7. ExhaustibleResomrce Use

u7

supply shifters. The dynamic marketmodel allows demandand supply functions to vary over time. The dcmandand supply curves for period t are lttustaled in Figure 7-1. With this procedure,the interceptof the der"attdcurve is determinedby the value of the two demandshifters,Q<,-o and R,, and the interceptof the supply cgrve is determinedby the valuesof the nvo supply shifters,s, anóG,. rn u p,rrety competitive industry, the equilibrium price of oil is p*, andequilibrium extraction of oil is Q**

NeÉSocial Benefit Efficient intertemporar extraction of an exhaustible resource refers to the efticient rates of resource extraction over time. These rates are determined by maximiztng nct social benefit (NSB). In the case of dissrete time, NSB is:

NSB = pV(80,..-,Br) =,!oB,{tr+ r)*, whele PV(Eo,-.-,81) denotesthe present value of net benefits of resource extraction in all T + 1 periods, r is the discount rate, (1 + r)-t 1, the discount factor in period t,

St: Pg=C+dQr1

Dr: BÈ=a-bQdE

qsanÈity

Figure 7.1. Demand @J and suBpty (s) curves and manket equilibrirrm for an exhaustible nesouncein period t under [Durecompetition

12,E

Natural Resource and Environmental EcononÍcs

0 is the initial period andT is the last period in the planning horizon. Net benefit in period L 8,, equalsproducersuq)lusplus consumersurplus,which is the areabetweenthe supply and demandcuryesfor the r€sourcein period t at the equilibrium extractionrate. B.(i. + r)* is the presentvàlue of the net benefit in period L Hence, NSB is the present value of net benefits of extraction over the planning horizon. NSB must be maxinized over all possibleextraction ratesfor the resourcein the T + 1 periodsin the planning horizon. ,É Efficient intertemporal extraction of an exhaustibleresourceis evaluated for two periods in the next sectionand for multiple periods in the subsequentsection. Both evaluations are basedon two simplifying assr:mptions.Fin$t, the resource is usedin the sameperiod in which it is extracted.This imFlies that there is no storageof extractedresourcefrom one period to the next. Second,resourcemarkets are assumedto be purely competitive. Consequencesof imperfectly cornpetitive resourcemarkets are discussedin the last section of this chapter.Oil is selectedas the exhaustibleresource.

Two-Feriod Dynamíc Effiiciency This section determines the equilibriurn conditions for efficient intertemporal extraction of oil in t'ro periods referred to as the curTent peiod and the future period- Two demand conditions are evaluated: cotrstcvú resource demand (Case l) and variable resource demand (Case 2). Constant resource demand means demand for oil is the same in both periods. It is appropriate to consider a constant demand when oil demand is relatively stable between the current and futrue period. Variable resource demand means that demand for oil changes between the current and future periods. Variable Íesource demand is appropriate when the demand for oil is expected to change over time. The constant and variable resource demand condition is evaluated for trro sqr ply conditions: unre.îtrícted supply (Cases lU and 2IJ) and restrîcted supply (Cases !R and 2R.) of oil- Oil supply is restricted (unrestricted) when the stock of oil is less than (greater than) total quantity dbmanded of oil in the two periods. Two cost conditions are considered'. zero margínal ettraction cosf (MEC - 0) and positive margbnl extraction cosr GVIEC> 0).t Marginal exEaction cost measures the change in total cost of oil extraction when an additional unit oil is extracted- For simplicity, MEC is assurned 1s !6 gsas,rant(the same in both periods). In srmrnary, the economic evaluation of efficient intertemporal extraction of oil grven below considers the following cases: Case l: Constant resource demand lU: Unrestricted supply MEC=0orMEC>0 llb Restricted supply MEC=OorMEC>0

7. ExhaustibleResouree Use

129

Case2: Variable resourcedemand 2U: Unrestricted supply MEC=0orMEC>0 2R: Restricted supply

MEC=0orMEC>0 cA.sE 1: TV[o-FERtoE]EFT"rclENCywflrE coNSTANir orn DEMA,ND.

In this case, efficient oil extractionrates are determinedfor the current and future periods. The constantoil demandis as follows: D:P=10-O.2OQd,

wherep is theprice of oil in dollarsperbarrel(bbl) andQois the quantirydemanded in bbl- The price interceptof the demandfunctionis 10 and the slopeis -O.ZO.necausethe demandfor oil is the samein both periods,there is no neeàto place a time index (subscript) on the price and quantity variables.This demandfunction is illustratedin Figure 7.2A. Casel[I: No Supply Reshiction The constantdemandfunction for oil with MEC = 0 is illustratedin FigureT.ZAandwith MEC = $5 in Figure 7.28. For MEC = O' NSB is maximizedby extractingthe amountof oil given by tbe quantity intercept of the demandfunction, namely,50 bbl. Therefore, the efEcient extraction rates are Q*o = Q*r = 50 bbl. Total oil extaction is 100 bbl. Equilibrium prices ile P*o = P*r = 0- Extractingmore than 50 bbl in eachperiod.addsnothing to NSB and, hence,is not in the bestinterestof society. For the efEcient extractionratesand an g percentdiscount rate, NSB is: NSB = PV(Q"o = Q*r - 50) = (0.5OX10X50X1.08-0) + (0.5oX10Xs0X1.08-') = $520. The first term (0-50X10X50)(1.04+11 is the presentvalue of the entire areaunder the demandfunction in the cr:rrentperiod,namely,Bs, or the areaunderthe demand cnrve in Figure 7-lA. Since 1.08-{= 1, the rtisgsualfactor is droppedin all subse_ quent present value terms for the current period. The second term (050X1OX50X1-08-l)l is the presentvalue of the entire area under the demand function in the perio4 namely,81. The expression(0.50X10X50),which ap pears in both terms, is the forrrula for a triangular area For MEC = $5, NSB is maximizedby extractingthe amountof oil in eachperiod which makesp = MEC = $5. This occursat ZjbUl as shown in Figure 7.28. The equilibrirrm extraction ratesandprices of oil in eachperiod are = Z5 bbt *A e* P* = $5- As long as oil demandand MEC are constanLand there is no supply restriction, the efficient extaction raîesand prices are the samein both perioÀ-. Totat oil exnaction is less when MEC = $5 thanwhen MEC = 0 (5Obbl vs. 100bbl). For the efEcient extractionratesand an g percentd.iscountrate, NSB is:

rc0

Naturatr Resourceand Enviroamsnrql Economics

PrieE

($ per bbl)

10

P=10-0 .20Qa

Fríce

($ Ber

bb].)

p=10-0.2OQa

50 Qua:eÈiÈf'

(bb].)

Figure 72. CaselU: F.fHcientextraction rates for oil with constant demand CI))aod unreshièted supply when narginat exhaction cost (lffiC) = 0 (A) and when MEC = 5 (B).

7.

Frhnrrstibls Resource []se

13L

- 5X25) NSB = PV(Q*o= Q*r = 75)= (0.50X10

- sx25x1.08-') + (0.50x10

= $120.37. The first tem, (0.5oX10 - t(25), is the present value of the area between the demand cunre and MEC = $5, narnely, 81. The second term, (0.50) (10 - 5X25X1.08-r),ib the presentvalueof the areabetweenthe demandcurve and MEC = $5, namely,82. CaselR: Supply res&iction- Wtren there is a supply restriction, it mwt be taken into account when determining the efficient extractionrates.The criterion for maximizing NSB in this caseis to selectextractionratesthat makediscountedprice equal to discountedMEC in both periodsandthat satisfy the supply restriction. Let the oil reservebe 80 bbl. For MEC = 0, NSB is maximized by solving for the extraction rates, eo md Q1,that make discountedprices equalin the both periodsand that satisfuthe supply restriction. Specifically, the following equationsare solved for eo and e,: Poo= Por Qo+Qr=Qe, where P0,= P,(1 + r)* is the discountedprice of the resotnceand Q{ is the oil reserve. For r = 8 percent, the discounted oil prices are poo = (10 - 0.20eJ (1.08)4 in the crurentperiodandp0,= (10 - 0.20QrX1.08;-t=9.26- 0.l9er in the funue period- substituting thesevaluesinto the last two equationsgives: l0 - 0.20Qo= 9.26 - 0.l9Qr Qo+Qt=80' solving for Qo and Qr gives the efEcient extractionratesfor oil, namely: Q*o = 40.37bbl and Q*r = 39.63bbl. Substituting Q*o and Q*r into ttre respectivedemandfunctions gives an equilibrium price of $1.93 per bbl in the current period and $2.07 per bbl in the funue period. This equilibrium is illustated in Figrrre7.3. For the efficient extraction rales and an 8 percentdiscountrate, NSB is: NSB = PV(Q*o='4O.37,Q*r= 39.63)= (0.50X10- 1.93X2tO.37) + (0.50)(10- 2-o7)(39.63X l.08rr = $308.39 As expected,NSB is lower with than without a supply restriction when MEC = O ($308.39 versus $520). Net benefit in the current period is the area under the demandfunction up to 4O.37bbl, which is Boin Figure 7.3A.Net benefitin the future

t32

Natural Resonrceand tsnvinonnrental Economics

p=10-0 .2OQa

44.37 50 quaatl.ty

Price

(bbl)

(g per bbl) B

10

P=10-0.2OQa

2.O7

39.63

50 EuantLÈy

(bbI)

Figure 73. CaselR: Efficient extraction rates foroil with constant denand @), reshicted supply (E0bbD and marginal exhaction cost (MEC) = 0 forcùrrent period (A) and future period (B).

7. ExhaustibleResource(Jse

133

period (Br) is the area under the demandfunction for the funre period up to 39.63 bbl, which is B1in Figure 7.3B..Any other extractionratesresult in a lower NSB. For MEC = $5, NSB is maximized at an extractionrate of 25 bbl in eachperiod, asshown in Figure 7.2J. The supplyrestrictionis not relevantin this casebecausetotal extraction of oil a.tp = MEC = $5 is less than the oil reserve(50 bbl < 80 bbl). In other words; the supply restriction is nor binding. when MEc = $5, the oil reservedoes not becomebinding until it falls below 50 bbl. For an efficient extraction rate of 25 bbl in eachperiod,NSB is the sameasit is in CaselU with MEC = $5, namely,$f20.37.

casE 2: TWGFERT(}DEFFICTENCY wlrH vARraBLE REsouRcE DE-

lldA'I\tD. Case2 assumesthat the demandfor oil increasesbetweenthe current period andfuture period. The following two dernandfunctions fiays rhis prope4y: Do:po = 10 - 0.20Qo Current demand Dr: Pr = 30 - 0.50Qr Futuredernand Thesedemandfunctions are illustrated in Figure 7.4.

Case2U: No suBplyresbiction. S/hen MEC = 0, NSB is maximized by extracting 50 bbl in the curent period and 60 bbl in the funre period (e*o = 50 and e*r = 60) as shownin Figure 7.4. Theseextractionrates arethe interceptson the quantity axis of the respectivedemandfunctions.Total oil extractionis 110bbl, and the equitibrium price (p") is zero in both periods. For the efficient extraction ratesand an I percentdiscount rate, NSB is: NSB = Ft/(e*o = 50, e*r = 60) = (0.50X10X50)

+ (0.50x30x60x1.08-r) = $1,083.33.

Bs is the entire areaunder the demandfunction for the curent perioq as shown in Figurc 7 -4A, and Bt is the entire aneaunder the dernandfunction for the future period, asshownin Figure 7.48. ComparingcaseslU and 2lJ forMEC = 0 showsthat when demandincreasesbetweenthe current period and future period, total extraction increasesfrorn f00 bbl to 110bbl and NSts increa.ses from $520 to $1,093. For MEC = $5, NSB is maximized by selectingextractionratesthat make p = MEC in both periods. The condition p - MEC requires10 - 0.20e0 = 5 in rhe current period and 30 - 0.50Qt = 5 in the futpre period. Solving theseequationsfor eo and Qr grvesQ*o = 25 bbl andQ*r = 50 bbl as shownin Figure7.5A and7.58. To. tal oil extraction is 75 bbl (25 + 50) and equilibriurn price (p*) is $5 in both periods. For the efficient exFaction ratesand an I percentdiscount rate, NSB is: NSB = PV(Q*o=,25, Q*r = 50) = (0.5OX10- 5X25)

- 5Xs0Xl.08-') + (0.s0)(30 = $641.20.

Na&ual Resourceand EnvÍronrnental Econonics

Lg

Priee

1$ per

bbl)

Po=10-0.2OQa

(g per

bbl)

Pr=30-0.50Qu

60 SraaÈitf?

(bltl)

Figure 74. Case2U: Efficient extraction rates for oit with increasing demand @)' unrestric'ted supply and marginat exhaction cost (MEC) = 0 for crùTent perid ú{) and future period (B).

7. ExhaustibleResourceUse

1_0

135

Po=10-0.20Qao

P*o

Price

($ per

QuanÈiE:r

(bbt)

60 QuantLÈy

(bbI)

bbl)

trr=30-0.50Qar

Figure 75. Case2U: Efficient exbaction rates for oil with increasing dernand @), unrestricted supply and marginal extuactioncost (MEC) = 5 for *rri."t perioa ia) and future pcriod (B).

136

Fiatural Resourceand Envinonmental Econornics

As expected, NSB is lowerwhenMEC = $J thanwhenMEC = 0 ($641.20vs. $1,083.33). Case2R: Suppty restriction. When total dernand for oil exceeds the oil reserve,the extraction rates that maximi2e NSB are determinedusing the sameprocedr:reas in CaselR For MEC = 0 and an oil reserveof 80 bbl, efficient extraction rate#are determined by equatingdiscountedprices in both periods and imposing the supply restriction. The effîcient extraction rates are determined by solving the following equationsfor Qoand Q1: l0 - 0.20Q0=27.78 - 0.463Qr Qo+Qt=80' Efficient extaction ratesareQ*o= 29.05bbl and Q*r = 50.95bbl. Equilibrium price is $4.19 per bbl in the current period and $453 per bbl in the funrre period. Discountedequilibriumprice is $4.19per bbl in both periods. Anotherway to determinethe equilibrirrm extrzrctionratesand discountedprice is to use a face-to-face diagrarn like the one shown in Figure 7.6. The diagrart showsthe demandfunction for the current period (D0)in the conventionalposition. The discounteddemandfunction for the future period (D,) is rotated 180 degreesso that it facesDs. Quantity extractedis measuredfrom left to right in the current period andfrom right to left in the future period'.The length of the quantity axis equals the supply restriction of 80 bbl. Efficient extraction rates and the discountedequilibrium price are determinedby the intersectionof the two demandfunctions. For the efficient extractionrates and an 8 percentdiscount rate, NSB is: NSB = PV(Q*o=29.O5,Q*r = 50.95)= (0.50X10- 4.19X29.05)

- 4.s3xso.9s) + (0.50)(30 =$733.24.

When MEC = $5 in both periods, the efficient extraction rates are found by solvingp*o = MEC = $5 to obtain Qo* = 25 bbl andsolving p*r = MEC = $5 to obtain Qr* = 50 bbl, as shownin Figure 7.7.Total oil extractionis 75 bbl, which is less than 80 bbl. Hence,an oil reserveof 80 bbl is not a binding supply restriction when MEC = $5. For the demandfunctions usedin case2R.andMEC = $5, the oil resetve becomesbinding when it is less than 75 bbl. When the oil reserveis a binding constrainL the efficient oil extraction rates have to be determinedby equatingp - MEC in both periods and imposing the resEiction Qo+ Qr = Q- Considerthe efEcientextraction ratesfor an oil reseryeof 60 bbl and MEC = $5. firis oil reserveis binding becauseit is less than 75 bbl. Extracting morethan 10 bbl in the current period causesthe amount of oil available in the funre period to fall below 50 bbl, which decreasesthe future period's net benefit. The prcsentvalue loss in the funue period's net benefit from extracting an additional barrel of oil in the current period is called marginal user cost MUC). How is MUC calculated?Let oil extraction in the cwrent period be increased from 10 bbl to 11 bbl. Sincethe oil reserveis 60 bbl, a 1 bbl increasein current ex-

7. ExhaustÍbleResourceUse

737

d

Ocl ,A

FIC{+{

!tOn o r|ot{ É+{ ottÈ

O

l[ B. ru! O l{$l-

AO

F{

I à

$ ."1

r, É

,i

6 (l)

€ èo 'ó Rc

H n Ia

',s trì e. -!

'68 lrlrn

î1

oto Ll c\ IIl od .t*

ool

ga)

.9É gt

-4

st Ei c€ ii lr

Éx eo)

.r€

ú^ îtE 9a >ì Cl Fr A tlr I

o t{ oo

il

oA l| {u}

o|v

ri

trL .en

\o-

ÉU eÈ

='r

FoE

iqg

traction reducesfunlre èxtraction from 50 to 49 bbl. The MUC of increasingoil extraction from 10 bbl to 11 bbl in the curent period is the presentvalue of triangle abc in Figure 'l.TB,which is $0.231K0.5OX5O - 49X$S.Só _ SS.OOI(1.08-r)1. This value is the slope of the MUC curve in Figure 7.7A.The efEcientextraction rate in the current period (Q*d is determinedby solving po = MEC + MUC for the equi_ librium quantity 1ssftain Q*o = 14.53bbl. The efficient extractionrate in the fuhue period is Q*r = 60 bbl - 14.53bbt = 45.4Tbbl.

138

Nahrral Resourceand Environnental Economics

(s

bbl)

A

L0 tr'o=?.09 PoPo=10-0 .20Qao

0

Price

0

Q'o= 25 14.53

50 Qtraatityr

(bb1)

($'per Lrtrl)

Pr=30-0.5OQar

Q*r= 45.47

50

60 euaar,iÈy

(bb1)

Figure 7J. Case2R: Efficient exbaction rates for oil with increasing demand @), restricted supply (6{tbbt) and marginal extr-action cost (MEe) - g for cunrent period 8{) and futur€ period (B).

7. ErhaustibieResourìce Use

Í!9

EfEcient extraction rates can be determineddirectly by solving úé fo[owing equationsfor Qs and Q1: p o s - M E C o o =p o r-ME C o r Qo+Qt=Qe-

SubstitutingMEC = $5 andQe = 6Obbl into theseequationsgives: - 4.63 10- 0.20q - s - 27.78- 0.463Qr Qo+Qt=6O' Solving the two equationsfor Qoand Qr gves Q*o = 14.53bbl and Q*r = 45.42 bbl. Substituting Q*o into the demand function for the current period Go = l0 0.20Qd) and Q*r into the dernand firnction for the future perioa (pr = 30 - 0.50Qr) gives the following equilibrirm prices: P*o= $7.09and p*r = $7.26. For the efficient extraction rates and an 8 percentdiscount rate, NSB is: NSB = FV(Q"o = 14.53,Q*r = 4547) = [(7.09- 5) + 0.5(10-:7.W)1L4.47 + (1.08)-'[(726- 5) + 0.s(30-7.26)]45.n = $625.14.

MuttiptrePeriod Efficiency The tweperiod analysis used above is limiting becauseit allows the stock of the r€sourceto exceedtotal quantity demandedof the resource.When this occurs,someof the resourceis not extracted,which reducesits value to society.This limitation is easily overcornein a multiple-perioa analysisby requiring total extraction of the resourceto equal the stock of the resource.Given that efficient resourceextraction can be determinedfor an infinitely long planning horizon Cf = *), this requirementdoesnot imply that the resourceis unavailahleto futnre generations.

EQUILIBRfUM COI\DIIEONS. Efficient extraction of an exhaustiblerìesource over multiple periods requiresthat nro equilibrium conditions be satisfied.TheTîrsr equilibrttnr condirton is: ps - MECs = po,- MECorfor t = 1,...,î

140

Natural Resource and Environmental Econonics

where p is the market price of the resourceand MEC is margiial extraction costThis condition statesthat the difference betweendiscountedprice and discounted MEC must be equalin all periods.This condition applies even when demandand./or marginal extractioncost vary over time. For Case2R with MEC > 0: p6- MEC - $7.09 - $5 = $2.09and .é

pot- MECIr = ($7.26- $5y1.08= $6.72- $4-63= $2.09. Becausep - MEC = MUC in pure competition, the fist equilibrium condition for efEcient intertemporalextraction of an exhaustibleresourcecan be written as: MUC6= MUCr = ....=MUq. In equilibrium, MUC must be the sarnein all periods.As shown in the two-period. analysis, MUC is positive when the total dernandfor an exhaustibleresourceexceedsthe availablesupply.If MUcr > MUCr (t + t'), thenNSB is increasedby raising extaction in period t and lowering extraction in period t' until MUC is equal in all periods. When the first equilibrium condition is satisfieù MUC increasesat a compound rate of r over time: MIJCr = MUCo(1+ r)t for t = 1,...,T, where r is the discountrate. \\e secondequilibriwn condition requiresthat total extraction of the resource equalstotal resourcestock To satisfy this condition, resourceprice must increaseat such a rate that quantity demandedof the resourcebecomeszeroin the sameperiod as the stock of the resourceis exhausted.The secondequilibrium condition ensurcs there is neither a surplus nor a shortageof the resourceat the end of the plenning horizon (I).

TIME PAfE OF PRECtsSA,F[I) ÉXfnaCTION. The two equilibrium conditions have implications for the time path of resourceprices and extraction. In the special casewhereresourcedemandis constantand MEC = 0 over time, the pattrof resourcepricesis describedby Hotelling's condition: Pt= Po(l + r)t for t = 1,...,7 This condition requires: (p,*r-pJpt=r, which implies that resourceprice increasessmoothly and exponentially over time by the rate of discount.When prices increasein this rnÍrnner,resourceextraction decreasessmoothlyand exponentiallyover time. The time pattrsfor resourceprice and extraction ratesimplied by Etrotelling'scondition are illustrated in Figrre 7.8.

7. ExhaustibteResourceUse

141.

A,

È Pc=Po( 1+r)

B

F-igure7.S. Hotelling iiine path for resource price (A) and extractÍon rate (B) when resoureedemand is constant and marginal extractÍon cost (MEC) = 0 in atl perÍods.

!42

Natural Resourceand Environment-l Econonics

When MEC = 0, equilibrium requires p = MUC, which requires prices to increasein accordancewith incneasesin MUC. Wben MEC is greater than zcro and constant over time, the time path of prices is displacedupward by MEC. In period T, the extractionrate is zero andresourceprice reachesits highest level, namely,ps. Changesin resourcedemand resourcesupply and the discount rate influence the equilibrium time pattr of resourceextraction and prices. Dernand can increase due to incrcasesin populationand income and can decreasedue to lowd prices for substitutes.MEC canincreaseovetrtime when the resourcestock is not homogenous (stock effects) and per rrnit taxes on resoruceextraction (severancetaxes) are increased.MEC can decteaseover time due to technologicat improvements that increase the efficiency of resourceexploration and extraction aud lower severance taxes. Other things equal,a higher discount rate acceleratesr€sourceextraction and a lower discount rate deceleratesresource extraction. The direction of change in near-termresourcepricesand extraction for different demandand supply conditions is summarizedin Table7.1. Consider the implications of an increasingdemandfor oil demand with constant MEC. Increasesin the demandfor oil imply that oil prices increaseover tirne. This causesthe presentvalue loss in returns from current oil extraction to increase, which meansMUC is higher in later periods than in earlierperiods. Equalization of MUC acrossperiods,which is required by the first equilibrium condition, necessitates shifting oil extractionfrom the presentto the future. llow do oil companiesreactto an increasein resourcedemand?If oil companies do not adjust intertemporalresourceextraction rates, then oil shortageswould occur in the funre andoverall profit would be lower. By shifting extraction from the present to threfuture, companiescan eliminate shortagesand increase profit. Oil companies would continue to shift extraction from the presentto the future until profit margins on oil extraction(p - MEC) are equal in all periods. As shown in Table 7.1, certain combinationsof changesin resource demand and supply result in a particular change(up or down) in resourceprice and extraction and other courbinationsresult in indeterminatechangesin resource gice and extraction. Elecauseanexhaustibleresourceis finite, higher extraction rates shorùen the period required to exhaustthe stock of the resource.ImprovemenB in technology can lengthenthis period.

Table 7.1.

In Denand Constant Increase Increas€ fncrcase Decrease Decrcase Decr€ase Constant Constant

Directionsl movenent in neaptem prices and esùaction of an e-haustible r.esource forvarious resourse dcnands and MEC Fufirre Change Near-Term Change fn MEC In Pricc In Extraction

Constant Constant Decr€ase Increase Constant Decrease lncrease Decrease Incr€ase

MEC = margiDal extraction cost

Smooth inctease Increase Ideterminae Indeterminate Decrease Decrease Decrease Incrcase Decrease

Smooth decreas€ Decrease Decrease Indeterminab Increase Indeterninate úrc:rease Decrease Increase

7. Exhaustible ResourceUse

1{t

Undenlying Factors This section describeshow six factors influence the efficient rate of resourceextraction and resourceprices: a) technologicalprogress, b) imqerfect competition, c) externalcosts,d) discountrate, (e) recycling and (o ex_ ploration and developmenl conclusionsare based on ,n" *.n-ption that only one factor at a time is being variedpRoGREss. Technological TEcENor,oGrcaL progress,caninfluence resource extraction and prices two ways. First, it can increase the efficiency of resourceextraction' Second'technologicalprogresscan lead to developmentif substitutes for the resource. Supposea oevitoping technology has the potential to reducefuture MEc relative to currentMEC ròr oil. This causesfunue MUCs to exceedcurrent MUCs, which violatesthe first equilibrium condition. To restoreequilibrium, oil extraction must be shifted tom tie present to the futgre: How do oil companiesreact to-the new technology?Part of tle decrease in future extraction costswill be passedon to consumersin the fonn of lower prices. If demandfor oil is elastic' then lower future oil prices would increase funue oil consumption and revenues'The expectedincleasein future revenueswould prompt oil companiesto shift oil extraction from the presentto the future. Supposetechnologicalprogresslowers the cost of photovoltaic cells (electricity from solar energy) and makes electricity productiàn from photovoltaic cells competitive with electricity production tom oit-powered ,o*."i. This changein the relative cost of might cause some households to substitutephoto_electricity voltaic cells for oil furnaces, which would reduce the demandfor and price of oil. If the decline in oil prices were appreciable,theu oil extraction would ur."rv decline. A major concernwith technologicalprogress is the ungeftainty regarding its timing and impact-BecausetechnologicJ pÀgrrs is usually the result of enginegring and rnan4gs6snt innovations, the rate of development of new.'extraction technologies and substinrtesis affected by nonmarket conditions. The history of mariy industrialized countries indicates that technological progress is accelerated when there is a greÍrterneed for the technology.Deviopment of synthetic rubber {*iog v/orld war r was the direct result of cÈÀnetiog oàtoral rubtrerinto the production of tires for airplanesand vehicles used in tne-war effort- As pointed out in Ch4pter I' technologrcalprogressoften increasesthe use of natural resourcesand degrades the environmenr Development of inoqganic fertilizer decreased the anount of land neededfor crop production (fertilizer was substitutedfor land) but increasedthe use of natural gas (which is used a p-do"" inorganic fertilizer); hence,extraction of natural gasincreased. TMPERFECT coMPETrytoN. Most marketsfor exhaustibleresourcesare nor competitiveExceptforpubticly sanctionedmonopoliessuchasthoseestab!*Iy lished for the local and regional disniúution of oil, gas a;d water,a monopoly is illegal in the united States-Nevertheless,exploration, development andmarketing of many exhaustible resources,especially energy and minerals, are done by a few, large compnniss.f,Ience,most natual reso'rce markets have elementsof imperfect competition.

7M

Natural Resource and Environrnental tsconomics

How doesimperfect competitioninfluence effrcient intertemporal extraction of an exhaustibleresource?This questionis answeredby comparing efEcient extraction of an exhaustibleresourceulder pure competition and imperfect competition. Let the oil reservebe 60 bbl and assumethat the marketsfor all other inputs usedin exmcúon of oil are purely competitive.As shown in the previous section, efficient extraction in purely competitive marketsrequiresp0,- MECo, to be the samein all of the resource.ffiEcient experiods (ignoring environmentalcosts)and exrra-*ustion and price is $7.09per bbl in bbl equilibrium tractionwith pure competitionis 14.53 the currentperiod, and 45.47bbl and$7.26 per bbl in the funre period" as shown in Figrrre7.9. This is the sameequilibrium illustrated in Figure 7.7. Hence, with pure competition, an oil reserveof 60 bbl constitutesa supply restriction. Under imperfect competition,profits are maximized by selecting resourceextraction ratessuch that MR - CMEC+ MUC) is equal in all periods on a discounted basis, and total extraction equals the stock of the resource.The abbreviation MR standsfor marginal revenue,which is the changein total revenuefrom a one-unit changein resourceextraction.When the market demandfor a resourceis negatively sloped,marginal revenueequalsone half of the price. Hence, the slope of the MI{ curve is one half of the slope of the demandcurve. For the demandandmarginal extractioncostsillustrated in Figrre 7.9, efEcient resonrceextraction and price in an imperfectly competitive market is Q*o- = 12.5 bbl and p*o- = $7.50 per bbl in the currentperiod md Q*r^ = 25 bbl and p*t^ = $17.50per bbl in the futureperiod.EfEcient extractionis slightly lower (12.5 bbl < 14.53bbl) and equilibriun price is slightly higher ($7.50> $?.09) in the current period with imFerfect competitionthan with pure competition- In the funre period" efficient extractionis substantiallylower (25 bbl < 45.53 bbt) andprice is much higher ($17.50> $7.26) with imperfectcompetitionthan with pure competition.Because total oil extractionis lessthan the oil reserve,z2.s bbl of oil (60 - 137.5bbl) are unusedat the end of the future period. The time paths for resourceprice when MEC is constant over time and the samediscoutrtrate is used fs1 imperfect competition and pure competition are illustratedin Figure 7.10.When theprice of oil exceedsthe price of an oil substinrte (pj, consumersof oil switch to the less expensivesubstitute,and the quantity demandedof oil becomeszero. Thergfore,the upper lirnit on oil price it pr. Because the initial price of oil is higher with imperfect competition than with pure competition (ps- > pù), more time is requiredto exhaustthe resourceunder irnperfect competition than under pure competition (I- > TJ. In other words, extraction of the resource is spreadout over a longer period with irnperfect competition. When the' discountrate is positive, shifting oil extraction from the presentto the future reduces NSB. Therefore,NSB is lower with imperfect competition than with pure competition. Different results can occrr when MEC and the discount rate are not the same for pure competition and imperfect competition. EXIERhIAL COSTS. The first equilibrium condition for efEcient resource extraction requires that marginal user cost be the samein all periods. Extraction of many exhaustibleresourcesgeneratesan external diseconomy, which imposes a cost on affected parties. Surface mining of coal severely disturbs the landscape. Mining of precious metals, like gold and silver, result in slag piles. R.ain leaches

7. ExhaustlbleResourceUse

Pries

($ per

145

bbl.)

A

10 P'o-=7 - 50 P'o"=7. 09 Do:po=10-Q . lóuo

Prj.ce

Q'or=

Q'0"=

12.s

1 4. 5 3

($ per

bbl.)

25

B

P'i-=17 '?5

Ds:pr=l9-6 - 50., f i.=7.25

Q'r.=25

Q'r"=45.47

60

SuarÈLry

(bbI)

Ffficient extraction rates and prices for oil under pure competition Figure 79(c) and imperfect conpetition (m) with a supply rrestriction of 6O Uhl in current períod (4') and tuture period (B). MEC = marginal extraction cost; MIIC = marginaì user cost; and MR = marginal Feyenue.

t6

Natural Resourceand Environnental Economiis

Prùce

Figure 7.10. Time path of resource price and tine to exhaustion under pure competition (p, TJ and inperfect cornpetition (p- TJ when p" is price of a sobstiùfe nesouroe.

heavy metals from slag piles. The metals are Eansportedto stre:urxiand lakes in runoff, causing water pollution. Burning fossil fuels contributes to global warming and acid precipitation.Environmentalpollution c:rn diminish hrrmanhealth and reduce the capacityof the environmentto assimilatewastesand perform vital ecological services.Lossesin environmentalquality from the extraction and use of exhaustibleresourcesare an externalcost.External costsshouldbe takeninto Írccount when selectingthe socially efficient extraction ratesfor exhaustibleresources. Supposethe marginalenvironmentalcost of oil extraction in period t (MNCJ is positive when oil extractionexceedsa threshpldextractionrate of Q5, as indicated in Figrne 7.11.When the extractionrate is below Qu, úe environmept 6ssimilates all the distrubancesand wastes associatedwith resource extraction. Therefore, MNCr = 0 for Q < Qr. When the rate of extraction exceedsassimilative capacity '(Q > QJ, MNCr increaseswith the rate of extraction-Threshold exmction ratesand the rate at which MNC. increaseswith extraction are likely to vary over resonrces and time. For example,coal generatesabout 75 percent more carbon dioxide per 1,000BTUs of heatenerg'ythan doesnatural gas.2Therefore,burning coal produces a greaterrisk of global warming than does burning natural gas. Undergroundmining of coal usually causesless environmentaldegradationthan doessurface mining of coal. Tunporal differencesin environmentaldegndation can also be significant. Once degradationof an ecological systemexceedsa cerain level, the loss in biodiversity increasesrapidly.

7. ExhaustibleResounce Use

I47

QuaatíÈy

Figure 7.1tr.- l$fiarginal environrnental crosÉG/fiSC) crurye for an exhrustible Fesource in period t

The efficient extraction rates for an exhaustible resource when marginal environmental cost are considered are illustrated in Figure 7.12. When MNC is ignored, the efficient extraction rate is Qo where p = MEC + MUC. When MNC is nonzero, the efficient extraction rate is Qo where p'o = MEC + MUC + MNC. Because eo < Qo and y'o > Po,the efEcient extraction rate is lower, and the efficient price is highea with than without environrnental cost. In general, the condition for efficient intertemporal extraction of an exhaustible resource is that the present value of p MEC - MUC - MNC be the same in all periods and that total resource extracrion equals the stock of the resource.

DESCOUFIT RiftrE. É{ow do changes in tho discount rate influence the efEcient intertemporal extraction of an exhaustible resource? A lower discount rate causesoil prices to rise more sloriily, according to ttrotelling's condition, pt = po(l + r)r. For a fixed demand, slower growth in oil prices means faster growth in quantity demanded of oil. ds a result, the oil r€serve is exhausted before the quantity demanded of oil reaches zero. There is excess demand for oil and the second equilibrium con, dition is violated. To re-establish equilibrium, the initial price of oil (po) must be increased until once again the oil reserve equals total extraction. When po is raised, oil prices are higher in earlier periods than later periods, which allows oil companies to increase

148

Natural Resource and Envírorunenfal Economics

Price MEC+UUC+MNC

p;

Po

ah

a;

Qo

$ranÈLtrr

Flgure 7.12 Comparison of egilibriun extuaction rate (Q) and price (p) in cnrrent period considering (9ù and ignoring (Qù environrnental cwts. MEC - marginal extraction cost; MUC = marginal nrsercost; MNC = narginal environmental cost; and D = demand.

profit by shifting extraction from later to earlier periods.A higher initial price, combined with a lower discountrate,increasesthe time requiredto exhaustthe resource. A higber discount rate has the oppositeeffecl The initial price must be reduced so that the resourcecan be exhaustedin a shorterperiod of time. This effect can be illustratedin Figure 7.10 by lening p" be the price path before md p. the price path after the discount rate increases.The higher discount rate increasesthe time to exhaustionfrom T. b T.. How do oil companiesrcs1nndto a lower discountrate?A lower discount rate incteasesthe presentvalue of funrreincome from selling oil. Therefore, oil revenues canbe increasedby shifting extractionfrom the presentto the future, provided marginal extraction costs do not rise over time. In conúasL a higher discount rate redbcesthe presentvalue of funue income from selling oil, which causesoil companies to shift extraction from thefutnre to the present-Consequently,a change in the discountrate gives oil companiesa pnofit incentive to makethe sameadjustment in extractionrates as required by the equitibrium conditions. What are the intergenerationalimplications of changing the discount rate? When the amount of resourceextractedis fixed, a lower discount rate shifts extraction from the presentto the future,which increasesthe amountof the resource avail-

7. ExhaustíbleResourceUse

t49

able for future generations.Conversely,a higher discountrate shifts extractio1from the funrre to the present,which depletesthe resourcemore rapidly and reducesthe amount of the resource available for futurc generations.This intergenerationaleffect of the discount rate on resourceextractionhas sparkedinterest in other criteria for allocating exhaustibleresourcesover time. Following ùe line of thinking proposedby Howarth and Norgaard,3intertemporalexnaction canbe determinedby assigning funre generationsa property right to a portion of the current resourcebase. In essence,this reservesa portion of the crurent stock of the resourcefor future generations.

RECVCLXNG. Recycling converts residuals from production and consumption into useful products. lvlany materials are recycled, including newspaper,glass, metal, cardboard,plastic, motor oil and by-products of agricultural and industial production. Froducts can be made from primary (virgrn) material and/or secondary (recycled) material. Consider aluminum products, which include containersfor a variety of consurnerproducts,equipmenl structuresand motor vehicles parts.One of the major aluminum products is beveragecontainers.Atuminum beveragecontainers can be made frornprimary and/or secondaryaluminum. Primary aluminum is manufactr:redfrom bauxite ore, which is mined- Secondaryaluminum comes from recycled aluminurn containers.Most consumerscannot tell the differencebetween aluminum products made from primary or secondaryaluminum. This is not tnre of all products. Recycledpaper can often be distinguishedfrom viryin paper. There are three types of recycling that apply to both exhaustibleand renewable resources. Closed-loop recycling involves converting a residual into a new consumer product that has form and propertiessimilar to the residual. Using recycled 4lssf11umin alrrminumcontainersor usingold paperfiber in new paperproductsis each an exarnpleof closed-looprecycling. Open-looprecycling utilizes residualsin a product that is different in form and/or properties from the residual. Using the residuals from timber harvesting (bark and branches)to make a rnulch for ornamental beds or utilizing sawdustfrom a lurnber mill for animal bedding are e&tmples of open-loop recycling. Enzrgy recycling recoversenergy from residuals.Using methanegas recoveredfrom animal manure to generateelectricity or burning solid wasteto produceheatgre examplesof energyrecycling.Becauserecyclingis not 1@ percent efficient, it lenerates its own wastes. Recycling hasbenefitsand coststhat dependon the type of recycling andother factors. Considerthe benefitsand costsof closed-looprecycling of aluminum-There are severalbenefits.First, it decreasesthe demandfor bauxite, which reducesthe extraction of bauxite and extendsthe life of the bauxite resource.Second,environmental degradation from bauxite mining declines.Third, recycling aluminum decreÍìses the energy required to mine, mnsport and process bauxite. Making aluminum products froin recycled aluminum requires only 6 percent as much energy Írsproducing theseproductsfrom bauxite.4 Fourth, aluminum recycling reducesthe anrount of householdand industrial trastL which increasesthe longevity of existing landfills and decreasesthe demand for new landfills. The longevity of a landfll is the time required for the landfill to reach its capacity.Increasingthe longevity of landfills is a significant benefigespecially in major cities wherelandfills havereachedor Íue near cE)acity and suitable

150

Naturatr Resourceand Environmental Fcononics

space for new landfills is very limited. Lanrtfills also involve atr opporhrnity cost equal to what the land would earn in its next best use.Fifth, alrrmìnnmrecycling reduceslitter, which has aestheticbenefits. Recycling of aluminum enrrils several costs.Firsg tbe household or business must separate4luminum residuals from other types of residuals. Second"the alulaiarrm hasto be transportedto a recycling facility. Recycling costs are influenced by the technologiesfor gathering and processingresiduals;thè geograptúcconcen_ tration of recyclablematerials;and governmentpolicies, sucn as aritrs, discriminatory freight rates,tax credits, severancetaxes and depletion allowances. Benefits and costsof recycling determine the extent to which householdsand businessesrecycle their residuals.Considera householdthat is deciding whether or not to recycle a residual and, if so, how much of the residual to recycÉ. The decision dependson the marginal private benefit (MpB) and marginal cóst (Mc) of recycling' asillustrated in Figure 7.13. MPB reflects the private benefit to the household of recycling. If the household is refunded a deposit when the recyclable material is returne4 then MpB includes the refund. The figure also showsthe mar_ ginal socialbenefit (MSE) of recycling. MPB is generallyless rhan MSB because the household does not consider the benefits to society of recycling, such as extending the life of the primary resourceand the longevity of landfills, decreasing wasteloadsand aestheticbenefitsof reducedlitter. MC include the marginal cost to the household of separatingresiduals (aluminum, paper,glass, etc.) and transporring them to a recycling center.The transport cost is negligible in cities that have curbside rerycling. When MC is gîeaterthan MPB, as shown in Figure 7.13A+the privately efficient artount of recycling is zero (Qr= 0). The socially effi.cientamount of recycling is positive (q>0). When MC and MPB intersecl as depictedin Figure 7.138, the privately efficient arrrountof recycling is positive (Q">0) but less than the sociaily efEcientamount(q < Q'J. Next, considera firm's decisionwhetheror not to tuiesecondary(recycled) materials in its production activity, and if so, how much secondarymaterial to use. When primary and secondarymaterials are perfect substitutes,the isoquant is a straightline with a 45-degreeangle,a.sillustratedin Figure 7.l4A.In this case,the decision about how much primary and/or secondarymatedal to use dependson the relative pricesof the materials.If the price of the prinary material exceedsthe price of the secondarymaterial, then the isocost line has a slope greater than 45 degrees and production cost i5 minimiz.edby using only the secondarymaterial (point a). Conversely,if the price of the pnmary material is less than úîe price of-the secondary material, then the isocost line has a slope less than 45 degreesand production cost is minimized by using only the primary material (point Uj. f" the event the primary and secondaryrnaterialshave the sarneprice, the isocost line is congruent with the isoquantand production cost is the sameregaÍdlessof which combination of prirnary and secoúdaryrraterials is used. When the primary and secondarymaterials are less than perfect substitutes, production cost is minimized by using a combination of the two-materials, as illustrated in Figure 7.148. The higher the trrice of the primary (secondary)rnaterial relative to the price of the secondary(primary) material, the greaterthe use of the secondary (primary) material.

7. EvhanstibleResource[Ise

151

A,

enou8t

recarcled

B

a: Àngua,È

racycl.ed

Figure 7-13. Prtvately (Q)_an-rlsociatty (eJ efficient amount of recycring showing when it is inefficient (A) and e$cient (B) foi a hotrsehold to recycle.i,rC I marginar cost; MPB : marginal private beneftt; and MSB = narginal social beneft-

152

Natural Resourceand Envirorunental Economics

Secoadatfz naterial

A

.é

pa'{nrry

maÈerial

Secoadarar materia]-

B

PrlmarT'

Uaterial

E"tgure 7.14. Efficient use of primary and secondar5r materials when they are perfect substitutes (A) and iess than perf,ect substihrtes @). Y = isoquant; atrd pr = ratio of price of primary rnatsrial to price of secondary material

7" EshaustibleResourceUse

153

EPLORÀIION Ahln XIEVELOPMENT. While the stock of an exhaustible resourceis fixed' the size and location of specific resource deposits are uncertain. The degreeof uncertainty is higher for certain exhaustible resources(petoteum) than others(coal).Exploration is the processof determining the location and size of resourcedeposits.If the searchresults in a discovery then exploration continuesuntil the extentand size of the deposit are confirmed.If a deposit is economicalto produce, then developmentfollows. Darclopmentinvolves the activities leading up to exEactionof the resotuce.If resourcedepositsare not found in favorableareÀ, then estimatesof the resourcestock are usually reviseddownward. Significant discoveries canlead to upward revision in the estimatedstock of the ,rooo", which exers downward pressureon resource prices. Downward (upward) revision in the resouf,cestock decreases(increases)the time to exhaustion,other things equal.

Sumnrasy Exhaustible resoÌrces have the fundamental properry that cuxrent extraction decreasesthe stock of the resource, which reduces the amount of the rcsource available in funrre periods. This property of exhaustible resources makes resource extraction and prices dynamis or timedependent. Market dynamics can be introduced by placing a time index on stocks, extraction, prices and demand/supply shifters such as population, income, availability of substiurtes and technology. Efficient intertemporal extraction of an exhaustible rcsource is determined by maximizing net social benefit, whích equals the present value of the sum of prodo".t surplus and consumer surplus over all periods. In general, efEcient intertemporal extraction'of an exhaustible resource requires the present value of resource price minus marginal extaction cost minus marginal user cost minus marginal environmental cost ó U. tn" r"*tù uUl"rioar, and all of the resource to be extracted. The time path of resource extracùon and prices is influenced by extraction costs, resource demand and the discount rate. In the special case where resource demand is constant and MEC is zero in all periods, resource price increases over time by the discount rate. Efficient extraction rates and prices for an exhaustible resource are influenced by several factors, including tecnnàtogical progress, imperfect competition, external costs, discount rate, recycling and exploration and dèvelopmenl-Technological progress can darnpen and even reduce resource prices. Relative to pnry competition, imperfect competition typically extends the period needed to exhaust the resource, which reduces net social benefit from the resource. Consideration of external environmental costs of resource extraction reduces the socially efficient extraction rates and increases resource price. Iligher Qower) discount rates increase (decrease) the rate of extraction in the near term and shorten (lengthen) the period over which the resourcc is exhausted Recycling of residuals generated.by consumption or production of products made uéing exhaustible resources has several benefits and cósts, including conserving the resource, decreasedenergy use, extending the longevity of landfills, reduced linering and others. Resource exploration is undèrtaken d find additional resource deposits and to reduce uncertainty regarding the location and size of resource deposits.

154

Natural Resourceand Environmental Economics

Questionsfor Díscussion 1. Modify the stock accountingrelationship for an exhaustible resource (S, = So U,-,) to take Írccountof recycling. 2.It is often arguedthat the discountrate for a private company is higher than the discountrate for society.What is the basisfor this argument?How does the discrepancybetrpeenpnvate and social discountrates influence the efficient intertemporal extractiotrof an exhaustibleresource? 3- Show that Hotelling's condition (R = po(r + r)r for t = r,-..,T) is consistent with the equilibriurn condition for effrcient intertemporal resource extraction (r, = MEct + MUC.for t = 1,...,T)when resourcedenand is constantand MEC = 0. 4. Supposethe demandequationsfor oil ue po= 10 - 0.20eo in the current period andPr = 30 - 0.50Qr in the funre period-Marginal extraction cost is $1 per bbl in the current period and $2 per bbl in the funue period Determine the efficient prices and extaction in both periods and net social benefit when the oil reserve is 80 bbl and the discouut rate is 10 percent. 5.Abackstoptechnologyis a technologythat becomeseconomicalto usewhen the price of an exhau.stiblercsourceexceedsa certain level. For example, elecEicity generatedfrom photovoltaic cells is a backstoptechnology for electricity generated from fossil fuels. FIow is the efEcientintertenporal extraction of an exhaustible resourcelikely to be influenced by backstoptechnology?Does it make any difference whetherthe backstoptechnology for an exhaustibleresource involves extraction of anotherexhaustibleresourceor exploitation of a renewableresource? 6. The rate of recycling in St Lucia is low. The SL Lucia City Council is reviewing a policy recommendationfrom the ResourceRecovery Commission to initiate curbsiderecycling. The cost of providing this servicewould be paid by the city. Use Figure 7.13 to illustrate the likely effectsof this recommendationon household recycling in St Lucia Do the effects qf this policy dependon who pays the cost of providing curbsiderecycling?

Further Readings Common, Michael. 1988. "Natural Resource Exploitation." Chapter 7 in Envircnmental and,Resource Economics: An Intrcdrction New York Longman Inc., pp- 198-268. Dasgupta P, S. and G. M. Ileat. 1979. Economic Thèory and Exharsrtbb Resources. Cambridge: Cambridge University Press. Hotelling H. 1931. ''fhe Economics of Exhaustible Resources." Journal of Polîrtcal Econonry 39:137-175.

7. ExhaustibleResourceUse

155

Notes 1' while MEC = 0 is highly unlikely, it is evaruated for nro reasons.Fint, it providesa stepping stone to the more complex caseof MEc > 0. second, MEC = 0 is one of the as_ sumptionsunderlying Hotelling's condition, which explains the behavior of prices and extraction over time. 2' Chrisopher Flavin' tlthe Bridge to clean Enetrgy," world warchcwashington,D.c.: S/orldwarchInstitute,July/August lggz),pp. l0-l g3' RichardB Howarth andRichardB. Norgaard,'Tntergenerational ResourceRights,Efficiency, and Social Optimality,', I_arrdEcorwmics66(1990t1_11. 4. John E- young, "Aluminum's Real Tab,', worrd watcn (washington, D.c-: v/orrd_ watch Insriùrte,March/April Igg2), pp. 2f-33.

CEAPTER,

E

RenewableResource Management Destruction of tropicalforests drives the extinction of countless unique plants and animals. It also adds to Eartk's greenhbuse effect, ,purc erosion of valuable topsoil, and exacerbates deadly flooding. -Rrcrnnp

Mouesrensry, l99O

enewable resources have a capacity to renew or regenerate themselves. There are two

-E-L. types of renewable resources:conditionnlly rencwable or nondegradable-Conditíonal$ renewableresources,suchas soil, watet f,sh, wildlife and forests,have a regenerativecapacity,which is influencedby a variety of natural processesand human activity. Soil regenerationis influencedby chemical, geological, hydrological and biological processes.Water regenerationis controlled by the hydrologic cycle, which is affected by solar egerg;y,ctim31"-O topography.Regenerationof fisb, wildlife and forestsis influenced primarily by biochemical and hydrologic processes-The rates at which conditionally renewableresourcesare harvestedaffects their capacity to regenerateparticularly whenharyest rates exceedrates of regeneration. A conditionally renewableresourceis degradedwhen userates exceedregenerative capacity.Excessivedegradationcan lead to total exhaustion or extinction of the resource.Huge irrigation diversions from the Aral Sea in Soviet Cennal Asia have causedwhat was once the world's fourthJargestinland seato be dramatically reducedin size and decimateda highly productive fishery.rIJse rates for certainex_ haustible resourcescan influence the regenerativecapacity of conditionally renewable resources.Extensive use of coal to generateelectricity in the Mdwestern United Smresproduceslarge dmountsof sulfur dioxide, whictr, in combinationwith rain water, produces acid precipitation. Deposition of acid precipitation in forests and lakes in the norttreasternUnited Statesand easternCanqdaLas dareased the productivity of these ecosystems.Sustainableuse of conditionally renewableresourcesrequires that use rates be kept below regenerativerates-When this occgrri, the flow of human and environmentalservicesprovided by these resourcescan be maintained indefinitely, which benefitscurrent and future generations. Nondegradablerenewableresources,such as energy from the sun, wind and tides, have a regenerativecapacity that is not influenc.a Uy human activity. Only a small fraction of the energycontainedin nondegradablerenewable resourcqsis directly utilized in economic activities. For exarnple,only a small amountof the so-

158

Natural Resourceand Envinonnental Economics

lar energythat reachesúre earttr'ssurfaceis usedby plants in photosynthesis.While hr:man activities do not influence the regenerativecapacity of nondegradableresources,they influence other environmentalconditions. For example, atmospheric testing of nuclear devices introduceshighly toxic substancesinto the atmosphere and the burning of fossil fuels contributesto global wamring. This chapter focuseson the managementand use of conditionally renewable resourcesin general andbiological resourcesin particular.The bioeco*é:nic implicationsof threemanagementregimesare evaluated:prív^te pîoperty, conlntonproperty with limited accessand commonproperty wíth mlímited access.Private and socialty efficient hanrestrates and optimal resourcestocks are evaluatedunder static and dynamic conditions. Ftrarvestrates that result in, maximwn sustaìnable yield, speciesextínction and,maximwnnet social benefit are compared.

SfunptÍfyin g ^A,ssumptions The economicanalysisof conditionally renewable resourcespresentedhereis basedon a combination of the following assumptions: AsswnptionI. T\e resourceis private property,which implies limited Írccess. There is either a single owner or rnanageror multiple ownerswith a single menag€,Í. The resourcemanager'sobjective is to ma"ximizeprofit from useof the resource.An exampleof this assrmptionis aprivatelyownedranch.Only the ownersof theranch and other individuals designatedby the owners have a legal right to use the prop erty. Asswnpti.on2-T\e resourceis common property with limited access.The resourcemanager'sobjective is to maximize total profit from use of the resource.An example of this assumptionis when a tribe rations the use of uibal grazing land amongits members. Assunnption3. Ttre resourceis common property with unlimited access.Each resourceuser atternptsto mzurimizehis or her own profit fron use of the resource. An example of this assumptionis when fishers have unlimited accessto an oceao fishery. Asswnption 4. Biological growth processes,demandfor the r€source and cost of harrrestare known. This assumptionimplies an absenceof biological and ecoynic uncertainty Asswnption 5. The resourceis managedfor a single use and/or for a single species.Single-usemanagementimplies that a forest is rnanagedfor its commercial timber or recreationalvalue, or tbat an oceanis exploited for its commercial.fishery. Singls speciesmÍrnagementignoresinterdependenciesamong ryecies in an ecosystem such as the potential negativeeffects on small mammalsof managing a forest ecosystemfor grizzly bear habitar Managing for multiple speciesor uses is more complex than managingfor a single use or species.

8.

Rencwable ResourcellÀanagement

159

Assumption ó. The resource is menagedfor multiple uses and/or multiple species.By law, many publicly ownedresourcesin the United Statessuchasthe national forest and lands man4ggdby ttreBrueau of Land Managementmust be npnagedformultiple uses..Multiple-usemanagemententailsboth cornpetitiveand complementary uses of the resource. Outdoor recreation and commercial timber production are likely to be competitive usesof a forest when timber harvestingrates are very high and/or there is clearcutting. Enhancingfish and wildlife habitat and irnproving fishing and hunting conditions arelikely to be complementaryusesof the foresL Assumption 7. Markets for naflual r€sourcesand inputs used in conjunction with natural resourcesare purely competitive. Pure competition requires complete and accurateknowledge of markets and technology,large numbersof buyers and sellers, and homogen@uriand divisible inputs and outputs.

Natraral Growth The basic accounting relationship for a biologrcal resource is:

S,=So+&-tL-L" This equation states that resource stock or biomass (S) equals initial biomass (S), plus cuurulaúvebiomass growth (R), minus cumulative harvest of the resource (H), rninus cunulative biomass losses (LJ, all measr:red at the end of the current period (t). For example, in the case of an ocean fishery, S, is the stock of fish (biomass) at the end of the curent perio4 Ssis the initial fish biomass, R, is currulative growttr in fish biomass tbrough the end of period q [\ is cnmulative harvest of fish tbrough the end of period t, and L, is cumulative fish losses through the end of period f Losses are due to nafirral c:ilrses such as disease,tsunami and changes in ocean temperahres (El Nino), floods and earthquakes. While this simple accounting relationship gives a good historical accounting of the resource stoch it has several deficiencies in terms of explaining changes in the stock and detennining econornically efficient harrrest rates for the resource. Firsq it simplifies the dynamic nature of renewable Ésowces by iguoring important int€ractions betrryeenhanvest and growth over time. For example, when the rate of harvest exceeds the threshold rate of growttr neededto preserve the species, the species can become extinct at which point the resource stock (S) is zero. Secon4 it does not consider how chmges in technology and rersourceprices influence hawesl For example, improvements in technology that increase hanrest rate. per unit of effort have important implications for the profitability of resource extraction, resource price and resource conditions. A rrore comprehensive model of renewable resiource rnanagement is needed that takes into account the interaction between growth and harrrest over time. Narural gmwth is the growth in excess of biomass losses from nanual causes. Naural growth in Beluga whales equals additions to the population frorn birtbs mi-

16{l

Natual R.esource and EnvinonmentalEcononics

nui losses due to mortality. It describesthe changein biomass in the absenceof commercial harvestingand can be discreteor continuous. Discrete growth occurs in discretetime periods (week, month or year) over a finite or inhnite numberof periods as indicated by the following equation: Gr=Sr-S.-,

(t = 0,...,T). é

This equation statesthat growth in period t (GJ equalsthe differeuce between biomassat the end of the cufrent period (SJ and biomassat the end of trnevionsperiod (S,-ù. Discrete time is indicatedby placing a t subscripton a variable.T is the number of periods in the planning horizon and is referred to as the length of the planning horizon. Continuousgrowth occurscontinuously over a finirc or infinite numbe,rof time periods: G(t) = dS(t/dt

(t = 0,..-,T).

This equation says that growth at time t equals the instantaneouschangein S(t), or ùe shangein S(t) for a small changein t, which is written as dS(t/dr Continuous time is denotedby placing a parenthesizedt on a variable. S/hen biomass growth dependson the level of biomass,as in the last two equations,growth is said to be density dependent,To indicate that growth is dependenton biomass,growth firnctions are sometimeswritten as G(SJ for discrete growth or G[S(t)] for continuous growth. Nahral growth ratesfor biological resourcesdiffer over spaceand tirne due to natural variation in nutrients,precipitation, ternperature,topography,wind and other biogeophysical conditions. While no single mathematicalequation best describes natnral growth in biomass^thelogistic cune haq cousiderableappeat.The logistic gowth rate in continuoustime is: Gts(t)l = is(t[l - S(I/SJ, wherei is the intrinsic growth rate and S,'o is the naximum stock-A logistic growth curve is depicted in Figrrre8.1. Giowth rate, G(S), increasesat a decreasingrate as the stock increasesfrom S.r to S.rr. 516 is the minimum or tbreshold biomass. When S-i. = 0, as in Figure 8.1; thereis exhaustionof the resourceor speciesexrtnuion S,orb the sùockthat achievesnaximpn sustainableyield (q), which is the maximum growth that canbe sustainedby the resource-Asthe stock increasesfrom S.", to S-o, the growth rate declinesand evenhrallyreacheszero at S-.-. The magnitude of Sr"" is determinedby the environmentalcarrying capacity. Purely cornpensatorylogrstic growth requiresS.io = 0 and that G(SJ or G[S(t)] 'be strictly concave (n) as illustrated in Figure 8-1. For any initial biomass, if S(t) approachesS.* as t approÍrchesinfiniry then growth in biomassover time can be describedby a logistic crlrye asillustrated in Figure 8.2. The generalhartest fmctíon for a renewableresourcewithout the time designationis: q = H(S, f)

GrorsrEb a-d ProductLoa Rates

F (S./13)

F (S/12)

F (S/r1)

Srio=0

sr=v

Flgure E.1. hrely cornpensatory togí$ic gFowth iR stock of rcnewable resonrce, G(S), conditional ha$est ftrnctiong F(S[j) and efficient harvest rates (q).

Stock

F'igure 82.

Logistic biomass (stock) growth over time for renewable resource.

tú2

Nahtrdl Resourceand Environmental Economics

where q is the rate of harvest,S is the stock and I standsfor the inputs usedin harvesting the resource.For the moment, I includes only variable inputs (fixed inputs iguored). The harvest function indicatesthat the hanrestrate depeadson both input use (f) and stock level (S). rn general,q is an increasingfunction of I and S. fre conditional Inmest fiirction rs: q=F(S/I=D.

,.st

This function expressesthe relationshípbetweenharvesrrate (q) and the stock (S) when I is fixed at \- When input use is fixed, harrrestrate increasesas the stock incl€asies,and vice versa.In other words, q is an increasirg function of S for fixed I. Conditional harvest functions for input usesf1, l2,I3,I+ and I, are shown in Figure 8-1- Each conditional harvest function is a ray or straight tine through the origin. This implies that hanrestis zero when stock is zero and harvestper unit of stock is constantwhen input use is constant.Harvest increasesas input use increasesfrom 11to 15.Therefore, the conditional harvestfimction rctates counterclockwisearound the origin as I incre"ses. Biologically efficient harvestratesoccur at qr, gz and q: where the conditional harvestfunction intersectsthe growth curve. Why are theserates biologically efficient? ql is the most biologlcally efficient harvestrate for f1 becauseincreasing input use(I > It) causesthe harvestrafieto exceedthe natural growtta which decreases the stock Conversely,at a lower input use(I < IJ, natural growth exceedsthe harvest raîe causing the stock to increase.Biologically efficient harvestratqs increase with higherinput useas long as I.Ir, narnely,cb > llz > gr. What happenswhen input use exceeds13?Consider !, which corrcspondsto the conditional hanrestfunction labeledF(S&). Input use is so high relative to natural growth at Ia that the stock falls below the level that achievesrnaldmum sustainableylel{ 54 < S,"y, and harvestis lessthan at L (qz < q,). Flotting the biologically efficient harvestratesin Figure 8.1, namely,er, gz and q3,with the correspondinginput usegives the yield function depictedin Figgre 8.3. \\e yield fwction relates biologically efficient harvest rates to the corresponding inPut use. Input use greater than 13is biologically inefficient becauseharvest rafes decreasefor I > 13.For example,Inand12grve the samehanrestrate, namely, q,, but I is substantiullygreaterthan Ir.

Static Efficiency PRNfAIE PR'OPERTY. This section examines the managementof privately owned renewableresources(assumption1) when there is no uncertainty (assnmp tion 4), a single usefor the resourceor a single speciesbeing managed(assumption 5) and prue competition (assumption7). In addition, decisions are assumedto be madein a static setting, which makessingte-periodanalysisappropriate.When a resourceis privately owned, only the resourceowner and those having permission from the owner are allowed to usethe nisource.Othersare excludedfrom using the resource,which makesaccesslirnited.

E. RenewableResourcetrdanagenmt

163

Ea::vest Rat6

IDInrÈ

Figure E3. Yield function f,orrencwableresorrrcewithpurely comlrcnsatorygrowtb. Tonl profit or ecoìnomicrent for a privately owned resource is the difference betweentotal rcvenue (fR) and total cost fiC): tt(q)=TR(q)-TC(q). Maximizing r(q) withrespect to q gives theprofitmaximizing rate of harvest Total profit can also be defined in terms of input useasfollows: tt(D=TR(D-TC(I). Maximizing tr(q) *ith respectto I gives theprofit maximizing input use.Both ap proachesyield the sameefficient harvestratesand input use. In some applications it is easierto work with r(q) than rc(f), andvice versa In the following explanation, the efficient hrvest rate is determinedby ma:rimizingr(q). In the secondexample of profit mzurimizationgiven in the next section,efficient input useis determinedby maximizing n(D. When the resourcemarket is purely competitive,the price of the resource(p) doesnot dependon théhanrestrate (q). Therefore,TR = pq, which indicatesthat total revenueis a linear firnction of q as shownin Figure 8.4A. The total cost cgnre (TC) is derived from the yield function grvenin Figure 8.3. For simplicity, all inpuB are assumedto be variable, which represenbeconomic conditions in the long run- Multiplytng the amount of input from the yield cunre by its price gives total cosLWhen input markeB are purely competitive,input prices do not dependon the quantity of inputs purchased.If input use12requiresi, units of labor, i, gnits of fuel

Leve1

7@

Natural Resourceand Environmental Economics

and i3units of equipment and the market prices of theseinputs àf,ec1,c2and c:, rEspectively,then total cost for 12is: TCCIT-TC4= crir + c2i2+%is. Other valuesof TC are derived by repeatingthis calculation for other input levels. Ploning total cost for different input useswith the correspondingdarvestrafes grves the total cost curve in Figure 8.4A. Harvest rate qs and total cost TCa conespond to maximum sustainableyield. Only the segmentof the total cost crnve between 0 and f contains economically efficient harvest rates. Harrrest rates on the baclrpard bending segmentof the total cost curve (f to h) are economically inefficient becausethese harvest rates can be achievedat lower total cost by decreasing input use.For glarnple, I4is greaterthan Ir, yet both levels of input use provide the sameharvestrate (g). Therefore,TC is greater-ith Io than wittr I, CfCo> TQ). Total profit is maximized at a harvestrate of q, where the difference betweenTR and TC,.namely, TR2 - TC2, is a maximum. Hanrest rates above or below q2 are less profitable. Becausegz( gr, the profit maximizing harrrestrate is less than maximum sustainableyield. Figure 8.48 depicts the profit maximizing hanrestraùein terms of marginal revenueGvm.)and marginal harvestcost (MIIC). MR equalsthe changein total revenue with resp€ctto hanrest.Becausethe resotuceis sold in a purely competitive market, MR. equatsresourceprice, which makesthe MR curve horizontal. MHC is the changein TC with respectto a changein the hanrestrate, which equalsthe slope of the TC curve. Becausethe slope of the TC curve increasesas hanrestincreases, MHC iocreasesat an increasingrate as harvestrises.For a trarrrestrate greaterthan qr, MHC > p, which implies cost increasestnore than revenue. Conversely, for a harvestratelsss than gz,p ) MIIC, which implies revenueincreasesmore than cost. Profit is a maximum at q2 where p = MHC. As resourceprice increasesand/or harvest cost decreases,the hanrest rate that maximizes profit approachesmaximum sustainableyield (q2+q). In summary, when a privately owned conditionally renewable resource is managedfor maximurn profit under static conditions: 1. The profit maximizing harvestrate is generallyless than maximum sustainable yield (qz< qJ. maximum sustainableyield 2. Tbreprofit maximizing hanrestrate apprroaches (qz+%) as resourceprice increasesand/or marginalharvestcost deffeases. 3. In the unlikely event that marginal harrrestcost is zero, the profit maximizing hanrestrate equals maximum sustainableyteld (q2= %). 4. The resourceis not likely to becomeextinct becausethe input use that maximizes profit is below the input usethat lserls to extinction CIz< Is). EX.AMFI-ES. Two exarrples are used to illustrate how the profit maximizing harrrestrate for a privately owned renewablercsourceis determined.The first exarnpledoes not specdy the mathematicalform of the yretd function, whereasthe secondexarple does.

8.

Renewable ResourcelVfanagement

Total

16s

Value

A h TCn ToEaI Cost,

(rc)

îcr

TRz TCz

S4

9r

Earyest Rate

Va3.ue per trRrLt B Average harrzest cosÈ (AIIC)

rarwetst Rata

Ptrofit -l"inrizing

harvest rate based on total (.a) and marginat (B)

tffi

Natural Resourceand Environnental Econonícs

The first exampleis basedon input use, harrrestrates,total cost, total revenue and profit given in Table 8.1. The table includes only the efficient portion of the yield function- Input price is $0.5Oand resourceprice is $3. Input use is in column I and harvestrate is in column 2. Total cost equalsinpot use (column 1) times the price of the input. Total revenueis harvestrate (column 2) times the price of the resource.Profit is total revenue(column 4) minus total cost (column 3). Profit reaches a maximum of $2 at a hanrestrate of 2 andan input useof 8. Maximudsustainable yield is greater than the profit maximizing harvest rare (5 > 2). Io terms of Figue 8.4A: jz=2 and 12= 8; qs = 5 and Is = 35; and% = 4 andl+=24- Note thatprofit is negative (there is a monetaryloss) at maximum sustainableyield. In the seconds;amFl€, growth in biomassis logistic and the lurttest fwtction q is crSI where a is a constanl pe1 rhis harvestfunction, harvestper unit of input approacheszero as the stock approacheszero (qA{ as S+0). The resulting yield finctionls'. 9 =a N I(l -q VF) , where N is environmentalcarrying capacity and F is the intrinsic rate of growth in the resource.For this yield function, hanrestis a maximum when.input use is2:

y= pl2o,. Hanrestrates(q) correslnnding to different input use(D for ct = 0.002, N = 150 and p = 0.40 are given in Table 8.2. q increasesas I increasesfrom 0 to 100 and decreaseswhen I exceeds100.Maximum sustainableyield occurs at I = 10O. As statedearlier,the profit function in terms of I is: n(D=TR(D-TC(D. Substinrtingpq(t) forTR(I) andctrforTC@, wherep is theprice of the resourceand c is unit input cost"gives the following profit functiou: n (f)=p c1 (D - Ct Substinrtingthe yield function for q(t) in the last expressiongives: a(I)=pal$I(l -aVp)-Ct Substiurtingthe numericalvaluesfor tr,,N and F,rsed in Table 8.2 into the last exîabte EJ. Exanple of harrest rates for dífrerent input levds and corresponding total cosú'total rwenue and Input Level

3 8 l5 24 35

Harvet Ratc

I 2 3 4 5 Profit is a maxinrumat I = 8.

Total Cost($)

150 4.00 7.50 12.00 17.50

Total Rwenue ($)

3.m 6.m 9.00 12.00 15.00

hoft

($)

150 2.00 150 0 -250

8.

Renelvable Resourcelldanagenent

rfl

Table &2. Eanest rates and input lweLsfor q - aN IG- aI/D" Input Level IlarrrestRane ?i 5.4 4 9.6 60 12.6

E0 100 r20 1zt0 160

r4.4

15.0 t4A 12-6 9.6 nq is tre rateof harresgN is cnyironrnentalcarrying capacity,I is input, c' is a constaú, andp is the inrrinsicrue of gpwth in ùe resource-cr = 0.(XÌ2,N = 15Oand p = 9.46.

pression,setting the derivative of the resulting expressionwith respectto I equal to zero and solving for I gives the following profit maximizing input use: ,*_0.3p-c. 0.0O3p I

--

For p = $2O and c = $4, I* = 33.33.SubstitutingI* into the yietd function gives a profit maximizing hanrestrate of q* = 8.33. Substinrtingq{' and I* into the hanzest function and solving for S grvesan optimal stock of S* = 124.96-Finally, su-bstituting p, c, q* and I* into the profit function grvesa ma:rimumprofit of $33.2& Note that the profit maximizing harrrestrate is lessthanmaximrmr sustainableyield (8.33 < 15)- For p = $25 (higher price) and c = $3 (lower cost of input), the profit maximizing harvest rate increasesfrom 8.3 to 12.6.Therefore,asp.increasesand/orc deq* approachesq-*. crea^ses,

COMMON PROPERTY. Many renewableresourcessuch as national forests, big game herds and ocean fisheries are corrrmonproperty resources.A common property resourceis a resourceowned by a large group of individuals whoseaccess to the resonrcecan be timited or unlimilsdl National forestsin the United Statesare the common property of the generalpublic and arernanagedformultiple usesby the United StatesForest Service.Accessto national forests is essentiallyunlimited althougb use of certain portions of the forest, such as cÍìmpgrounds,usually require pa5rnentof a fee. Access to common property resourcescan be limited by a variety of instinrtional arrangements.With pastoralgrazing, such as in the developing countries of Africa" gnnng land is the common property of a tribe. The tribe limits irccessto commonly owned grazing land by specifying the period of time eachmember is allowed to graze cattle. Grazingon tribal land is not permíttedby norunembersof the tribe. Grazing on publicly owned land in the westernUnited Statesis managedby the Bureau of Land Managementand the ForestSenrice.Both agenciesissue grazing permits to private ranchers.A permit glves the rancher an exclusive rigbt to $f:ar;ea certain number sf animalsin a particular area-In retqrn for grazing rights, rancherspay atr annual grazingfee to the agency,which is basedon the fee per animal times the number sf animalsgrazedin the area This section g;ernines the use of renewablécommon pfop€rty resourceswith

r68

NaturatrResourceandEnvironmentalEconomics

limited access(assumption2) or unlimited access(assumpion3). There is assumed to be no uncertainty (assumption4), single-useor speciesrumagement(assumption 5) and pure competition (assumption7). Limited.A,ccess. SupposeÍrccessto and harvestingof a renewable cornnron properry resourceis controlled by a single resourcemanager.If the resource manager's objective is to mÍximize profit, then the manegerselectsthe úre input use and harvestrate as a private owner of the resource,namely,I2 and qr, respectively. There is brpically no difference between the profit ma:dmizing i"put use and harvest rate for a privately owned renewableresourceand a commonly owned re1ewable resourcewith limited accesswhen both resourcesareman4gsdfor maxirnum profitUnlimited Access. When accessto a renewablecommonproperty resourceis unlimited, useof the resourceis quite different even whenthe objective of each resource user is to maximize profit. Total revenue exceedstotal cost (there is excess profi$ at the harvest rate that maximizes profit when Írccessis limited (q, in Figrrre 8-4). When there is unlimited access,excessprofit causesresourceusers to increase input use andharvestratesin order to capture someof the excessprofir In addition, excessprofit is likely to attractnew resourceusers.Input use and harvest increase until excessprofit is zero at q4.In terms of Table 8.1, input useincrcasesfrom 8 with limited accessto 24 with unlimited access.At a harvestnte of 24.profit is zero and there is no incentive for firms to increaseharvesl A harvest rate in excessof qo generateseconomic lossesthat snmulates resourceusersto reduceinput useand harvestrates-In particular,for q > ga,TC > TR. orAHC > p, which resultsin economiclosses.In aneffort to reducelosses,resource useni decreaseharvestrates until qo is reached-For the revenueand cost relationships depicted in Figure 8.4, the profit maximizing harrrestrate is greater with unlimited accessthan with limited access(q+> qJ and both rates are less than ma;dmum sustainableyield (q, < g+< g:). The profit maximizing harvestrate can also be determinedusing marginat and averagecost curyes as shownin Figure 8.48. For a privately owned resource,profit is a maximum at the harvestrate that equatesprice to marginal hanrest cost (p MHc), narrrely,gz.At gz,p > Ar{c, which implies excessprofit per unit of harvest; the sameresult sltained with the total revenueand total csst curyes.When access to the courmon property resoruceis unlimited" excessprofit causeshanrest to increaseuntil price equalsaveragehanrestcost (p =AIIC at point g), which occursat qo where profit per unit of harvestis zero. Point e in Figrre 8.4A, at which there is zero economic profit, correspondsto point g in Figr:re 8.48. In general,there is greaterlikelihood of resourceoverexploitation and extinction for a renewablecornmonproperty resourcewhenacccssis unlirnited than when {t is timited. This occurs for severali"*o*. Firsq increasesin resource price generally lead to higher input usewhen accessto the resourceis unlimited. Supposeresourceprice increasessuchthat total revenueequalstotal costat lnint h on the backward bending portion of the total cost curve in Figure 85. Excessprofit is zero at h. Becausepoint h correspondsto point d in Figures 8.1 and8.3, the input use at point h is I and the stock is Sa.BecauseSa< Sr"r, the resourceis being overexptoited at

E. RenewableResounc€ Management

169'

an input use of l. In general,when there is unlimited Ílccess,inc:reasesin resource price bring about increasesin input usethat causethe optimal stock of the resource to aPprorichS*o. Therefore, the likelihood of overexploitaiion and extinction is much greater with unlimited accesstlmn with limited access,other things equal. A secondsourceof overexploiation is optimism regardingthe productivity of the resource.Supposeresourceusersin the industry ou"t"rti-ut" the yield for the resource.In this case,the estimatedyield firnction lies abovethe uue yield function as shown in Figure 8.64 Basedon the estimatedyield function, resourceusersbelieve I6results in maximum sustainableyield; however,the true mardmum sustainable yield occunsat Ir, which is substantially less than 16.Bcause the true yietd function is below the estimatedyield function, the tnre total cost cnrve (TC) is to the left of tbe estirnatedtotal cost curye (TC) as shownin Figurè 8-68. When accessto the resourceis unlimite{ resourceuseincteasesuntil profit is zero, which occurs when total revenueequalsestimatedtotal cost.This occnrs at I, whereTR = TC(IJ. At Ij, resourceuSérsexpecta yield of q, but only achievea yield of Qo.Because15is greaterthan the input use that achievestme maximrmr sustainable yield CIi), the stock falls below the level that achievestrue maximum sustainable yield and the resourceis overexploited.The greaterthe overestimationof yield, the greater the overexploitation and the likelihood of extinction. High resource prices in combination with optimism regarding resourceproductivity result in an

Eota1

Vatue

Ealvest

RaÈa

Figure E5. Overexglloitation of common propeÉy rcnewable Fesorurewhen accessis untirnited and resource price is high. TC = total cost; TR, = total reyenue.

L7A

Naturnl Resourceand Environmental Econornics Eanregt RaÈe A

(Is

Qe

0 ToÈal

I?

rs r 6

IDEUÈ

Level

Va1ue B Estimated

Total

Cost

(TC)

osÈ (TC')

T C( r s )

9s

Ea-west Rate

Figure E"6. Effects of biologicat uncertainty on input levels (A) and profit mq-irnizing harvest rates (B). even greater likelihood of overexploitation and extinction than either factor taken alone. fsl unlimited accessto a common property resource: 1. llarvest rate is higher and the stock is lower than with limited access. 2- Harvest rate is likely to exceed maximum sustainable yietd3. Resource stock can drop to levels that eventually lead to extinction.

E. RenewableResourseht[anagement

L7t

MI,]LTIPLE OBJECTIVE II,{ANAGEMEI\IT. Multiple objective managsnsnf is desirablewhen the resourcehas more than one use and/or harvestrafcs for one speciesinfluence the productivity of other species.Conflice in multispeciesmanagementis exemplified by the hrnadolphin controversy that occurredbentreenthe United Statesand Mexico. In early 1991, the United Statesplaced an embargoon hrna caughtusing hawesting methods(purse-seinenets) that causeincidental death of dolphins. The embargowas motivated by amendmentsto the United Sùates'Marine Marnmals Protection Act that limited dolphin killed dudng tuna hanresting. Mexico, which relies heavily on the objectionableharvestingmethod,chargedthat the Act violated the GeneralAgreementon Tariffs and Trade's (GATT's) free trade rules becauseit constituted a barrier to trade. A panel of the GAIT ruled that the tuna sanctionsimposedby the Act did in fact violate free trade rules- This ruling brought into question not only the vatidity of the Act but the whole issue of inconsistenciesbetween domesticenvironmental Mexico decided not to use the ruling policies and international tade agreements.3 to opposethe United Statesban becauseit did not want the tuna-dolphin controveniy to jeopardize the North Anerican Free Trade Agreement among the United States,Canadaand Mexico. Resourceconflicts from multiple-speciesmanagementoccur in the protection of endangeredspecies.In a landmarkcasebasedon the EndangeredSpecieAct, the United StatesForest Servicereducedharvestîatesin old grourthforestsin the northwestern United States to protect the habitat of the northern spoúed owl. These forests are the only habitat for this speciesof owl. Effects of multiple usemanagementon resourceuse dependon whetherthe resource uses are competitive or complementaryand how alÌernative management strategiesinfluence use.Considermultiple usenumagementin which nonconsurn1> (competitive use of a renewableresourcedecreasesas consumptiveuse inc:reases tion in use). For exarnple,the roads neededfor commercial logging operationsare a major sourceof water pollution in streamsand lakes. Waterpollution impairs the ecological serrricesprovided by the forest. Supposethe loss in ecological services per unit increasein harvest rate, called marginal ecological loss (MEL), increases exponentially when the harvestrate exceedssomethreshold rate of qs as sho\iln in Figure 8.7. Becausemost ecological senricesprovided by a forest are unpricedand do not influence the value of commercial timber, they are usually ignored by timber companiesin determining harvestrÍrtes.The privately efficient harvestrate is q2where p = MHC (p is the price of timber) and the socially efficient harvestrate is ql where p = MHC + MEL. Becausefb ) gr, the privately efficient hanrestrate exceedsthe socially efficient harvest rate. Therefore, harvest rates are higher and the stock is smaller when marginal ecological lossesfrom timber hanrestingare ignoreù Not all usesof renewableresourcesare competing. For example,the clearcutting of forest patchesito'*r sunlight to reachthe forest floor, whicÈ imp-uo feeding habitat for deer and other grúng animals.In this case,there is a complernentary relationship betweenthe two usesof the forest up to somerate of clearcuning. What are the irnplications of complementaryuses?Supposeharvestingof, timber generatespositive ecological benefits for wildlife that graze but that the marginal ecologicalbenefit ClffB) decreasesas harvestingincreasesand evennrallybecomes zeroat qaasshown in Figrrre 8.8. When the resonrceis managedto maximizeproút, the efficient raîe of hanrestis q2whereP = MFIC.

Value

per Uait

Eawest

RaÈe

F'igure E.7. Effrcient tinber hawest rates in a forest with (qJ and without (q2) competitíon between timber production and ecological senrices.MH, = marginal ecologicalloss; MHC : marginal harvest cost; and p = resounceprice. Value

per lla.it

EarrtesÈ

Figure E.E. Ffficient haruest rates ín a f,orestwith (t13)and without (qz) complementarity between tirnber production and ecologicalsewices. I\,il08 = marginal ecologicatrbenefrt; MHC = marginal harvest cosÉ; priceMFIE = marginal environmental benefit; and p = rrelKtrlr.ce

R.a'Èe

8. Renewable Resource Management

\73

S/hen the resourceis managedto maximize net social benefiLthe ef6cient rate of harvestis q wherep = MIIC -MEB. Becauseq2< q3,theprivately efEcientharvest rate is less than the socially efficient harvest rate wheuresourceusesare complementary. The relationship between private and socially efficient harvest rates with complementary uses is just the otr4rositeof what it is for competitive uses (comFareFigures 8.7 and 8.8). Static efEciency conditions for a conditionally renewableresogrcehave limited value in evaluating renewableresourceissuesbecausethey ignore the tirnedependent interactions betweenphysical factors (natural growth and stock) and economic factors (prices and costs). The next section exarrines efficient use of a conditionally renewableresourceusing a dyn"mis frarneworkthat explicitly recog_ nizes these interactious.

Dynamic Efficiency A renewable resotrrce generatesdirect benefits to thosewho produce or use it andindirect benefits to sciety. Direct benefits include: income from production of the t€source,suchasrevenuefrom the saleof timber and fish, employment and tax revenues.Indirect benefitsrnay or may not involve use of the resource (see ChErter 12).An indirect benefit that doesnot involve use of the resourceis preservationvalue. Renewablerqsoruceshavepreservationvalue when society wants to preservesuchresourcesfor the benefit of future generations.When certain speciesof whales becametbreatenedby excessiveharvesting,the International Whaling Commission announcedvoluntary harrrestquotas.Theserestictions . \uere supportedby most countriesthat harvestedwhalesand by consumerand special interest groups concernedabout preserving whales.The EndangeredSpecìes Act and Marine Marnmals ProtectionAct in ttre United Statesaddressthe preservation of plant and animal speciesthreateìredor endangeredby humanactivities (preserving biodiversity). More recently, the objective of resourcemanagementhas shifted from preserving speciesto preserving ecosystem$.Generally speaking, preservationof an ecosystemdominatedby renewableresources,zuch as a forest or coral reef, is higher (lower) when the stock of the resourceis higher (Iower). In continuous tìmc, social benefit derived from a renewableresourcecan be representedby the following function: B(t; = Blq(t), S(t)1. This function statesthat socialbenefit, B(t), dependson the rateof hanrest,q(t), and the stockof the resource,S(t).How do q(t) and S(t) influenceB(t)? B(t) is poìitivety related to q(t) and S(t). Increasing(decreasing)the harvestrate of commercial timb€r in a rain forest increases(decreases)the cornmercialvalueof the foresf but decreases(incrcases)the stock of trees and related biota A lower (higher) forest biomassdecreases(increases)preservationvalue (biodiversiry), which lowers (raises) social benefit Ttrerefore, increased(decreased)timber harvestingin the rain forest increases(decreases)direct benefitsbut decreases(increases)indirect benefits. In other words, enhancingdirect andindirect benefitsof a rain forest arecompeting ob-

tI4

Natural Resourceand Environnental Economics

jectives. Such competition causesconflict betweencommercialtimber and environmental interests. The social benefit firnction gsltains a threslwld $ect when decreasesin the stock of the resource do ngt affect social benefit until the stock drops below a thresholdlevel. When there is a threshold effect, the benefit function is: B(9 = Btq(t)l if s(0 ) s' or Blq(D, s(t)l if s(t) < s,.

4d

The first function statesthat social benefit is not influencedby the resource stock as long as the stock exceedsa thresholdlevel of 51.The secondfunction statesthat social benefit is affected when the stock falls below the thresholdlevel. Applying the benefit function to the spottedowl exemple iídicates that the preservation vatue of the forest as habitat for the spoued owl is not adverselyaffected as long as forest biomass is above the threshold level. However, if forest biomass fails Llow the threshold level, then additional harvesting degradesowl habitat, which endangers the owl. For stock levels below the threshold level, preservationvalue of the forest decreasesas forest biomass decreases,which reducessocial benefit. This impties that decteasesin S(t) decreascsocial benefit when S(t) < S,. In díscrete time, the benefit function is expressedby replacing the parenthesized t in the continuousversion by a subscript I namely: B, = B(q) ff S, > S' or B(q,, S) if S, ( S'. The efEcient intertemporaluse of a renewableresourceis determined by selecting harrrestrates and stock levels that maximize net socialbenefit (NSB), which equals: T

in continuoustisre, and -I0 nt,l.-"At T

Èoe(t + rF in discreterime, whereB(t) or B, is the undiscountedsocial benefit in period I r is the discount rate and (1 + r)-t or e-n is the discountfactor and e is the basefor the natural logarittrmBenefit in eachperiod equatsconsumersurplus plus producer surplus. Both of the above expressionsindicate that NSB eqrral5the presentvalue of benefits over the entire planning horizon. The remainderofthis sectiondiscussesasimplifieddynamicmodel of efEcient intertemporal use for a conditionally renewable resoruce.The model invokes assumptions 3 (no uncertainty), 4 (single use or speciesmanagement)and 6 (prue coupetition).

OBJECTItIES AFID CONSTRAbES" tionally renewableresourcebe:

Let the demandfunction for a condi-

PG)= Dlq(t)], wheredp(t/dq(t) < 0. This condition statesthat resourceprice in period t, p(t), is in-

8. RenewableResoulcel!fianagenent

t75

versely relatedto quantity demandedof the rcsourcein period t, q(t), when demand shifters are held constanl Hence, the denand cr:rve is negativeÙ rfop"c as ill'stated in Figure 8.9A. Total economic value from using a given amount of the resource,say qr(t), is -A.gi-Ndu,hthe shadedareaunder the demandcurve bctween0 and q'(t) in Fig're ematically, this areais: cc) Vlq'(t)l = J D(-)dto, where D(m) is the demandfunction. This areais also known as total willingness to PayLet the supply function for the resourcebe: p(t) = Slq(t)1, where dp(t/aq(t) > 0- This condition statesthat resourceprice in period t, p(t), is directly related to quantity suppried of the resourcein period q i(t), wnà" suppty shifters are held constanl Hence, the supply curve is positivelv srópéaas illustrated in Figurc 8.9B. Total cost of producing q'(t), designatedctq-(t)1, is the area under the suppry curve between0 and d(t), which is the shadedareain Figure 8.98. Mathematically, total cost of q'(t) is: C(t)

ctq'(ùl= slmlom, { where S(m) is the supply function. The benefitof d(t) is:

Btq'(t)l= vlq,(t)l - ctq.(t)1. BtC(t)l equatsconsuulersurplusplus producersurplusat q'(t). It is the shadedarea in Figrrre8.10. Efficient intertemporal harrrestrates for a conditionally renewableresource maximize NSB subjectto two conditions.T\efirst conditionrequiresthat changes in the stock over time equal growth minus harrrestrate and thesecondcondition requires that the stock of the resourcein period 0 (initial stock) is known. Other conditions canbe imposed.For exanple, sustnin4ile useof a renewableresourcemight be achievedby requiririg the stock of the rcsourceto be abovesomeminimrm levef specifically S(t) > S.i".

NIECESSARY CONDffIONS. Certain necessaryconditions must be satisfiedùo achieveefficient intertemporalharvestratesand stocksfor a renewableresource.A necessarycondition does not guaranteethe desiredresulf; however,the result cannot be achievedwithout satisfying the necessarycondition. 'with rare exceptions,to

176

Natural Resourceand Environrnental Economics

Dts(t) l

q'( t) $raaÈ:iÈy

sts(t) l

q'( t) QuaaÈiÈy Flgure 89. Q{) I}enand cnÌrve. Shadcd araa indicates total economic value. (B) Supply curye. Shaded area indicates total cmt of production.

t.

R.enewable ResourceManagement

!77

Fríee

s te(t) l Dte(t) l

q'(È)

Flgure 8.10. Net social benefit of q'(t) or coruiumersurplus plus producer surplus (shadcdarea).D = demand; S = supply.

enter college you rnust have a high school, or equivalenE diploma- EIaving a high school diploma is a necessarycondition for entering college; however, entering college requires more than a high school diploma The person must apply and be accepted for admission, and acquire the necessary financial resources to pay tuition, fees and living expenses. This section derives and discusses the necessary conditions for efficient intertemporal harvest rates for a conditionally renewable resource. To simplify the derivation and interpretation of the necessary conditions, the demand curve for the resource is assurned to be perfectly elastic, input markets are assumed to be purely competitive and all costs are assumed to be variable. A perfectly elastic demand curve implies that quantity demanded is not a function of price, which fneÍrns the demand curve is horizontal. Prnety competitive input markets imply that the supply curves for all inputs used in conjunction with the resource are perfectly elastic- In*the case of timber production, this assurnptiou implies that the demand cunre for timber and the supply curves for labor and mnnufachrred capr ital are perfectly elastic. The assunption that all costs are variable implies a longrun situation. Under these assumptions, total economic value and total cost are, respectively:

Quaat,i.ty

Natural Resounceand Environmental Economics

178

vtq(t)l = p(t)q(t) ctq(t)l = clq(t)lq(t)' where p(t) is resourceprice and c[q(t)] is cost per unit of harvesl Social benefit in periodt is: d B(q = p(Dq(t) - c[q(t|q(t). Factoring out q(t) gives: B(t) = {p(t) - clq(t)l}q(t) = n(t)q(t), where n(t) is net retum per unit of resourcehanrestedThe first necessarycondition for efFcient intertemporal harvestis: q(t) = 0 if n(t) < p(t) or q."*if n(t) > p(t)' where q-,*is the maximr:m harvestrate and p(t) is the shadowprice of the resource in period L The shadowprice of the resourceis the.increasein social benefit from allowing the stock of the resourceto increaseby one additional unit- The latter could be accomplishedby reducing the hanrestrate by one unit. Therefore,the first necessarycondition requiresthe harvestrate to equal zero when net return per unit of harvestis lessthan the shadowprice or to equal the maximum harvestrate when net reftrn per unit of hanrestexceedsthe shadow p'nce. For example,if n(t) is $4 and p(t) is $5, then the hawest rate should equal zero becausenot harvesting the resource(allowing the stock to increase)increasessocial benefit. Conversely,if n(t) is $5 and p(t) is $4, then as much of the resourceshould be tranrestedas possible becauseit increasessocial benefit The remaining necessaryconditions (not presented here)place limits on changesin the shadowprice and stock. The optimal stock dependson whether or not the cost of harvesting the resourceis dependent(stock effect) or independent(no stock effect) of the stock. If thereis a stock effect" then the natural rate of return on the resourceis less than the discountrate.When thereis no stock effect, the nanrralrate of return on the resource equalsthe discount rate. As a result, the optimal stock is greaterwith than without a stock effecl The stock that achievesmaximum sustainableyrel{ S."", is the efficient stock if and only if thereis no stock effect and the discountrate is zero. When the necessaryconditions for efficient intertemporaluse of a renewable resourceare satisfie{ NSB is a maximum, the harvest rateequalsthe natural growth rate, and the stock achievesan optimal steady-statelevel of S*,. Except in the un,likely event that the initial stockequalsthe optimal steady-statestock (So= S*J, the harvestrate needsto be adjusteduntil the optimal steady-statestock is achieved. Under certain conditions, the steady-statestock can be achievedby adjnsting the harrrestrate accordingto the following rule: q(t) = 0 if S(t) . s*o or GIS(t)l if S(t) = Sop,or q.oif S(t) > S"p,. This condition statesthat the hanrestrate in period t should equal a) zero when the stock falls below the optimrmr;b) the growth rate, G[S(t)], when the stock equals

8. RenewableResource &fanagement

179

the optimum; and c) the maldmum harrrestrate when the stock exceedsthe optimum. In special circumstances,ttrcreis a unique solution to this dynamic optimization problem. While tesource users do not like a policy. of zero harvesf such a policy has 6ses irnFlementedin cîses where the stock of the resourceis very low. For exaul_ ple, fishing for oceansalmon in the northwesternUnited Stateswas bannedin the mid-1990s to allow stock of these fish to r€cover.The seasonfor Atlantic cod on GeorgesBank off the coast of the northeasternUnited Stateshas beentemporarily closedto allow stocksof cod to recover-In addition, fisheriesmanag€,ment agencies routinely control harvest by irnFosing quotasand/or fimiting the length of the harvestseason. When steady-stateconditions are achieved,the hanrestrate equalsthe grourth rate in all periods and the changein harvestequalsthe changein growttr over time. The equilibrirrm stock condition in steadystateis: dNSB/dS

r

= p - c(q),.

where dNSB/dS is the changein NSB with respectto a changein the stock,r is the discountrate, p is the resourceprice andc(q) is the unit cost of harvesLY/hen there is a stock effecl c(q) dependson the level of the stock. For an infinite planning horizon (T = *), the left-hand side of this equation equalsthe loss in NSB from reducing the stock by one unit or equivalentlyby increasingcurrent harvest by one unif This loss eqrralsmarginal user cost MUC) of current harrrest.Hence, in steady-state: P-c(q)=MUC' This condition statesthat current net return per unit of resourceharvestedequals marginal user cost of harvesting, which is analogousto the condition required for efficient intertemporal extaction of an exhaustible resource. The equilibrium steady-state condition for a renewableresourcestock is illustratedin Figrre 8.11. Net price, P - c(q), is an increasingfunction of S becauseunit harvestcost generally decreasesas the stock increases.MUC is a decreasingfunction of S because MUC desreasesas the stock increases. The effects of changesin resourceprice, unit hanrestcost and the discountrate on the optimal stock are as follows: 1. Increases(decreases)in tesourceprice (p) holdirig unit harvestcost and MUC constentcauseSoÉto decrease(iricrease).When resourceprice increasesfrom pr to pz,net return increasesfrorn p1- c(q) to pz- c(q), which causesS* to decrease from S(Doe, to Se)opn an$ vice versa,as shownin Figure 8.12A2. Decreases(increases)in unit harvest cost (c) holding resourceprice and MUC constantcalrseS*. b decrease(increase).Adecreasein unit hanrestcostfrom cr(q) to cr(q) increasesnet return from p - %(q) ro p - cr(q), which causesthe optimal stockùodecreasefrom S(2)opt a 5(t)*t,andvice versa,as showninFigure 8.128. 3. trncreases(decreases)in the discountrate r holding resourceprice and unit cost constant cause Soo,to decrease(increase).When the discount rate increases from 11to 12,Muc decreasesfrom MUC(rJ to MUC(r), which causesSon,to decreasefróm S(l)op, to S@*, and vice versa,as shown in Figure 8.12C.

Va1ue per

Olit

s*" Flglrre S.11. Equilibríum steady-statestoc.k(S*) for a renewable resource. MUC = marginal user cost; [E- Fesounceprice; and c = unit cost offhawesL

Value

per

llaLt

e1-c (9)

c (2) opÈ

c(1)

opÈ

Figure S.Ul. Etrects of chalrgesin resource price (r4,),unit cost (B) and discount rate tC) on optimal steady-statestoclL MUC = marginal user cost; [D= FesonneeFric,e' c = unit hawest cost and r= discmnt rate. 1E0

Val'rre

per

Ua,it

p-c2 (q)

c, (g)
q (21 opÈ

Val'ue

per

q (1) ODÈ

BaiÈ p-c (q)

MUC (r1)

q (2) opt.

E5gnreE.Ul. continuod-

e(11

ofrÈ

LW

Naùual Resource and Environmental Econonics

RenewableResourceFolícies EfEcient intertemporal u,seof renewableresourcesis basedon the economicprinciple of maximizing net social benefir Sociatly efficient resourceuse is typically not achievedfor a variety ofreasons. In the case o-f privately owned renewableresources,socially efficient harvestrates arc not achieved becauseof external diseconomies.For example, hydroelectric powe5.g[evelopment in the northwesternUnited Stateswas done with little regard for the negative impacts on spawning and migration of anadromousfish. As a result, populations of certain speciesof anadromousfish have becomeextinct and othershave been seriously depleted.As discussedearlier, overexploitation of a renewableresource can also occur when accessto the resourceis unlimited. Major declines in ocean fisheries and the near extinction of certain speciesof whales areprime exarrples of this phenomenon.Overexploitation occursbecausereducing harvest to its socially efficient rate is not profitable. This causesthe stock to fall to levels that can lead to extinction of the resource. F.xternal diseconomiesc:rn occnr for common property resourceseven when accessis limited.An exampleof this is the ecological rlamagecausedby timber harvesting in national forests.Even thougb private :rccessto timber harvesting in national forests is controlled by the United StatesForest Service, ecological damage still occurs.If this damagebecomesserious,then hanrestratesin national forests are too high from a social viewpoint (seeFigure 8.7). Potential social lossesfrom overexploitationof renewableresourceshave been or can be reducedby variouspublic policies including: a tax on harvest;accessfees; and limitations on :rccessto and harvestof the rcsourceand subsidies.These policies are discussedbelow.

TAX ON HAR\IEST. A tax on harvest attemptsto bring the privately efficient rate of hanrestin line with the socially efficient rate of hanrest.Consider an optimal tax to reduceoverexploitationresulting from unlimited accessto arenewable common prcperty resource.Supposeeachfirm haniesting the resourcehasthe samecost function: tCtq(t)l = clq(t)lq(t), where c[q(t)] is the unit cost of harvestand q(t) is the harvestrate.Assuming perfectly elastic resourcedeurandand pruely competitive conditions in input markets, social benefit in period t is: Btq(t)l = {p(t) - clq(t)l}q(t), 'where p(t) is the price of the resourte in period r Socially efEcient rates of harvest are determined as follows. Let q;(t) be the haryestrate for resourceuserj (i = 1,...,J,where f is the numberof users) in period t (t = 0,...,T,whereT is the nrrmberof periods over which the resourceis harvested). Socially efficient harvestratesaredeterminedby solving the following opnmization problem for q,(t):

8. RenemableResourcelìdanagement

1S

Tr

Maximize J,!, ",tnlt)le*dt

wirh respect to qj(t) subject to ds(t/dt = Gls(t)l -,t,q1t). B;[q(t)] = {p(t) ctqlt)llqi($ is the social benefit generatedby userj, dsi;t is the changein resource stock over time, Gts(t)l is natural growth of theresourcein period t and \(t) is total harvestof the resourcein period t The first equationrequires choosingthe harvest ratesfor eachuser in all periods that maximize the user's contribution to NSB. The secondequation requires that changesover time in the stock equal the differencebetwee,lrnanrral growth and harvest The necessarycondition for a solution to this problem is: p(t) = MHC(I) + p(t) for all t, where MHC(D is the marginal harvest cost and p(t) is the shadow price of the resource in period t. The latter equals the increasein net retuui from increasingthe stock by one unit in period t- The necessaqfcondition for socially efficient harvest ratesis p(t) = MHC(I) + [r(t) in all periods,which occurs at q,(t) as shownin Figure 8.13. S/hen Ítccessto the resouÍceis unlimiteq resourceusersselectharyestrates that drive the price of the resonrce down to averageharvest cos! nanely: p(t) = Arlctq(t)], where AHc[q(t)] is the averagecost of harvesting q(t). Hence,the privately efficient harvest rate with unlimitetl accessis q.(t) in Figure 8.13. Because MHc(t) + t{t) > AHc(t), the socially efficient harvestrate is less 'han the privately efficient harvestrate with rmlimited access,q"(t) < qr(t). \lalue

per

IInLÈ MHc(t) + P(t)

AI{C (tr) + F'(E)

AEC(r)

p (È) F'(t; p(t)

q" (È)

a"(t)

Fìgure E.1!}. comparison of privately efficient harvest rate with rrntimited access(qJ and socùaltyefficíent harvest r:ate ($) f,or a rcnewablenesource..aHC = avenge hawest cost; MHC - narginal harvest cost; p(t) = shadow pric-e of roo.r""u; aoa ID= Fesonnceprice-

Ean:vgsÈ

RaÈe

1M

Natural Resounceand Enviromnrental Economícs

Imposing a Figouvian tax on hanrest equivalent ro l/(t) shifts the AItrC(t) upward until it intersects MHc(r) + tr(r) ar q,(0. With a tax of pi(ù, tne privately effi_ cient harvest rate with unlimited accessequals the socially efficient harvest rate. Because t/(t) > p(t), the tax exceeds the shadow price. Determination of the Pigouvian tax is difficult because it requires information on the marginal harveqt cost for all users in all periods. Unless, a regulatory agency has the authority to require resource users to reveal such information"dePigouvian ta:( cannot be determined ahead of time. In the absence of this cost information, the regulatory agency could adjust the tax until the desired harvest rates are achíeved.. For exarnple, an initial tax can be selected. If the resulting hanrest rates still cause overexploitation of the resource, then the tax is increased until the desired rate of harvest is achieved. H the resulting harvest rates are below the desircd harvesr rates, then the tax is reduced.

A,CCESS F'EES, EFT'ORT R.ESTRTCTTONS AD[E} OTEER. A,PPROACFTF'.S. Another public policy for achieving a more socially efEcient use of renewable resources is to require each resource user to pay an accessfee- For example, an access fee for an ocean fishery requires every fishing vessel to pay a set fee for each day of fishing. An access fee represents a variable cost because it depends on the level of fishing effort- In contras! a license fee is a fixed cost per season, the pa5rment of which gives a resource user a legal right to harvest the resource during that season. Daily Íìccess fees decrease the privately efEcient rate of harvest by reducing the nurnber of days harvest effort occurs. Access fees can be adjusted upward or downward to reduce or increase total hanrest effort. Because an accessfee is based on the level of harvest effort and a tax is based on actual hanrest, it is somewhat more difficult to achieve the socially efficient rate of hanrest with an accessfee than with a tax. Revenues generatdby access fees can be used to offset the administrative cost of enforcing and collecting the fee. As wittr any fee, the incentive to cheat (notpay the fee) increases as the fee increases. Cheating is greater for more widely dispersed resources such as fish in an ocean or rhin@eros in a large game resewe. A common way to limit overharvesting of a renewable resource is to conhol when and where accessto the resdurce is perrritted, the type of resource that can be harvested and/or the maximum daily harvest- In the case of fish and game, access is limited by restricting the length of the harvest season, sex, age, size and number of fish or game that can be harvested. In the case of timber harvesting on public land" Írccessis lirnited by contoiling the timing and volume of timber sales to private companies. TVhile controlling access does not generate revenue, it reduces over€xploitation of the resotuce. To be effective, managément policies need to be revised periodically to reflect changes in harvesting technology. 'i Anovel way !o control access to a renewable rqsource is to pay resource usersi for not harvesting the resource. This is a subsidy. In 1993, the Secretary of the Interior for ttre United States announced a plan to restorc seriously depleted stock of salmon in the Atlantic Ocean off the northeastern corìst of the United States. Because the depletion was caused by overfishing, the plan paid $8O0,0O0 to fishermen to stop fishing for Atlantic salmon for a period of nryo yeils. A more extreme exarnple is the total ban on salmon hanresting in the Pacific Ocean off the northwestern United States, which was imposed in the mid-l990s.

8. RenewableResourcellfianagement

1E5

A combination of resource policies typically affords greater flexibility in achieving the desired stock and hawest ratesthan a single poli"y. For examFle,in the United States,rights to hunt and bag ceitain big garrrespecies(big horn sheep 41d glssltain goat) are typically rationedby a lottery that tirnits the numberof hunt_ ing permits issuedfor thesespecies.Each season,huntersrandomly drawn from an eligible list of hunten are issuedpermits rh* allow them to hunt. If an animal is not bagge4 then the hunter may be allowed to apply for anotherspecialpermit, perhaps after a delayed period of time. In some states,baggrngan animal meansyoo .* never again apPly for a special permit. Additional flexibility is achievedUy attowing special permit holders to sell their permits to hunterswhose namesare not selected during the lottery. This makesthe hunting permits tradable.

Suxmrmaly Renewable resources are either conditionaly renev/able or nondegradable. Growth in conditionally renewable resourc"r, ,o"ú as fish, wildlife and forests, allows these resources to be managed on a sustainable basis for an indefinite period of time. The stock of a conditionally renewable resource is influenced by harvesting and natural growth (regeneration). lvlanagement objectives for and Property rights to conditionally renewable resources influence the rate of hanrest and the likelihood of overexploitation- Availability of uondegradable renewable resourcqs, such as the sun, wind and tides, is independent of h-umanactivities. Overexploitation of conditionally renewable resources occurs when hanrest rates exceed natural growth rates causing the stock to decline. Failgre to control overexploitation of conditionally renewable resources increases the likelihood of species extinction and loss of biodiversity. Conditionally renewable resources can be managed under different property regimes: profit maximization by a single owner or rumager of private property, profit maximization by multiple users of a coutmon property resource who limit access to the resource, and profit maximiza_ tion by multiple users of a cornmon property resource who have unfimited accessto the resource- Renewable resources can be managed for a single objective or species or for multiple objectives or species. Determining the efEcient intertemporal harvest of a renewable resource requires knowledge of the growth function, harrrestfunction, yield function, resogrce prices and harvest costs. The growth firnction expleins the relationship between changes in the stock sf the resource in the absenceof harvesting. The harvest function describes how the harvest rate changes with respect to the rto"n and input use. The yield function relates efficient harvest rates to input use. Ilanresting a-renewable resource involves expendihrres on inputs such as labor, fuel and equipmenr If per unit cost of harvesting depends on the stoch then there is a stock effect. Privately efEcient harvest rates for conditionally renewable resources under static conditions (no time-related interactions between biological and economic factors) require that resource price equals either marginal harvest cost with limited access or average harvest cost rfirith unlimited íEcess. Compared to limited access, the harvest rate with unlimited Írccess is generally greater and more likely to exceed.

186

I\iatural Resource'andEnvironmental Economics

maximum sustainableyield. In addition, the stock is lower with unlimited access that increasesthe risk of speciesextinction and loss of biodiversiry The socially efficient rate of harvest for a conditionally renewableresonrcefor which economic and ecological usesarecompetingoccurs where resourceprice equals marginal harvest cost plus urarginal ecological loss. When economicand ecological uses are complementary, the socially efEcient harvest rate occurs where resonrce price equalsmarginal harvestcost rninus marginal ecologicalbenefit. 4 Evaluating efficient intertemporal resourcetrarvestin a static framework ignoresthe timedependentinteractionsbetweenbiological and economic factors. Deterrrining harvestratesand stocks in a dynamic framework entails maximizing net social benefit over someplanning horizon subjectto conditionsregarding the initial stock and changesin the stock While the mathematicalderivation of efficient harvest rates is tedious,the resulting necessaryconditionsfor efficient intertemporal usehave arelatively sraighforward bioeconomicinterpretation.Thenecessarycondition for efficient intertemporal harvest is that the harvest rate equals zero (the maximum harvestrate) when net return per unit of hanrestis less (greater) than the value of allowing the resource stock to increase by one unir When the stock achievesa steady state(harvestequals growth), the loss in net social benefit from reducing the stock by one unig which equalsmarginalusercost, must equal the current net retum on the resource.Under steady-stateconditions,increasesin resource price, decreasesin cost of harvest and increasesin the discount rate cause efEcient harvestrates to increaseand the stock to decrease.Oppositechangesin these variables causeefEcient harvestrates to decteaseand the stock to risa External diseconomiesin the useof renewableresourcescausethe privately efficient harvest mte to exceedthe socially efficient harvestrate that reduces net so. cial benefit from useof the resource.^A.variety of public policies can be usedto reduce external diseconomies.Theseinclude a tax on harvesqaccessfees; restrictions on when, where andhow the resourceis accessedandhanrrested;and subsidiesfor not harvesting the resource.A combination of policies is generally superior to any single policybecauseit affordsgreaterflexibility in achievingresourcernan4gs66af objectives and generatesthe revenue neededto fund resourcerrvìnagementactivities.

Questions for Discussion 1. Explain how the degreeof accessto arenewablecourmonproperty resource influences the rate of harvestand net social benefit comparedto a sinration where the resourceis privarely owned. 'i 2. Wbat are the likely economiccons€quences of eroding soil at a rate that exceedsthe rate of regeneration?\Mhat public policies might be usedto alleviate these economic consequences ? 3. Compare the efEcient harvest rates for a renewableresource under static conditions when the demandfunction for the resourceis downward sloping and the resourceis managedto maximize net social benefit. 4. The yield cuwe for a nonrenewablelesonrceis q = cù{I(l - cEI/p),where o = 0.002, N = 150 and P = 0.40. Determine efficient input use, efEcient hanrestrate and oprimal stock whenprofit is maxirnize4 p = $25 andc = $4.

8. RenewableResoureenAanagement

tt7

F'unthenReadings tnomics: Tlu Optimal Mutagemcnt of Renewi7. RenewableResources.Chapter 2 tn Natural Cambridge: England: CambridgeUniversity Howe' charles w' 1979.The Managementof Fisheries: A case of Renewablebut Destnrctible Common property Resources-Chapter 13 n iotuiot ResoutceEcornmics. New Yorlc JohnWiley & Sons, pp.E6_275. Pearce'David w" and R- Kerry Tumer- lgg0. RenewableResources(chap. ra- Eco_ nomicsof Natural Resourcesand thc Erwirorunenr. Baltimore, Maryland:TrreJohnsHopkins Universityhess, pp. 242--261.

NoÉes 1' Al Gore' 1993'Earth in ttrcBalnnce:Ecology and theHwnqtspriir (New york penguin BooksUSA Inc.), pp. 19-20. 2' This expressionfor optimal input useis obtained by sening the derivativeof q with respectto I equal to zero and solving for L 3' Hilary F' Frenctr"'"TheTirnaTest GAllt'î andthe Environment,,, worldwatch(washington,D.c-: worldu/atchInsÈitute, March/April lggz),p. q---

CEAPTER

Economicsof Environmental Pollution I fmalty c'losed nry mowth and began looking at the planet in more detaiL Most people donT get to see how widcspread some of the environm"ewal d.estruction is. Frcm up there, you look arowtd, and see that it's a worldwid,e rarnpage. -Mnnro Rurco, Jn-,U.S.esrnoxerr, 1991

he material balances approach discussed in Chapter 4 indicates that the environment provides three services to the economy: resource extraction, assimilation of residuals, and amenities. Extractive seryices refer to the exhaustible and renewable tesources that are used in the production of commodities. Residual assimilation services refer to the assimilation of production and consump tion residuals by various enyironmental recepton (ar, land and water).Amenity services include the natural beauty, solitude and recreation provided by the environmenl Chapters 7 and 8 focused on efficient use of exhaustible and renewable resources in economic production, which is equivalent to efficient use of the extactive services provided by the environmenl Chapter 12 deals with the valuation of amenity services provided by the environment that are not priced in regular markets- This chapter addresses efficient use of the residual assimilation services provided by the environment, which constitutes the environmental sector of the rurterial balances modelTwo major issues arise regarding the efficient use of the environment's capacity to assimilate residuals. First, the residual assimilation services provided by the environrnent tend to be overexploited because they are unpriced. When the environment's capacity to assimilate residuals is exceeded, pollution ociurs. Second, pollution reduces the environment's capacity to provide exhaustible resources,such as coal, timber and precious metals; amenity services, such as outdoor recreation; and ecological senrices, such as air and water purification. Pollution damages are an external diseconomy that can have a negative effect on both humans and ecological systems- A major goal of environmental economics is to determine efficient levels of environmental pollution or pollution abatement and the effectiveness of alternative public policies in controlling pollution. This chapter expands the environmental segment of the material balances model to account more fully for the relationships aurong residual loads, residual emissions, pollutíon and pollution darnages-The expanded rnodel is combined with static and dynamic efficiency criteria to derive the private and socially fficient tev18!)

1!r0

Natural Resourceand Environmental Economics

els of pollution and'pollurton abatement In addition, efficient allocation of pollution reduction ùopollution generatoÉand the rcle of goverrùnentin reducing pollution-relatedextemalities are addressed-Finally, specificpublic policies for reducing point and/ornonpoint sourcesof pollution areevaluated:namely, emissioncharges, input taxes,tnput restríctìorrs,emissionstandards,nwtdatory production methods, cost slnring, tradable emhsíonpermíts and envhorancntallìabil$ 1

Residual Emissions, Pollution and Pollution llamages Fmissionsof residualsto the environmentcome from multiple sources.Pollution and pollution damagesresultingfrom residualemissions have important spatial and temporal aspects.Consider global warnring, which re, sults from the accumulationof carbondioxide, methaneand other greenhousegases in the upper atmosphere(multiple sources).Carbon dioxide, which is the largest sourceof greenhousegases,is producedwhen fossil fuels are burned-Becausethe bulk of past carbon dioxide emissionswere generatedby developedcountries (see Figure 1.1),most of the global warming that hasalreadytaken place is attributed to developedcountries.The greatestgrowttr in future carbon dioxide emissions is expectedto occur in developing counties, and advancedtechnology for reducing carbon dioxide emissionsresidesin developedcountries(spatiatand temporalaspects)Besidescountry-to
9.

Economics of Environmental Pollution

llrl

certainty regarding the extent and timilg of benefits from reducing global warming, and the huge invesEnents needed to reduce greenhouse gas emissions. Unlike global warming, localized pollution has a much smaller sphere of influence. There are two types of localized pollution: point source and nonpoint source. Point source pollution is pollution that can be traced to a single, well-identified source, such as a paper mill that disposes of is effluent in a pipeline that empties into a river. A pesticide holding tank that is rinsed near a wellhead is a point source of pollution for groundwater. Nonpoint source pollution is pollution from diffi$e sources such as agricultural fields in a watershed and streets and parking lots 'Water in urban arcas. The U.S. Environmental Protection Agency's (ffA) National Qudity Inventory report for 1994 indicates that nonpoint source pollution is the major cause of water pollution in all types of water bodies. Of the data submitted to the U.S. EPA covering assessmentof 17 percent of the nation's rivers, 42 percent of lakes and 78 percent of estuaries, agriculture is the prinary source of water pollution in rivers and lakes-3 It is difficult to trace nonpoint source pollution to specific sources- Runoff from cropland treated with herbicides can pollute receiving water bodies such as streams and lakes. The pollution is difEcult to trace to an individual field or farm without taking extensive measurements or using a biophysical simulation model. Environmental economics does not provide a comprehensive framework for dealing with environmental pollution aad damages.For the most part, the economic theory of pollution control deals primarily with darnagesfrom a single point source of pollution. In addition, most of the legislation aimed at reducing environmental pollution addrbsses individual pollutans. Even within the same category such as water pollution, separate legislation has been passedto reduce point sources of water pollution versus nonpoint sources of water pollution. There is growing awareness of the need to address the multiple sources and impacts of pollution. For example, Carol M. Browner, Administrator of the U.S- EPA, stated that *We need to approach water quality not pollutant by pollutanf not coungr by count5r,but by looking at entire watersheds, the entire natural systerL as single units."4 This approach, referred to as total watershed uurnagement or ecosystem management, has been endorsed by several resource agencies in the United States including the Natural Resoruces Conserrration Service, the Forest Service and the Fish and Wildlife Service.

EPAI\IDED MAIERIAL BALAI\ICES MODEL. The environmental component of the material balances model presented in Chaptera @igure 4.2) is expanded in Figure 9.1. The upper left corner of the figure shows t}ie residual loads generated by economic prodrrction and consumptiss. R.esidrrelsare either recycled (A) or emitted to the environment @). Recycling of residuals has a double benefit It decreases the demarul for natrual r€sources (D) and rcduces residual emissions to the environment (B); howéver, recycling of residuals generatesits own residuals, which ae emitted to the environment (C). Overall, recycling resulB in a net loss in residual emissions- Because alrrminrun recycling decreasesthe demand for bauxite, the mineral us€d to produce aluminum, it extends the life of bauxite resources and reduces ttre amount of alurninum emitted to the environment. Recycling in the United States haq drarnatically reduced primary consumptiou of iron and aluminum.

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'When Several things can happen to residuals. residuals are not assimilated or degraded by the environment, they become accumulated residuals @). Unrecycled glass and metal containers; toxic residuals such as dioxin, which is a degradation product of creosote; PCBs, which leak from discarded electical capÍrcitomi plutonium residuals from nuclear power plants and facilities that rnanufacturc nuclear weapons; and heavy metals leached from the tailings of abandoned mines accumulate in the environment. Accumulated residuals can be harmful to hurnans and ecosysten$.

9. Economics of Environmental Pollution

llB

Residualsthat are not accumulatedin the environmentare eitherassimilated in the currentperiod (F) or assimilatedinfunre periods (G). Carbondioxide and sulfirr dioxide emissionsfrom electricalpower facilities that burn fossil fuels and that portion of apptied nitrogen fertilizer not used by plants are examplesof residuals that are assimilatedby the enrriroirmentin the current period or temporarily stored in the environment for assimilation iu future periods. Hunan settlementand resourcedevelopmentpatterns,suchas urban and commercialdevelopmentin floodplains, loss of prime farmland to urban development,conversion of prairie, wetlands and forests to crop and livestock production, overgrazing of rangeland and others,decreasethe capacity of the environmentto assimilateresidualsand to temporarily store residuals. In residual assimilation, biological, chemical and hydrological processes driven by carbon, nitrogen, water and other nanrralcycles tansform residuals into derivative products that can be harmful to humansand other living organisms.A portion of the nitrogen fertilizer appliedto agricultural crops is usedby the crops for growth. That portion not used by crops is assimilatedby or storedin the environmenl Some of the nitogen fertilizer is converted to nitrate-nitogen, which is highly soluble. Water having nitrate-nitrogen concentrationsthat exceed 10 parts per million is consideredpotentially harmful to humans,especiallyinfants andpregnant women. Pollution (II) rezults from accurnulatedresiduals@) and/orresidualemissions not assimilateduntil funre Periods(G). Pollutinn darnagesto humansand ecosystems (K) dependon the potency andpercístenceof the pollutant (I) and thevulnerabilíty of human and biological systemsto that pollutant (J). Potencyrefers to the toxicity of the pollutant and persistencerefers to the time it tekesfor one half of the original nurss of a pollutant to degrade(half-life). Plutoninrn is a very hazardous substancebecauseit is extremelyharmful to living organisrns,evenin minute doses (hlgh toxicity), and takes thousandsof years to degrade(hlgh persistence).Other highly persistent substances,such as DDT, are especially detrimental to wildlife. Pollutants with high Potency and persistencetypically causethe greatestdarnage. Vulnerability refers to the degreeto which humansand ecosystemsare at risk from pollution. For exanple, there is a health risk to humanswho drink \rraterwith concentrationsof nitrate-nitrogen in excessof 10 ppm. There is, however,no health risk when the water is usedfor purposesother thanhumau consumptionsuchas hydroelectric power generationand recreation. Elumans and ecosysteursare adversely affected by pollution damages (L). Ozonedepletion occurswhen total emissionsof chlorofluorocarbons(CFCs)exceed the capacity of the upper atnrosphereto assimilatethem- Ozone depletionreduces the stratosphere'scapaclty to screenout ultraviolet radiation from the sun. Higher levels of ultraviolet radiation at the earth's surfaceincreasethe risk of skin cancer. Air pollution, water pgllution andhazardousresidualssan impaii humanheatth an4 in extremecases,causedeath.Major sourcesof urban air pollution include particulates(smokeand soot), sulfur dioxide, ninogen oxides,ozone,carbonmonoxide and lead-sSulfir dioxide and particulate matter impair respiratory functions and increasethe risk of lung disease.Nitrate contaminationof waterin excessof the drinking water standardcan result in methemoglobinernia(blue-babysyndrome).'When pollution impairs[rrmarthealth,workerproductivitydeclines.andcostofproduction rises.Pollution can als,srlamagehumansby reducingthe amenityservicesprovided by the environmenl Pollution of lakes,reservoirsand coastalareascan diminish the

fn

Natural Resource and Environnental

Econo,nics

quantity and qrrality of recreational activities such as swimming, boating, fishing and wildlife viewing. Pollution can damage ecosystems in several ways. Acid rain, which is caused by sulfur dioxide emissions from coal-fired power plants, has damaged 2qrratis and forest ecosystems in the northwestern United States and eastem Canada- In several parts of the worl4 extensive irrigation and groundwater mining in coastal areas lead to excessive salt buildup in topsoil (salinization). Excessive salinizaúún decreases soil productivity an4 in extreme cases, leads to abandonment of agriculhrral landThe World Bank has estimated that approximately 5 million acres (2 million hectares) of irrigated land are lost each year due to irrigation-induced salinization of soils.6 Ecosystem damages can reduce the productivity and hence the quantity and quality of natural rcsources (M). Timber operations, such as road building and clearcutting in mountainous terrain, often cause sediment pollution in nearby streams, which reduces biological productivity and diversity. Sediment pollution can also occur when farming operations and urban and commercial develìpments do not incorporate soil conservation practices.

Efficient Reduction in Environmental Pollution Pollution of environmentalresourcesby husran activities is an extemal diseconomy.The efficient level of an external diseconomy is determined using externality theory which is discussedin Chapter 5. This theory indicatesthat the privately efficient rate of production exceedsthe socially efEcient rate of production when there is an external diseconomy(see Figure 5.1). Because it is usually not feasible to establishcompleteproperty rights for environrnental resources,especially coutmonproperty resourcessuchas air and water, and the transaction costsof negotiating a settlementbetweenacting and affected parties is high, public policy is often neededto reducethe loss in social welfare from pollution externalities. If pollution damagesin the current period dependonly on residual emissions in the culrent period then the efficient level of pollution externality can be determined using static efficiency criteria. If, however,current emissions influsagg po1lution danagesin current and future periods,thenthe efficient level of pollution externality shouldbe basedon dynamic efficiency criteria A similar argumentis made in Chapter7 to justify the use of dynamic efficiency criteria to determine the efficient intertemporal depletion of an exhaustiblercsqurce.The next section covers static principles and the following sectioncovbrsdynamicprinciples for controlling prollution. "i' Numerouspollution control policies havebeenemployedincluding restrictions on the use of polluting inputs, maximum emission levels or pollutant concenùations, taxing pollution, subsidiesfor production methodsthat reducc pollution, best available control technologies,tradableernissionpermits and environmental liability- This chapter evaluates specific policies for controlling point and nonpoint sourcesof pollution. Implications of pure and imperfect competition for pollution control are also considered.

9.

Economics of Environmental Pollution

19s

srarrc ErrrcrENcY wrrE puREcoMpETnroN. staticcfficiencycri-

teria are used to determinethe efEcient level of pollution under pure competition when residual emissionsin the curcnt period ale capableof causingpollution damagesin the current period. Severalsourcesof pollution satisfy tnis requirement. For exarrple' particulate emissionsfrom a coal-fired power generatessoot, which falls on the surrounding communities.Householdsand businessesin that community are likely to incur pollution d"mages in the form of higher cleaning bills that occur shortly after the particulatesare emined. Reducingparticulate emissions from the plant will result in an immediatercduction in pollution damages.

ProductionResEictions. The efEcientlevel of pollution can be achievedby restricting the production of commoditiesthat causepollution when there is a fixed, proportional relationship betweenresidualemissionsandproduction rates.This implies that emissionscannotbe reducedby utilizjng other inputs. While this assumption of the production-restrictedmodel is quite restrictive, the model is helpful in demonstrating the basic relationshipsamong spris,rmption,production, ernissions and pollution. The model is as follows: Utility function:

U= U(e, L)

Production function: Q = FCX) Emission function: P= R(Q) Pollution function: L =L(R) The utility function statesthat a household'ssatisfactionor utility (II) depends on coruilrmption (Q) and pollution (L).Utility is assumedto be an increasing fiuiction of Q and a decreasingfunction of L. In other words, U increaseswhen ine creasesor L decreases,or conversely,U decreaseswhen Q decreasesor L increases. The production function implies that each firm's productionrate (e) is an increasing function of input use (X). Fims are allowed to disposeof their rcsidnntsto the environment freely, which implies that the residualassimilationcapacity of the environment is unpriced.The emissionfunction statesthat emissionof residualsto the environment (R) is an increasingfunction of prodrrction(Q). Becausethe production-resEicted model does not allow substitution betweeninputs and emiùon, X does not app€arin the Emissionfunction. The pollution function indicates that pollution (L) is an increasingfunction of cmission @). Takencollectively, thesefunctions irnPly that a) firms are the acting parties (polluters)andhousehoid, the affected parties (pollutio-n victims), b) there is only one pollutanl and c)"r" pollution irnpairs hurnansand/oí ecosysterns. The external cost of pollution dependson the relationship benveenresidual emissions CR)and production (Q) as shown in Figure 9.2A and betweenpollution CL)and residual emissionsas depictedin Figure 9.2B. Let residual emissioìs be related to production in the following uvurner(seeFigure 9.2A): R=aQ(a>0).

196

Natural Resourceand Environmental Economics

This relationship statesthat residual emissions (R) increasein fixed proportion to the production rate (Q), which irnplies that firrrs are unableto reduceemissions by using different inputs and/ortechnologies. The relationshipbetweenpollution and residual emissionsis expectedto have a thresholdeffect. This meansthat for R < K, residualsareassimilaied by the environment andpollution is zero.For R > RÍ, however,pollution is expectedto increase .1 at an increasingrate as R increases.Thereforez L= 0 forR < R andL= bRr forR > R (b > 0, l, > 1). This relationshipis consistentwith a decreasein the environment'scapacity to assimilate additional rcsiduals as residual emissionsincrease.The more rapidly assimilative capacity decreaseswith increasedemissions,the higher the value of L The b term captureslocal environmental conditions that influence the extent to which residualemissioncausespollution. For exarnple,pesticideresiduesfrom surface applicationof pesticidesto cropland is more likely to result in pesticide pollution of surfacewat€r when application is followed by a major rainstorrn than when rain follows applicationby severalweeks. Combining the residual ernission-productionrelationship (Figure 9.2A) and the pollution-residual emission relationship (Figure 9.28) indicates that Q' is the production rate abovewhich pollution occurs.That is, for Q > Cf, R > R and L > 0. The relationshipbenreen total pollution damage(LD) and emission of residuals is shown in Figure 9.3A, and that betweenpollution darnageand production in Figure 9.38. LD equalsdanage per unit of pollution (d) times the level of pollution (L), namely: LD=dL=dbRrforR>R'. If Per unit damage(d) doesnot dependon the level of p,ollution,then LD is an exponential function of R for R > R as shown in Figrre 9.3a-When d increaseswith pollution, LD increasesmore rapidly as R rises for R > R'. The pollution damage function is more complexwhen daurageis causedby morethan one pollutant and./or lifestyle factors influencevulnerability to pollution. For g;ample, exposure to tw.o pollutants at levels below the maximum contaminantlevels could result in human damagesbecauseof interactionsbetweenthe two pollutants.In ùis case,d is a function of emissionlevels forboth pollutanls. Lifestyle choiceslike snroking are likely to increasethe risk of getting-emphysernafrom air pollution. In this case, the damage function is steeperfor a person who smokes. Quite often, pollution damagecanbe reducedby avertingbehavior. Apotential decline in recreational swimming in a lake due to pollution might be partially 'Averted by building a comnunity svdmmingpool. Simitarty,damad from pollution of well watermight be reducedby substinrtingbottled water or water obtained from a nrral water district In somecases,averting behavioris less costly than reducing pollution. For example,usingbottled \ilater may be lesscostly than attempting to reduce the source of pollution particularly when the pollution is from nonpoint sources.While bottledwaterreducesthe hnmanhealthrisk of drinking polluted well water, it doesnothing to reducethe ecological damagescausedby water lnllution. Therefore,avertingbehavior does not necessarilyeliminds pollution damage.

9. Economicsof Environmentalpollution

Residual.

[n

híssioa,s

Productiole

PolLuÈion

Reeidual

bíseLoas

Figure 92 Relationships between rcsidual enissions (R) and producti,on (e) and between lnlhrtion (L) and residual emissions.8{) Residual emissionsas a fun-tfion of production (B) Pollution as a function of residual emissions.

19t

Natural Resour,ceand Environmental Economics

lloÈa]' PolluÈioa Danage

Residua].

EcisgioD.s

Pol].ution Total Da.uage

Produetioa

Figure 93. RelatÍonships between total pollutiop rlarnnge (LD) and rcsidual emissions (R) and between total pollution rlrrn-g€ and production (Q). (A) Total pollution .rîmage as a frrnctíon of residual emissions with constant per unit pollution damage. (B) Total pollution damage as a function of production

9. Economicsof EnvironmentalPollution

r!x,

The relationship betweenLD and Q, as depictedin Figure 9.38, is detemrined as follows. For Q I Q', R < RÍ and L = 0" which implies LD = dL = 0. For e > q, R > R, which implies LD = dbRr. For Q > g, R = aQ, which implies LD = dbarQlr. Snmmarizing: LD = 0 for Q < Q' and LD = dbaaQl for e > Q. Marginal pollution damages(MLD) equal the derivativeof LD with respectto e, namely: MLD = 0 for Q < (f or KQr-r for Q > Q, where K = ldbar. MLD is illustrated in Figure 9.4A for different values of L The privately efEcient production rate occurswhere ouq)ut price equalsmargrnal production cost (p = MPC), which occuniat q in Figure 9.48. 'Whenprice exceedsmarginal production cost (p > MPC), profit is increasedby raising production. conversely, when price is less than marginal productioncost (p < Mpc), profit is increasedby reducingproduction. Thercfore, in a purely competitive industry,profit is maximized at the ouq)ut where prlce equalsprivatemarginal production cost (p = MPC) which occu$ at Q in Figure 9.48. The socially efficient production rate is detennined.by equating p to MLD + MPC, which occurs at Q" in Figure 9.4B. Increasingproduction beyond Q causes total pollution damagesto inc:reasemore than net private benefig which decreases net social benefit Conversely,decreasingproductionbelow Q" causesnet private os"nefitto decreasemore than pollution damages,which reducesnet social benefit At Q", net social benefit is area I and pollution damageis area2. An exarnpleof the privately and socially efEcientrates of production is given in Table 9.1. The figuresin the table are basedon the following MI-D, MPC and demand (D) firnctions, respectively: MLD-2.5quforQ)3 MPC = 0.25q D:P='14-1.9Q.

Table 9J.

Exampleof

efficient production rdes

a

MLD

MPC

MLD+túrc

3 4 5 6 7 E 9 lo

72.9 ,: 20.m n-95 36.74 46.30 56.57 ó750 79.06

225 4.00 625 9.00 12.25 16.00

t5.24 24.W 3/-20 45.74 58.55 7257 87-75 104.06

?n2s 25.00

D 383 36.4 345 32.6 30.7 28.t 26.9 25.0

Q = prodrction rm, MLD = pqglnal pollution rl'mege; MPC = marginal pmduction crxr! end p = price. Q = 5 is tbc socially efrcient prroduction'raE and Q - l0 is the privarcty efficient proOuction rate.

200

Natural Resourceand Environmental Economics

DaraEas per Unit

Productian

Va].ue

Ber lh.iÈ

Q.

Q.

Productíon

Figure 9.4. nnarginat lnllution rlarnag€ (A) and privatety (QJ ald socially (QJ efficient production (B) under pure comlrctition D = demand; MLD : marginal pollution dsmagei and MPC = marEinal production cosL

9. Economics of Environmental pollntion

20r

The privately efficient production rate is e, = 10 wherep = MpC (25 =25) and the socially efficient production rate is at e. = 5 where p = MpC + MLD (34.i = 34.2). Hence, the privately efficient production rate is greater than tie r*i"tty ef6cient production rate (9 > 6). As shown earlier, total net private benefit to the industry is maximized at e, whereP= MPC. At Q, netprivatebenefitequals areas1 +2+3 andpollutiondarnage equal areas2 + 3 in Figrrre 9.48. Becausepollution is an externaldiseconomy, therc is no incentive for firrrs to reduceproduction below Q' or equivalently,to reduce the externality. Net social benefit at e, is area I minus area4 (l + 2 +-3 - 2 3 - 4). Of the total externality occuring at q (2 + 3 + 4), rcmoving the externality given by 3 + 4 is Pareto relevanl Removal of this amountof externality increases net social benefit from area 1 minus area4 to area l. By reducing production from Q. to Q*' the Paretorelevant externality (3 + 4) is completelyreÀóved. The externality remainiag at q (2) is not Paretorelevant becauseits removal decreasesnet private benefit more ttran it decreasespollution dam2gs. For the deman4 MPC and MLD relationshipsdepictedin Figure 9.48, the socially efficient level of pollution damageis greater than zero. This can be seen as follows. BecauseQ" > Q', there is pollution damageat the socially efficient rate of production. ff, however, p = Mpc at a production rate lessthan or equalto (, as il_ lustratedin Figure 9.5, then the profit-maximizing productionrate is andìhere is eno pollution- Zero pollution is likely to be socially efficient when a) product prices are low andlor marginal productioncostis high and/orb) MLD is zeroat a r"hì.,r"iy high rate of production. In summary: l- The privately efficient productionrate exceedsthe socially efficient production rate (Q, > QJ. 2- The socially efficient productionrate approachesthe privately efficient production rate as the tbresholdproductionrate increases,which causespollution damage (Ql to decrease. 3.7Éro pollution is generallynot socially efEcient. EmissionRestrictions. Controlling emissionsby resricting productionis valid only when emission is a fixed proportion of production. In the ernission-restricted. model' firms can reduce emissionsby employing more inputs or changing technologies.For example, sulfiu dioxide emissionsfrom power plants Ue,eauc"A by substinrtinglow sulfirr coal for high sulfur coal or natural gasfor"ao coal. Alternatively, a cleanertechnologf could be used,suchas fluidized-bedcombustion,which removesthe sulfir from coal as it is brrned. The firur's production function in the enission-restricted model is: : Q=GQLR), where X representsingut and R representsemission of residuals.îre production function in the production-rcstrictedmodel includes only X, whereasthe iroduction function in the emission-restrictedmodel includes Uotn X and R This auows a given production rate, say Qo,to be achievedwith variouscombinationsof X and R as shown in Figure 9.6- When X and R are substitutes,the current production rate

2U2

Value

Natural Resourceand Enyironmental Economics

5ler Unit

Product,íoa

trìgure 95. Efficient pollution etlrrals zero when Q, S (f- D = demand; MLI) = narginal poUution damagq and MPC - marginal production cosL

Input

(X)

x4

xt

x2

Residua].

hissions

Figure 9.6. Combinations of input (X) and residual emissions (R) that give equal production (Q).

(R)

9.

Economics of,Environnental Pollution

2E

can be rnaintained while reducing ernissionsby employing more X. Moving from a to b reducesernissionsfrom & to R1butrequires increasinginput levels from X, to X,. For example, electical power production can be naintainsd" and particulate emissions reduced,by installing electrostaticprecipitatorsthat remove particulates from smoke before it leavesthe smokestackAlternatively, the production rate can be increùed without incteasing emissions.Increasingthe productionfrom Qoto Q, while maintainingemissionut n" "be achievedby increasingthe input level from X, to &- Installation of precipitators entails an investment in manufachuedcapital and labor that increasesthelost of production- BecauseR is a by-product of production, it might seem inconsistent with the rnaterial balancesmodel to allow substitutionbetrnreen X and R. It is nor R dependson Q, but Q is also a function of R. If pollution reducesnot only the general welfare of consumersbut also the firm's production, then L entersthe production function: Q = HQL R, L). Q is a decreasingfunction of L, other things constanl Supposewastewateremjssions from a shrimp pond result in pollution (L) of the wate,rsupply for the pond (Q). This is not uncoulmonin countrieslike Thailand-Then,L entersthe production function for shrimp. Reducingwaterpollution is beneficialto the firm becauseit improves shrimp health and hencethe pnoductivrtyof the pond. Just as producerscan undertakeinvestnrenBto reduce residual einissionsand pollution, householdscanmake defensiveexpendituresto reducethe adverseeffects of pollution. For exarrple, householdsmight relocateto a less polluted areato reduce water pollution-related illnesses causedby wastewater ernissionsfrom the sbrimp pond. Alternatively, the householdcan install a water fiInation systemro purify the water. Defensivebehavior by householdsis incorporatedin the utitity function as follows:

U = VlQ, F(L, Y)1. In this modified utility function, L is replacedby a subfunctionF(L, y), which representsthe household'sexposureto pollution- Exposue dependson the level of poìlution (L) and the level of defensiveexpendinnes(Y). BecauscF is a decreasing function of I- the householdcan reducepollution damagesby undertaking defensive expenditures. Determination of the efficient level of pollution abatementfor a single polluting firm in a purely competitive marketis ilustrated in Figure 9.7.ltis assunedúrat additional units of pollution abatementcan only be achievedby emptoyingincreasingly expensive abatementtechnologies.Therefore,the marginal cost of pott rtioo abatementMCe; is arf exponentíallyincleasingfunction of pollution abatementas shown in Figrue 9.7. When the firm receivesno benefitfrom pollution abatement(L does not enter the production function), the marginal private benefit of pollution abaternent(MPBA) is zero and the privately efficient level of pollution abatement (4) is zero as shownin Figure 9.7A. When pollution abatementenhancesthe firm's own production (L enters the production function), MPBA is nonzero as shown in Figwe 9.78. For exarrple,

2M

Nafural Resourceand Environrnental Economics

Value per Unit

A

PolluÈion

AbaÈenent

ValueperUnit

Pollution

Abatenent

9. Economicsof Environmentalpollution

205

$ per Unit

A" PolluÈion

AbaÈenenÈ

Figure 9.7. Í''fficient poltution abatementfor a single polluting sourseunder pure competition with zero margínal private benefit of abatement tl&n^l) (.4); nonzeru, decreasingMPBA (E); and noruzero'rte$easing narginal social benefitof abatement (iì{siBA) and a Pigouvian tax of ab (c). Mcl= Ea.g"al cost of abatcmenl

since waste\Yateremissionsfrom the shrimp pond pollute the water supply for thc pond' reducing water pollution improvesshrimp production. Reducingpolution of the pond increascsincome from shrimp production, but the incrementsin income becornesuccessivelysmaller as poltution abatementincreases.In this case,MpBA is an exponentially decreasingfunction of pollution abatementasillustatecl in Figure 9-78- The privately efficient level of pollution abaternentis Anwhe,reMpBA = MCA If the wastewat€r from shimp ponds degradesthe quatity of water used by nearbyhouseholds,then waterpollution abatementresultsin an externalcommunity benefit l-et the marginal comrnunitybenefit of pollution abatement(MCBA) be an exponentially decreasirt'$function of abatemenLThis meanstbat equal increments in pollution abate,mentresult in smallerand smaller incrementsin community benefits. Marginal social benefit of pollution abatement(MSBA= MPBA+ MCBA) as shown in Figure 9.7C. BecauseMPBA and MCBA are exponentially decreasing functions of abatement,so is MSBA EquatingMCA to MSBÀ givesthe socially efficient level of pollution abatementof A. BecauseA' < 4, there is a Pareto-relevantextemality at A. In particular, the

2M

Naturat Resourceand Environmental Economics

lossin net social benefitfromreducingpollution toA, insteadof .\ is ara,2 in Figure 9.7C.Arca 2 is the size of the Pareto-relevantexternality.Reducingpollution beyond d is Pareto-inferior becausethe cost of abatementexceedsthe social benefit For example,reducing pollution to AEax(zero pollution) generatcsa net social benefit equal to areas t + 2 minus area3, which is less than areas| +2. An exampleof the privately and socially efficient levels of pollution abatement is given in Table 9.2. T\e figr:res in this table are based on the follóÚing MCA, MPBA and MSBA functions: MCA = J[rs MPBA=Z2@rc-^. MSBA = 8200e-A. In this exarnple,the privately efficient level of pollution abatementoccurs atAn = d whereMCA=MPBA(40 =Q.29) andthe socially efficientlevel of pollution abatement @cursat A* = 5 whereMCA = MSBA (55.90= 55.25). The productisn-restricted and emission-restrictedmodels both indicate that a Pareto-relevant extematity is present. The production-restricted model (Figrrre 9.4B) showsthat the privately efficient production rate exceedsthe socially efficient production rate (Q > QJ andthe exteruality generatedby Q, is excessivefrom a social vievryoint (2 + 3 + 4 > 2). The emission-restrictedmodel (Figure 9.7C) shows that the privately efficient level is less than the socially efficient level of pollution abatement(,\
STATIC EEFICIENCY WIIH IMPERFECî COMPEIITION. The production- and emission-restrictedmodelshave been used to derive the efEcient rates of production and pollution abaterrentfor a purely competitive industgr. How are efficient ratesof production and pollution affected by imperfect competition?The answer is examinedby comparingproduction and pollution ratesfor imperfectly and purely competitive industries.For simplicity, it is assumedthat the de,rrandcurye, margind production cost (MPC), marginal pollution de.ttages(Ivtr-D) and marginal

Table 93.

1 2, 3 4 ) 6 7 8

f'--arnple of prÍvately and socially efEcient leveb of poltution abetencut

5.00 t4.t4 25.98 4{).00 5s.90 73.48 92.60 ll3.14

80933 2yt:t4 10953 n.29 14.82 5.45 2.Or o.74

3,016.61 1,109.75 40825 r50.19 5525 2038 7.4 2.75

A is the level of pollution abatemcnqMCA = naryiml cost of abanmenq MPB,\ = maq$nal private beneft of abafiemenqMSBA= marginal social beoefit of abatement A = 4 is the pnvaely efficient level of pollution abafement and A = 5 is dre socially efficient level of pollution abarcment

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cost of pollution abatementMCA) are the sarneunder pure and imperfect competition. Consider using the production-restrictedmodel to com[rarethe production rates under pure and imperfect competition.Under pure competition, profit is maximized at the production rate where p = MPC. p is determined from the demand function (D). Under imperfect competition, profit is maximized at the production rate that makesMR = MPC. BecauseMR < p with imperfect competition,the efficient rate of productionis lower with imperfect competition than with pure competition (Q- <.q) as shownin Figrrre 9.8A. Becausethe production-resticted model imFlies that lnllution is a continuous fimction of production abovesomethresholdrate of production,the privately efficient level of pollution is also lessunderimperfect competition.The -agnitude of the difference in production and pollution between pure and imperfect gsmFetition dependson the relative slopesof the underlying marginal revenueand margiual production cost curves. Likewise, the socially efficient level of pollution, which equatesmaqginalsocial benefit of abatementto marginal pollution dÍrmage, is less with imperfect competition than with purc competition. Next, considerthe emission-restrictedmodel. Let MPB be thc marginalprivate benefit to the industry for a one unit changein pollution abaternentIt can be shown that: IvPBA- > MPBAT. The last relationshipis depictedin Figrrre9.88. Efficient pollution abatementis less with pure competition than with imperfect competition.Hence,pollution is lessunder imperfect competition than under pure competition. In summary,both the privately efficient rate of production and level of pollution are greaterunderpurecompetition thanunder imperfect competition.While the lower pollution level achieved by imperfect competition is preferable from a social vievrpoint, the lower rate of production is not. It is coincidental that the privately efficient levels of production and pollution abatementare closerto the correspondingsocially efficient levelswith imperfect competition than with pure competition.

DYNAIIIC EtrtlCtnNCY. When residualemission in the curent period influences both current and funrre pollution damages,the efficient level of pollution abalementshouldbe determinedin a dynamis frasrework. This framework considers theintertemporalrelationshipbetweenemissionsand pollution damages.For example, pollution of groundwaterin some agricultural areashas been traced!o excessiveapplication of animal uranureand/orstorageof animal manurein barnyard areasthat occurredseveral years earlier. Nutrients in anirnal flurnrue are stored in the soil and releasedover time, which can causenutrient contaminationof groundwater. Dynauric efficiency analysis is considerably more complex than static analysis of pollution externalities. A simple dynarrric model is used here, which assumesthat a) some of the residuals generated by production are not assimilatled by the environment b) pollution and p,ollution damages ii're proportional to emissions of residuals, and c) there is only one pollutanl The model is in discrete time. Following the same logic as used in the static efrciency analysis of pollution externalities, pollu-

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Val.ue per Eait

Production

Val.ue

per

Us-iÈ'

\ PolluÈion

\"* ÀbaÈaeaÈ

Figure 9.E. comparison of efficient production under pure (QJ and imperfect (QJ competition for production-restricted (A) and emission-restricted (B) nodel. Efficient abatement Ís A. for pnre competition and A- for imperfect competitiono as shown in (B). D = flsmend; MPBA = marginal private benefit of abatenent; MpC = marginal producfion ccts; and MR = narginat neverrre.

9. Economicsof EnvironmentalPollution

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tion associatedwith current production (LJ is assumedto be a power function of curent production (Q): L, = qQr (t = 1,...,T,a.> 0 and l" > l). I-t can be decreasedby investing in pollution control technologiesthat reduceq. Accumulated pollution at time t (ALJ is the srrmof pollution flows through period t: AL, =

t

È,L,

Therefore: 't

AI" -

È, ",Q,r.

Pollution damagein period t (LDJ is proportional to accumulatedpollution through period t: LD, = bAI-r

(b, > 0),

where b, is the increasein pollution damageper unit increasein accumulatedpollution in period t, or the marginal cost of pollution damages.Substituting for AL. in the last equationgives: t

LD, = b, È, a,a*. This equation states that pollution damage in period t depends on the value of a", b, and historical production (Qr,...,Q). Consider first the socially efficient rates of production and levels of pollution. The socially efficient production rates over tsime are deterrnined by maximizing the present value of net social benefits. Net social benefit in period t equals net private benefit minus pollution damage in period t Let B, be net private benefit in period t. Then, net benefit in period t is: NSB.=Br-LDr. Overall net social benefit is the present value of the NSBr values, namely: T

NSB = t XNSBI(I + rF, =l where r is the discount rate. Marimizing NSB gives the socially efEcient production rates for all periods, namely: Q*rt,"',Q*.r' Substituting the efficient production rates into L, = a,Qr and LD, = brXare"t grves the socially efficient rates of pollution and pollution danuges, respectively, in all periods.

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Natural Resourceand Environmental Economics

If pollution damagesincreaseover time, then the socially efficient production ratesdecreaieover time- Decreasingproduction rateswould raise commodity prices over time, provided there are no offsetting decreasesin demandforthe commodity. Investrnentsin pollution conEol technologiescould moderate the growth in pollution damagesby lowering pollution flows per unit of production and/or the marginal cost of pollution danage (b). When pollution is a pure externality, reducing pollution does nt# benefit the acting party. Hence,the acting party ignoresthe pollution dauragesand sinply mD(imizes net private benefit, which is: T

NPB = t E. NPBr(1+ rF, =l where NPBI is net private benefit in period L The resulting privately efficient production rates and pollution damagesare greater than the socially efficient production rates and pollution damagesIs it in society'Sbest interestto impose restrictions on acting parties to eliminateexcessiveproduction or pollution? If the presentvalue of net social benefitsminus the present value of the cost of imposing the restrictions is greater than the presentvalue of netprivate benefits,then it is in society's best interestto imposethe restrictions.The next sectiondiscussesalternativepublic policies for restricting pollution.

Establishing Property Rights for Envíronmental Resources Unless polluting firms decide to reduce pollution on their own and/or a regulatory agency,such as the U.S. EPA",ta(es or regulatespollution, profit-maximizing firms have little economicincentive to reduce production and/orpollution to the socially efficient level. Elininating Pareto-relevantpollution externalitieswarrantssomeforrr-of public action when it is economically justified (benefitsexcced costs).Chapter5 explained that a principal causeof external diseconomiesis the absenceof a completesysternof property rights. One way to eliminate Pareto-relevantpollution externalitiesis to establish completeproperty rights for environmentalresources.These.ights would establishwhetherpolluters (acting parties)havea right to pollute environnental resourcesor whetherpollution victims (affectedparties) have a right to unpolluted envirorunentalresources.Either system of rigbts provides an economicincentive to negotiatea socially efEcient rate of pro.;ductionor pollution abatemenl Several factors impede a propefy rights solution to pollution externalities. First, evenwhen completepropertyrights for environmentalresourcesare specified, the cost of settling resourcedisputesbenveenacting and affected parties is high, particularly when there are severalacting and/or affected parties (hlgh transaction costs). Second,a property rights solution is unlikely when pollution darnagesernanatefrom a large number of diffirse sourcessuch as with nonpoint source Pollu-

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tion. In contras! a property righs solution is feasibtefor point sourcesof pollution, such as thermal water pllution from a nuclearpower ptant. Thirù even if pollution darnagescanbe linked to specific residual emissions, as with poittt sourcepollution, allocation sf demagesto specific pollutants is ditficult when the damagesfrom two or morepollutanB are multiplicative rather than additive. Fourtht a property rights solutiou is unlikely when there is nonrivalry in the consumptionof pllution. Nonrivalry is presentwhen pollution damagesto one affected party do not diminish d"rnages to other affected.parties. For example, health impairment from inhalation of secondarycigarette smoke is not diminished by the number of parties exlnsed to the smoke.The externality that occurswhen there is nonrivalry in consumption is an mdepletableexternalíty. One consequence of undepletableexternalities is that the efficient level of pollution is not the same for all affectedpartiesand is different thanthe socially efficient level. While a properly rights solution to pollution externalitiescanbe difficult to achieve,supportfor thi's type of solution has increasedin recentyears.T

Pollution Abatement Policies When there is prue competition in product markets and residual émissions are not proportional to production, the privately efficient level of pollution abaternentis less than the socially efEcient level of abatement (emission-restrictedmodel)-This occurs becausefinns orhouseholds ignorethe external costsof pollution on otherfirms orhouseholds.External environmentalcosts arise when firms and householdshave free accessto the residual assimilaúoncapacity of the environmenl In other words, the residual assimilation capacityof the environment is unpriced. This section evaluatesand comparesseveralpolicies for alleviating point and nonpoint sourcesof environmentalpollution. POINT SOURCE FOLLUTION. Environrnental pollution occuni when the residual assimilationsenricesof the environmentare free or unpriced. Becausepolluters do not have to pay for theseservices,a large amount of residualsis emitte4 which increasesthe likelihood of environmentalpollutiou, irnpairurent of human health and loss of ecological services.This section discusseshow ta.res,emission charges,ernissionstandards,tradable emissionpermits and environmentalliability can be used to control point sourcesof pollution. Elemene of thesepolicy instnrments canbe usedin controiling nonpoint sourcesof pollution. Their applicationto nonpoint sourcepollution is more complex becausethe links between sourcesof pollution and pollution lire not well-defuedTaxes. Pollution extenralities can be reducedto their socially efficient levpls by chargingpolluteis to use the residual assimilationcapacity of the environment. The efficient price for pollution is a Pigouviantax on residual emissionsthar cause pollution. The talcequals the difference betweenmarginal social benefit and.mar-

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gnal private benefit of pollution abatement at the socially efficient level of abatement (ab in F'rgure9.7C)Imposing a Pigouvian tax of ab per unit of pollution causes the marginal private benefit curve to shift upward until it intersects MCA atd. The tax sbifts MPBA upward by the amount of the tax because decreasing pollution desreases ta:c payments, which increases the marginal private benefit of pollution abatemenL After the tax, the original level of pollution-abatemen! A, is no longer edEient because an additional unit of pollution abatement increases total return more than it increases the total cost of abatemenl How much should abatement be increased? There is an econornic disincentive for extending pollution abatement beyondA*- Increasing abatementbeyondA=causes total abarcment cost to increase more than total revenue, which reduces total net return. After the tax, the privately and socially effrcient levels of pollution abatement are identical. In other words, A= is the profitmaximizing level of pollution abatement with a Pigouvian tax. Pigouvian ta:res have been criticized on the grounds that they might cause marginally profitable firrrs to leave the industry.t Other types of financial incentives have been used to reduce environmental emissions and pollution, namely: taxing inputs and/or production, subsidizjng defensive expenditures made by affected parties, compensating affected parties for daurages inflicted by acting parties, and subsidizing emission reduction by acting parties. The proposed carbon tax of $30 per ton proposed by the United States in 1993 was designed to reduce carbon dioxide emission. European countries have high taxes on gasoline. Taxes have been proposed and used to reduce municipal solid waste and congestion on highways and to encourage recycling. An examFle of a defensive expenditure is the cost of substituting bottled water for polluted u/ater.Is it efFcient to subsidize defensive expenditures, say, by offering government-financed rebates to individuals who purchase bottled water in areas with polluted groundwater? No. Households exposed to pollution will allocate their limited income to consumer goods and defensive activities so Írs to maxinize their utility. When utility is maximized, the added utility per dollar spent on goods and defensive activities is equal. Therefore, utility- and profit-maximizing behaviors will autornatically result in an efficient allocation of income or capital to defensive activities. In fact, subsidies to ac$ng parties distort incentives to reduce pollutiou. Subsidizing bottled water reduces its price and increases the quantity demanded, which reduces the health risk from polluted groundwater. Lower vulnera.bility to polluted groundwater reduces incentives to protect groundwater frorn pesticide contamination and increases the likelihood of groundwater contamination. Compensating affected parties for the damages caused by environmental pollution is also inefficient. Compensating households for each 100 gallons of polluted groundwater they consume creates a disincentive to purchase bottled water and re'..sults in an inefficient level of defensive expendihrres. In thiir ca,se, cornpensation causes the level of defensive expenditures to be too low. Finally, zubsidizing the acting party may also be inefEcient. An example of this is the reinbursement given to landowners to cover part of the cost of soil- and water-conservation practices. Consider providing landowners with a unit subsidy equal to t. At first glance, it might appear that a unit subsidy to reduce emissions has the same effect as a unit tax on ernission, namely, it-achieves the socially efficient level of pollution abatemenf ,\. There are important differences. A subsidy, unlike

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a tax' increasesfirm profits (it is tike an add.itionalsourceof revenue),which keeps some firrrs that are inefficient in reducing pollution from leaving the industry and atEacts new firms into the industry in the long run. Less exit and greater entry of firms are likely to increaseproduction and emissions-just the opposite of what is needed.In sumnary, subsidiesto acting and/or affectedparties, as well as compensation to affected parties, are generally socially inefficient Wbile Pigouvian taxestheoretically achievethe socially efficient level of pollution, their implementationrequires considerableinformation about polluting activities- The regulatory authority must lnow the following: a) the *".gi"uf cost of pollution abatementfor all parties,b) ttre marginal private benefitof poliution abatement CMPBA), c) the marginal social benefit of pollution abatement MSBA), and d) the emission levels for all acting partieg. Mthout this information, it is not possible to deterrninethe Pigouvian tax. Severalsecond-bestpollution-control policies have been developedand utilized, including emissioncharges,emissionstandards, tradable emissionpennits and liability rules. Traditional analysisindicates that the imposition and level of a tax or subsidy sreatesincentivesfor firrrs to enterthe industry when a subsidyis imposed,or possibly leave the industry when a tax is levied- Rent-seekingbehavior pìovides an alternative explanation of firm entry and exit relative to the size of ttre inaustry ttrat would exist under a system of complete property rights for environmental resources-eRent-seekingbehavior consistsof actionsdesignedto improve the financial position of a firrn, hoùsehold,indusbryor specialinterestgroup-roIn the caseof a Pigouvian subsidy,rent-seekingbehavior stimulatesfirms to enter the industry to competefor the excessrents generatedby the subsidies.Excessrents arisewhen the value of the subsidyexceedsthe cost of pollution control. While a Pigouviantax provides no-opportunityfor rent-seekingbehavior by polluting firms, it can stimulate general rent-seekingbehavior in wUictr interest grouPs compete for the revenuesgeneratedby the tax. For example, conservation organizationsmight lobby to have the tax revenuesspenton develòping less-polluting technologies-Industrialgroupsmight lobby to spendthe revenuesónretraining workers displaced by pollution control regulations. If the tax revenues are not evenly distributed among communities, those comrnunitiesreceiving a disproportionate shareof the revenuewould be able to upgradethe provision oipublic goods such as parks' libraries and educational facilities. This might stimulate a general movement of populationto thoseareasreceiving a disproportionateshareof the tax revenues. EmissionCharges- The emission chargesapproach,also called the emission chargesand standardsapproach,requiresthe regulatoryauthority to establishan environmental standardanda uniform chargeper unit of emissionfor eachsource.The charge is adjusteduntil the standardis achieved.In essence,the chargeis the price that the polluter paysfói using the assimilative capacrtyof the environmenLThe environmental standardcan be an arnbient standard or an ernússionor $luent standard- An arrrbientstandardestablishesa minimum standardfor environmental quality. For esamPl€,the current arrbient standardfor nitrate concentrationsin driniring water in the United Statesis 10 parts per million. An effluent standardestablishes the mean or maximum permissibledischargeof a residual for a given source. The Clean Air Act Amendmentsof 1990 establisheda goal of reduciig.total emissions

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of sulfir dioxide from coal-fued power plants by 50 milton tons. Ideally, effluent standardsarebasedon the likely benefig to society of avoiding various kinds of pollution. The efEcient level of pollution abatementfor a private firm is determined by balancing the costsand benefits of pollution control. The benefits of pollution control equalthe reductionin emission chargespaid to the environmentalauthority. Total emission chargesequal total emission times the charge per unittÎ emission. 'When the 1rr unit emissioncharge does not dependon the level of emissions,the marginal benefit to the finn of reducing pollution equals the per unit emission charge.A firm minimizes the cost of pollution abatementby equating the marginal benefit to the marginalcost of pollution abatementas shown in Figure 9.9. The efficient abatementlevel for a per unit emissionchargeof ft is A1. When abdtementis below Al, it is lesscostly to increasepollution abatementthan it is to pay the emission charge. Conversely,when the abatementlevel is greater than Ar, reducing abatementis costrffective becauseabatementcost decreasesmore than emission chargesincrease.Similarly, A, is the most efficient level of pollution abatement when the emissionchargeis f2. The regulatory authority achieves the desired level of ernission from all sorucesby increasingor decreasingthe uniform emissionfee. For a per unit fee of t, total emissionfrom all sourcesis: J

R(fJ =iì,\(f'),

Value

per

[Init

Pol]-uÈi.on

.AbateueaÈ

Iìgure 99. Efficient pollution abatement for two different ernission charges (0. MCA= marginal cost of abatemenl

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where Rj(f,) is the residual emission by firm j when the fee is f, and J is the number of firms or emission sources. If R(fr) is greater than the desired level of emissions, then the effluent stendard is not exceeded-In this case, the regulatory autbority must increase the emission charge until the desired emission level is achieved- Raising the emission charge from f1 to f2 shifts the marginal benefit of abatement upward" which increases the efficient level of abatement and decreases emissions, other things constent- Conversely, if R(fJ is more than the desired level, then the unit charge must be decreased in order to decrease abatement until the desired level of ernissions is achieved. Correct adjustments to the emission charge require the regulatory authority to monitor the level of emissions from all sources. While emission charges do not necessarily result in the socially efficient level of emission reduction, they are the most cost-effective policy for achieving a given environmental standard. The most cost-effective policy achieves the enyironmental standard at least cost to society. This is illustrated in Figure 9.1O. For simplicity, only two polluting sources are considered, X and Y. Both sources are assumed to maximize the net benefit of emission reduction. Source X has a lowe,r cost of pollution abatement than sotuce Y (MCA* < MCAy). For a uniform per unit charge of fr, the most efEcient allocation of emission abatement between sources X and Y is Ay andAy, respectively. Hence, the source with the lower cost of abatement CX) has gteater abatement (A* > Ay). For this reason, the average cost of achieving a particular enission reduction is automatically minimized with emission charges. This is true regardless of whether the polluting sources operate in a prrrely or imperfectly competitive markel One study showed ttrat the total cost of reducing emission of certain halocarbons was $11O million using emission fees versus $230 million using emission standards.lr Not only are emission charges more cost effective, but unlike a Pigouvian tax, they do not require knowledge of the marginal cost of pollution abatement or the private and social benefits of emission reduction for each source. Errission charges operate more smoothly, however, when the regulatory agency knows the average cost of controlling d^ifferent sources of pollution. This information can be used by the regulatory authority to deteiurine the level of emission charges needed to achieve the desired environmental standards. Mthout some knowledge of average cost the authority has to use an iterative approach in which emission charges are adjusted up or down until the standard is achieved. Such adjustuents can create considerable uncertainty for polluting firrrs especially when several adjustments ane needed to arrive at the desired standard. In addition to being cost effective, emission charges have four additional advant4ges. First, they provide an incentive for polluting sources to invest in new abatement technologies. In the long run, the firm can change abatement technology. If the cost of adopting an abatement technology is less than the saving in emission charges, then there is an economic incentive for the firm to adopt that technology. Suppose technologica['improvement reduces the marginal cost of pllution abatementfromMCAr to MCA2 as shown in Figrrre 9.11. The efEcientlevel of pollution abatement increases fromA1 toA2. Second, emissi,onchargesinternalize part of the cost to society of utilizing the residual assimilation capaciry of the environment- Imposing emission charges has the saure effect as pricing the residual assimilation capacity of the environrnenl Such charges increase the marginal cost of pollution abatement and the marginal production cost. Part of the increase in marginal pro-

Natural Resource and Environmental Economics

216

Value par unit

Va1ue Der unit

Figure 9.10. F.ffrcient allocation of pollution abatement between sourses X (A) and Y (B) for an enission charge of f1. MCA = marginal cost of abatemenL

9. Economics of Environnental Pollution

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duction cost is passed on to households in the fonn of higher product prices. Higber product prices reduce the quantity denanded of the producg other things equal. Third, ernissistl charges are a source of public revenue that can be used to develop less-polluting technologres, mitigate the adverse effects of pollution, and/or reduce budget deficits. It has been estimated that charges for sulfur dioxide and particulate flultter emitted to the uir by stationary sources would generate annu"l ta:r revenues of $1.8 billion tq $8.2 billion. ff the revenues from such chargesare substituted for revenues generated by taxes on labor (corporate) income, there would be an efEciency gain of between $630 milUon ($t billion) and $3.05 ($4.1y billion in 1982 dollars.r2 Fourth, emission charges are consistent with the polluter-pays principle, which maintains that polluters should pay for the external costs that theirpollution imposes on society. Emission charges have several drawbacks. First, the establishment of emission standards for all pollutants is a monumental task although less difEcult than determining the social damages caused by various emission levels. FurthermorE, there can be very different opinions regarding the appropriate ambient or effluent standards. For example, ambient drinking water standards for nitate-nitrogen and atrazine are continually being debated because of the uncertaingr regarding the advetse health effects of these subsrances.Second, ghanges in the nr:mber of emission source.s and pollution abatement technology necessitate periodic adjustnents in emission charges, which can be disnrptive to polluting industries.

Val.ue

per

UrriÈ,

Po11utLq,

Figure 9.U. Efrects of improvement in abatement technologr on efficient abatemenù MCA = narginal cost of abatement; and f, = emissioncbarge.

ÀbaÈererlt

2tt

Natural Resource and Environmsalql

Economics

Third, emission charges Íìre not effective in controlling emissions of toxic residuals because such emissions must be precisely controlled- Fourttr, a uniform emission fee is not efficient when emissions from different sources generate unequal unit damages..Consider a uniforrn charge on surface runoff that has a nitrate-nitrogen concentration in excess of the drinking water standard of 10 parts per million. Suppose one soruce is upriver from a reservoir that serves as a public drinking water supply and another source is located below the reservoir. A unifooe charge on emissions from both sources is not cost effective because emissions from the upriver source have a much greater potential impact on humau health than do ernissions from the downriver source. While this deficiency can be alleviated by setting higher charges in areas where nitrate pollution of water poses a higher risk to human health, the administrative cost of implementing differential charges is greater than for uniform charges. Fifth, even though emission charges achieve the desired reduction in emissions at least cost, entirely different approaches might be more efficient If the objective is to reduce sulfur dioxide emissions frorn electrical power-generating facilities, then a unit charge on emissions from these facilities is cost effective. Reducing the demand for electricity through conservation would be more cost effective. Conservation includes subsidizing the use of efEcient electrical lighting in new facilities, increasing the energy efficiency of lightbulbs and electrical appliances, and expanding spÍrceheating with passive solar energy. Sixth, environmental standards are not likety to be achieved when emission charges are too low and/or the standard is not enforced. No western country has set emission fees at a high enough level to achieve its environmental stendards. In Eastern Europe, emission charges are a major part of Poland's air pollution control policy. Poland's air emission charges are generally low, however, even though they have been increased since 1989 and emission charges or fines are not enforced because of the economic difficulties in restnrcturing the industrial sector.r3 Several countries in Western Europe, notably Gerurany, France and the Netherlands, have used emission charges to reduce water pollution. Except for the Netherlands, emission charges in this region have been set at too low a level to be effective in reducing water pollution. Í'.rnissioaStandards. An emission standard requires the regulatory authority to set an environmental standard for each emission source and to monitor the emissions for compliance with the standard. This is essentially a comrumd-and-control approach to control of point sources of pollution. In some cases, the regulatory auttrority requires each source to use the best available emission control technology. Emission standards are the most popular method of controlling point sources of pollution in the United States. Amajor udvaltage of emission standards is that unlike incentive-based ernission charges, they ensure that emission at each source and total emission do not exceed a certain level when the standards are enforced. Enforcement usually entails penalizing sources that violate the standardAnajor disadvantage of environmental standards is their inefficiency. Because information on the most cost-effective abatement technology for each source is usually not available, standards and./or abatement technologies for each source are tyPically based on general requirements and conditions in the industry. Because the most cost-effective technology varies across facilities and time, the emission stan-

9. Economics of Environmental Pollution

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dardsapproachends up requiring levels of pollution abatementanq in sornecases, abatementtechnologiesfor individual sources,that are inefficient. Studiesindicate that the cost to polluters of reducing air and water pollution in the United Statesis t*rice to 10 times as costly as the least cost alternative.raFurthermore, there is no guaranteethat environmentalstandardsestablishedby a body of electedrepresentatives,such as Congress,or by a regulatory authority, such as the Environmental Protection Agency, are efEcient from an economic viewpoint (marginal benefit equals marginal cost of abatement).Someecononists argue that establisbmentand enforcementof emission stendardsby pubtic bodies should be undertakenonly when emissionsgenerzrtehigh social costsandcompliancewith the standardssignificantly reducessocial costs. Emission standards are generally less efficient than emission charges in achieving the sarne level of pollution reduction as illustrated in Fig're 9.12. Consider a anifortn emissionstandardthat requiressourcesX andY to achievethe same level of emission reduction, namely,A. Marginal cost of abatement(MCA) is higher for sourceX than sourceY (MCAX > MCAy). The cost of reducing total emission by 2A is the areaunder MCA*up to A plus the areaunder MCA.rul to A. With a uniform emission charge,efficient abatementoccurs where the enission chargeequalsthe marginal cost of abatement.Hence,the efficient emission reduction is A* for sourceX andAt for sourceY. The total cost of abatementwith the uniform emission charge is the area under McAx up to A1 plus the area under

Va].ua

per

Uait

Po].1rrÈi@,

eJraÈ@€D.t

Figure 9.12- Comparison of abatement for sourcesX and Y with a uniform ernission standard (a) and a unifom emissioncharge (fJ. MCA: cost of abatement"

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MCAy up to Ay. Because this alea is less than the area below the two marginal cost of abatement curves up to A, the total cost of emission abatement is less with a uniform emission charge of f, than with an ernission standard ofA. This occurs because the uniforrn standard requires both sources to achieve the same level of abatement regardless of their marginal costs of abatement. In contrasl the uniform emission charge allocates more emission reduction to the source witb the lower marginal cosl of abaternent. \Some of the inefEciency that results when all pollution sources are required tc achieve the same emission standard can be reduced by varying the standard according to the type of facility. For example, if older facilities have a higher marginal cost of abatement than newer facilities, then total abatement cost can be reduced by requiring less abatement for older than for newer facilities. Alternatively, the abatement technology for each firm can be based on the size of its facility. Facilities above a certain size can be required ùo use a more efficient abaternent technolog; than facilities below that size. The inefficiency of emission standards is especially high when the regulator5 authority controls not only the level of ernissions at each source but also the technology each source must use to reduce emissions. It is quite cornmon for the regulatory authority to require use of the best available emission control technology. Re. quiring use of a particular abaternent technology has two negative consequences First, it can increase the social cost of reducing emissions by not allowing the emis sion sources to select the most cost-effective technologies for achieving thg stnn dard. For e;ampl€, in Figr:re 9-lZ,let MCA1 be the marginal cost of abatement fo the technology specified by the regulatory authority and let MCA' be the margina cost of abatement with the most cost-effective abatement technology for that par ticular source. Requiring the source to use a specific technology increases the tota cost of achieving A by the area between MCAy and MCAy up to A Second, allowing the regulatory authority to deternrine the abatement technol ogy to be used at each source might decrease the incentive to develop ne% mori cost-effective technologies. For exîmple, there is a strong disincentive for a firrn tr develop an atiatement technology that results in more efficient control of emission when the regulatory authority's response to new abaternent technologies is t tighten the emission standard and/or to require all ernission sources to use that tecb nology. On the positive side, the-cost of monitoring the installation and operation c pollution control technologies is much lower than the cost of monitoring specifi emissions. Emission standards have certain advantages relative to errission charges de spite their inefficiency. Consider an ambient standard that restricts the maximnr permissible concentration of a pollutant Empirical evidence suggests that an amb: ent emission standard is likely to result in less total emissions than is an enissio charge for the following r€ason.r5With an ernission charge, the implicit economj ' value to the firm of reducing pollutant concentrations below the maximum permi: sible concentration is zero. Hence, it is effrcient to increase emissions as long as tt pollutant concentation is below the maximum permissible concentration. An emi: sion standard typically has a nondegradation clause that disallows a firrr from ir creasing emissions when the concentration is below the am.bient standard. As note earlier, the inherent inefficiency of emission standards relative to emission chargr can be reduced by regulating total emissions at each source and allowing sources tl

9.

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flexibility to choose the most efEcient abatement technology for achieving partica ular standard. Deterrnining the maxinum permissible concentration of a pollutant for achieving an ambient standard can be much more complicated thanlening an emission charge becauseconcentrations are influenced not only by emissions but also by environnental conditions at the time ernission occurs. For example, a rainfall that occurs shortly after a particular herbicide has been applied to an agricultural field is likely to cause concentrations of that herbicide in .urfu"" runoff to exceed the ambient standard- To account for such events, the ambient srandard is typically compared with herbicide concentrations averaged over several time perio$. Foiexarnple, the ambient standard of 3 parts per billion for atrazine in drinking water is violated when the average concentration of atrazine in quarterly samples of drjnking water exceeds the standardSecon4 a uniform emission standard guarantees achievement of a specific level of environmental quality. An ernission charge achieves that sarne quality only if it is set at the proper level. This advantageis especially important in riducing the risk of pollution darnages during emergencies, and controlling the release of toxic substarrces.For exarrple, the risk of health-related problems increases drauratically when an air inversion traps hydrocarbon emissions in the Los Angeles, California, or Denver, Colorado, airshed. The increase in risk is caused not by the level of emissions, but by atrnospheric conditions. The risk of pollution damagescan, however, be decreasedby temporarily invoking a restrictive emission standard. An emission charge cannot achieve a quick reduction in emissions because it influences long-run decisions such as the use of a particular emission contrcl technology- What works in ernergency situations is direct intervention by the rcgulatory authority to reduce the level of emissions and the risk of pollutioo au-ug"r. The dauragescaused by an air inversion in Los Angeles or Denver can be reduced by restricting nonessential operations and transportation that conhibute to hydrocarbon emissions. Such restictions would be lifted when the emergency passes.In the case of toxic substances,it is vitally important to control emissions. An emission standard is better suited to handling emergencysituations and controlting the release of toxic substancesthan an emission charge. Thinù the greater efEciency of emission charges relative to emission standards . is achieved only when the emission charge is set at the proper level. Too high a charge can make an ernission charge more costly than an emission srandar.d.Deter_ mining the correct charge requires knowledge of the marginal costs of abatement for all firms in the industry. In general, the regulatory authority does not have such information. Tbadable Emission Permits. Tradable emission permits (IEFs) restrict the contribution that different sources make to ambient cóncentrations of a pollutant (ambient permit systemf,emissions from a source or area (emissionprr*lt system) or a combination of the two Qtotlution ffiet system). Permits ."n b. Uougirt anO sold according to the terms of trade specified in the perrnit. Tradable emission permits are like emission standards because they require the regulatory authority to set an upper limit on either ambient concenEations or total emissions. The main goal of TEPs is to minimize the cost of achieving predeterrnined environmental standards. In the ambient permit system, permits are defined in terms

7t'r.

Natural Resourceand Environrnental Economics

of the pollutantconcentrationallowed in a particularlocation. If a sourcehas emissionsthat contributel0 unitsper month to ambientconcentrationsin aparticularlocation and eachpermit in that location is for two units of concentration, then the source would needto purchasefive permits for that location. If the sourceis issued only three permits, then it must buy two permits or install a technology to reduce emissionsby four units. Source-to-sourcedifferencesin the arnbient concentrations of emissionsate usualty causedby differencesin abaùementtechnolúly and local environmentalconditions.If emissionsfrom a sourceinfluence arrrbientconcentrations in three locations,tÌrcn that sourcemight have to trade permits in the threelocations.fsl this reasion,the cost of an nmbientpermit systemcan be very costlyto sources. In an ernissionpermit system,the regulatory authority issuespermits in each of severalzones,which specify a maximum emissionlevel. The number of pennits issued in each zone dependson the environmental standard established for that zone. The regulatory authority issuesa certain numberof emission permis in each zone. Total emissionsallowed by all permits equal the environmental standardfor that zone. For example,if the regulatory agencywants to limit total sulfur dioxide emissions to 10O,000tons per day and each permit allows a fixed emission of 10,0m tons per day,then emissionsourcesareissued10 permitsAn emission permit is less costly for sourcesthan ambient permits because each sourceonly has to trade permits in the zone in which it is located. Emission permits are tikely to be more costly to administerthan will be ambient permits.This occursbecausein an emissionpermit systen the regulatory authority hasto increase or decreasethe nurnberof emissionpermits until the desiredlevel of environmental quality is achieved.Adjusting the number of ernissionpermits issued for that zone gives rise to the samesort of price uncertainty for sources as adjusting emission charges. In the pollution offset system"permits aredefinedin terms of the level of enrissions allowed within a zone.Trading of permis is allowed provided it does not violate the environmentalstandardfor that zone.This system results in least+ost attainment of environmentalstandardsregadless of the initial distribution of permitsThe only inforrration required to implement the pollution offset system is the contribution that the emissionsfrom each sourcemakesto ambient concentrations.For example, supposethe maximum'arnbientconcentrationfor a pollutant has already been reachedin a zone and sourceA wants to increaseits emissions by purchasing a permit from sourceB. ff one unit of A's emissionscontributes twice as much to ambient concentrationsas does one unit of B's emissions and each permit allows one unit of emission,then A would have to purchasetwo permits from B for each unit of increasein its own emissions.In order to sanction this and other possible trades,the regulatoryauthority must know how much a unit of emissions from each sourceconEibutesto arrbient concentrations.Becausepollution offset permiS are 'issued for individual zones,sourcesneedonly be concenrcdabout perrrit trading in one zone.This makesoffset permiS less costly to sourcesthan ambient permitsTradableemissionpermits give sourcesa property right to emit the amounts specifiedin the permit.In essence,TEPs confer the right to use a certain portion o1 the environment'sresidual assimitationcapacity.For TEPs to be effective, the regulatory authority must tack ernissionsand permit holdings for all sourcesUnlike emission standardsthat establish a fixed ernission standard for eacl

9. Economics of Environmental Pollution

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source, it is possible for TEPs to be Eaded on an international, national or regional basis by emission sonrces as well as members of the general public. psl sxample, the TEPs for sulfi,r dioxide emissions from coal-fired power plants established by the Clean Air Act Amendments of 1990 can be traded on a nationwide basis. Part of the cost of using TEPs is the transaction costs of nading permits. Tradable emission permits are generally more cost effective than are environmental standards because sources with low (hrgh) marginal costs of abatement are allowed to sell (buy) permits to sources with high flow) marginal costs of abatement. Because each source minimizes the cost of abatement by setting margiúal cost of abatement equal to the price of the perrrig the marginal cost of abatement is equalized àcross all sources. A market for TEPs is illustrated in Figure 9.13. Suppose the pollution abatement goal isAand each source reduces pollution by .5Abefore TEPs are issued. At this level of abatement, the marginal cost of abateinent is higher for source X than for source X MCArtlx > MCA@\. LetTEPs be issued that allow pollution to be reduced by A. Supposethe initial distribution of pennits is .5Ato each source. For this distribution, there is atr incentive for source X to buy permits from source Y provided the price of permits is less than MCAtt)*. Likewise, there is an incentive for source Y to sell permits to source X provided the price of perrrits is greater than MCA@\. Aperrrit prriceof m, as shown in Figure 9.13, satisfies both conditions. Because m < MCAo)x, it is cost+ffective for source X to buy permits from source Y and increase its emissions ùom A-.5A to A-.25A Similarly, since m > MCA(2)v, it is cost effective for source Y to sell permits to source X and reduce its own emissions from A - .5A to A - .75A.In equilibrium, the quantity of per:nits source X wants to buy equals the quantity of permits source Y wants to sell. Marginal cost of abatement is equalized across sources after trading. Emission trading minimizes the overall cost of achieving an environmental standard. Anything that impedes the free exchange of permits prevents achievement of the fuIl efficiency benefits of TEPs. In addition to providing more cost-effective conhol of emissions than a strict emission standard, TEPs internalize the cost of using the residual assimilation capacity of the environnent. Requiring sources to pay for the right to emit certain residuals increases the cost of production of commodities that generate those residuals. Higher production costs result in higher comrnodity prices, which reduce consumption. There is a net gain to society because consumption of commodities that generate potentially polluting residuals is decreased.By allowing TEPs to be bought and sold by the general public, the market price of emission permits reflects society's preferences for environmental quality. For example, suppose an environmental group believes thatthe total emission standard for a particularresidual is too high (environmental quality is not being adequately protected). The group can reduce total emissions by purcha.qingemission perrrits and holding them offthe marketEmission charges,.emission standards and TEPs internalize some of the cost of using the residual assiifulation capacity of the environment. The cost and equity implications for emission sources, the administrative cost to the regulatory authority, and the relative effectiveness of each policy option can be quite different when the benefits and costs of emission control are uncertain. First, the need for the regulatory authority to adjust ernission fees in response to economic growth and inflation is costly for the regulatory authority and increases uncertainty for emission sources. For example, inflation lowers the real cost of an emission charge and decreases the

2A

Natural Resource and Environmental Economics

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9. Economicsof Environmental Pollution

225

incentiveto reduceemissions.Inorderto maintainemissionstandardsduring inflationary periods, the regulatory authority would need to periodically increaseemission charges.There is no needfor the regulatory authority to adjust for inflation or economic growth when TEPs are used. Inflation and economic growth automatically increasethe price of perrrits, but standardsarestill achievedprovided they are enforced. Secon{ while the social cost of reducing eurissionsis lower with TEPs than with emission standards,the cost brxden to emissio:r sourcesis generally higher when sourceshave to pay for the permits. If the regulatory agency decidesto auction the permits to the highest bidder, then sourcesmake an initial outlay of capital to acquircpermis. The greaterthe competition in bidding for permits, the higher the price of permits andthe greaterthe initial cost of acquiringthem.After the initial allocation of permits is made, sourcescan buy and sell permits. One study estimated that air emissionpennits for certain halocarbonsare six times more costly for emission sourcesthan emissionstandards.r6 For this rcsssn,sourcesare likely to resist TEPs. An alternativeto auctioning TEPs is to distribute them free of chargeto enission sources.Free distributionis lesscostly to sources,but it raisesan equity issue. For exarrple, if the allocation is basedon historical emission levels, then sources with low eurissionswould receive fewer permits than would sourcqswith high ernissions.This method of disfibution rewards sourcesthat have done a poor job and penalizessourcesthat have done a goodjob of controlling emissions.Free distribution of pemrits does not internalize any of the social costsof emissions.There is somecost internalization, however,when permits are taded. Finally, permit auctioning generatespublic revenuesthat can be usedto reducepollution darnages;free distribution doesnot. Third, regional differencesin pollution damagesare easierto handlewithTEPs than with emissioncharges.Supposea ton of sedimentfrom eroding cropland does greaterdnmageto streamecology in region A than in regioa B. It is more efficient to placea higher per unit chargeon sourcesin region A thanin regton B than to bave a uniform chargein both regions-Establishingdifferential chargesis difficult, especially when there is lirrited information on per unit damagesin the two regions.In addition, differential chargesmight be opposedon equity grounds. Becausesediment movementin the two regions is driven primarily by natural conditious (topography andrainfall), differential chargesfor sedimentmight be consideredunfairbecause they penalize sources based on factors beyond their control. Regional differencesin sedinent damagescan be handled by issuing fewer sediment dischargepermits in region A than in region B and disallowing perrrit trading between regions. Fourth, preferencefor emission chargesor TEPs is influenced by the uncertainry regardingthe costs andbenefitsof using thesetwo policy options.rTThe preferencefor either policy option is basedprimarily on the consequencesof selecting an inErpropriate level of emission chargesor nunber of ernission pemrits. First" considera caÍrewhere ttre marginal benefit of pollution abatementdropsrapidly as abaternentincreasesbut the marginal cost of abaternentis relatively constant;slope of marginal benefit curye exceedsslope of marginal cost curve for pollution abaternent. The rnarginal benefit curve would be steep when insuffrcient abatement causedconcentrationsof a highly toxic substanceto exceedsomethresholdlevel.

?26

Nafural Resourceand Environmental Economics

The risk in this situation is that the environmental authority might select too low an emission tax, resulting in insufficient emission reduction and exceedance of the threshold level. Because TEPs would allow the authority to achieve an emission reduction level that does not exceed the threshold., they are preferable to taxes. Therefore, when the slope of the marginal benefit curye exceeds the slope of the marginal cost of abatement curyq TEPs are preferable to emission ta:res. Second, suppose the rnarginal cost of pollution abatement incre#ls rapidly as pollution abaternent rises but the marginal benefit of pollution abaternent is relatively constant (slope of marginal cost of abatement curve exceeds slope of marginal benefit curve). The risk here is that the regulatory authority selects too stict an environmental standard and issues too few emission permits. This would require firms to undertake a substantial amount of emission reductiou, which is very costly- In this situation, an emission tax would be less costly becauseit would allow firms to avoid the high cost of pollution abatement by panng the tax. Not surprisingly, a combination of emission taxes and TEPs is superior to either policy takeu separately when there is uncertainty regarding rnarginal benefits and costs.rE Finally, environnrental standards and TEPs are likely to be preferred to emission charges when a) setting standards or allocating TEPs to sources is more politically acceptable than imposing a large tax burden on emission sources, b) the envirorunental authority is more concerned about controlling the level of e,missions than internalizing the social cost of pollution (although TEPs do both), and c) the environmental authority has more farúliarity with emission standards and perrnits than emission taxes. For exarnple, in the United States there is considerable experience with using site-specific pennits to control point sources of water pollution and national emission standards to control air pollution. Environmental Liability.p Another way to control point sources of environmental pollution is to make acting parties financially responsible for pollution daurages incurred by affected parties. This approach to pollution control is called ezvironmental liability, or EI . A prime example of environmental liability is the highly publicized lawsuit settlementfor pollution darnagescaused by the EnonValdezotl spill in Prince Willian Sound in Alaska" which occurred in March 1989. This accidenl the largest oil spill in United States history, spilled 40,000 tons of crude oil into a highly productive marine ecosystem. Crude oil spread over about 10,0m miz (25,900 h2), including 1,200 miles (1,932 kur) of coastline. It is estirnated that the b,xon Valdez oil spill killed 300,000 to 645,000 birds and 4,000 ro 6,000 marine nammals. The lawsuit brought against Exxon by fedeml and state governments was settled in October 1991. It required Exxon to pay a $25 million f.ne, $10O million in criminal restitution and $900 million over 10 years for civil darnages. After legal fees and expenses,about $745 million went toward environmental restoration.m En.;vironmental liabiliry allows affected parties to sue acting parties for d"nages trarismitùed through the environment. In the case of the Exxon Valdez oil spill, the suit only covered damages from job and income losses caused by the spill, not datnages to the environment itself. The assignment of property rights in environmental quality is quite different trr for than for emission charges, environmental standards or TEPs. Emission charges, such as a Pigouvian tax, implicitly assume that property rights to environ-

9. Economics of Environmental Pollution

227

mental quality belong to the acting party because the environmental authority is usually a govemment agency. Government agencies cÍrn only tax something that they do not own. Environmental standards asisumethat property rights belong to the environrnental authority because the authority is the one who sets and enforces the standards. Affected parties have the right to environrnental quality with EL because they can sue for danages related to the environnent. Envhonmental liability differs from taditional liabitity laws in several respects. First, the acting parly is usually a firm rather rhan a household. Firms are in a uruch better position than households to reduce the darrragesawarded in a liability case because they can inco4nrate. Second, the affected party does not influence the probability of an accident. Consider a midair collision of two airplanes that occtns when plane A enters plane B's airspace. There is just cause !o believe that the collision could have been avoided if both planes had maneuvered to avoid the collision. In other words, the behavior of both parties influences the probabilrty of an accident. This is typically not the case with environmental accidents. The wreck of tlrc Encon Valdezwas not influenced by the behavior of affected parties such as fisherlnen. In some cases,the behavior of affected parties does influence the extent of pollution damags5. For exarnple, health problerns from eating fish taken from polluted waters can be avoided provided affected parties heed the posted warnings. Finally, Fr cases typically involve a large number of affected parties, which makes mass torts appropriate. The expected marginal benefits and marginal cost of preventative action are illustrated in Figure 9.14. The expected marginal benefit of pneventative action taken by an acting Party, designated as E(MB), equals the expected reduction in dapage claims from an additional unit of preventative action. E(MB) reflects three probabilities: that damages occur, that a legal claim is made against the acting party, and that damages are awarded to the affected parties given that a claim is made. Because E(MB) is likely to become smaller as the level of preventative action increases, the E(MB) curve is negatively sloped. The marginal cost of preventative action (MNC) crrve is positively sloped because the cost of additional units of prreventative action is expected to rise as preventative action increases. The efficient level of preventative action occurs at C* where E(MB) = MNC. The price corresponding to the efEcient level of preventative action, p*, internalizes the cost of polluting activities. In this respect ELprovides an economic incentive to control pollution much the same \ilay as an emission charge. Environmental liability has certain advantages. First, it does not require collective action as do emission charges, emission standards or TEPs. Only the parties to a liability claim are required to take action. Second, EL substantiallyreduces the need for information because it does not require collective action. Information is gathered only when a liability claim is made. Third, EL does not require pollution sources to be in compliance with a standard, pay taxes on emissions, or incur the cost of purchasing and trading emission permits. Only those parties to a tiability claim incur costs. Fourth, EL does not require emissions to be monitored" at least in cÍIses where environmenta[ dernages are obvious. Hence, information and transaction costs are likely to be lower for EL than for other pollution control policies. Sixth, Ft- is effective in dealing with toxic residrrals- For example, during the 1987-1991 period" the release of toxic chemicals to the environment by chemical

NE

Value

Natural Resourceand Environmental Economics

1ler unit

Pr.veBÈative

à.cÈion'

Figur 9.14. Efficient level of preventative action (O to avoid pollution damage$ ntnlIB) = expectedmarginat benefit; and MNC.: marginal emrimnmental cost.

companiesin the United Stateswas reducedby 35 percent,in large part due to the ComprehensiveEnvironmentalResponse,Compensationand Liabitity (Superfund) Act of 1980.21 The EL approachdoes have certain drawbacks.Fint, it does not work well when property rights are incompléte.If the right to environnental quality is not assignedto someparry,it is not clear who should pay for pollution damages.If no one has the right to environmentalquality, then no one can claim damages from environmental pollution. Second,actual damagesmay exceedcompensation to affected parties due to imperfectionsin the legal syste,n-l.egal roadblocksinclude a) diffiio apportioningdamagesto a large number of affectedparties (mass torts)' b) "rrtry inability to identify liable partiesdue to lags betweenapollution event and damages Bausedby that even! c) statutesof limitations, d) complexity and cost of court cases, and e) ability of actingparty to avoid payment of damagesbydeclaring bankntprcyThird, the fairnessof the damagesettlementis coloredby the liability rules that apply. For exarrple, under the rule of comparative negligence,the acting party is fi-a5feonly when the minimun level of preventative action is not taken and the affectedparty takesduecareto avoid darnages.Becauseit is relatively easyto prove that minimgm preventativeaction was taken, the affectedpafty is unlikely to receive comlrcnsationfor daurages.This sort of difficutty can be reduced by imposing a

9, Economicsof Environnental Pollutiou

229

more resEictive form of liability. For exarnple, the Superfund legislation incorporates retroactive, strict and joint-and-several liability for accidental oil spills and leakage of hazardous residuals.z Retroactive liabiliry means the law appuls to offending activities that occurred prior to its enactnent. Strict liability -uko the acting party liable regardless of the level of preventative action taken, as long as due care was exercised by the affected party. This law is effective because there are a limited number of qualifying cases(spilts and leakage) and conventional monitoring of damaging activities is rlifficult23 sith the joint-and-several rule, howeve,Í, an acting party can be ordered to pay for the entire damages in the event other acting parties cannot be located or are not able to pay damages. Fourth, the insurance marke! which is the basis for limiting an acting paftyts liability fe1 damages, may distort economic incentives to reduce or p*u*t pollution. One such distortion is moral hazard, which refers to the decline in the acting party's incentive to prevent pollution after insurance has been purchased. Fifth, Fr could reduce the incentive for affected parties to make defensive expenditures. When an trL system incorporates a strict liability rule, it provides an ecònomic incentive for acting parties to reduce pollution much the sarne way as an enission charge.As shown in Figure 9.14, the expected price for the ef,Ecientlevel of preventative action (p*) internalizes the cost of polluting activities much the same way as an ernission charge. However, there is an irnportant difference. Emission charges are efficient because they achieve pollution reduction at least cost and do not reduce the incentive for affected parties to make defensive expenditures. The lafter occurs because emission fees are paid to the environmental authority.An Fr system that requires an acting party to compensate affected parties for damages incurred reduces the incentive for affected parties to make defensive expendinres. This aspect of an EL system makes it inefficient relative to emission charges. Not all FT systems compensate affected parties. Under the Superfund legislation, parties that rire responsible for oil spills and leakage from hazardous residuals that pose serious health and environmental risks must pay for the cost of cleaning up the site using remediation nteasures specified by the U.S. EPA. Superfrrnd does not involve direct compensation to affected parties. Environmental liability is an effective way to reduce environmental pollution especially when property rights to environmental quality are assigne4 frequency of darnagesis low 41d damages are high enough to wÍurzrnt conpensation oienvironmental remediation. On the negative side, the drawbacks to EL prevent it from dom. inating other policies for controlling pollution such as emission charges,environmental standards and TEPs. In summary, differences in the location, sources and consequencesof pollution, as well as in the economic and political feasibility of different approache, to po11rrtion control suggest that a variety of pollution control approaches is likely to be superior to any single approach.

NONIPOIhI"T SOLIRCE POLLUIION. Designing effective policies to control nonpoint source pollution is difEcult because there is a large number of diffirse pol-. lution sources, the relationships between production, emission and pollution are complex, and data regarding these relationships are limited. These same difficulties inhibit the application of the production-restriction and emission-restriction models

230

Nafural Resourceand Envinonmental Economics

to nonpoint source problems. Determining the socially efficient level of pollution with the production-restriction model requires specifying the marginal pollution damage function for each source of pollution. The marginal pollution d"rnage function is derived from the pollution function, L = L(R), which relates pollution (L) to residual emission CR).Residual emission, in turn, is affected by production. Determining the socially efficient level of pollution abatement with the emission-restriction model requires detennining the marginal cost of pollution abater#nt for each soirrce. Marginal cost of pollution abatement depends on the relationship between production and pollution. Application of the two models to nonpoint source pollution requires use of sophisticated biophysical simulation and economic analysisThis section utilizes the emission-restriction model to evaluate nonpoint source pollution. The emission-restriction model is selected because it affords greater flexibiliry in evaluating nonpoint source pollution than does the production-restriction model. Recall that in the emission-restriction model, production (Q) is a function of input use (X) and residual emission (R), narnely, Q = Q(X,R). This production function implies that inpus and residual emissions are substitutes. Such substitution is not allowed in the production-restriction model. With the emission-restriction rnodel, crop production can be maintained and nonpoint source pollution decreased by increasing input use. For exarrple, herbicide emissions can bE decreased by increasing tillage operations, which requires greater use of labor, fuel and equipment. The following nonpoint source pollution problem is evaluated using the ernissions-restrictiou model- Runoff from agricultural fields in a watershed is polluted by the herbicide litrex (fictitious name), which is used by fanners to reduce weed losses due to weed infestation in corn and sorghum production. Runoff enters the main stream draining the watershed. The stream eventually flows into a reservoir that serves as a drinking water supply for a nearby community. Litrex does not contaminate the drinking water used by residents of the watershed. Litrex pollution of the reservoir is an external diseconomy that is influenced by economic factors and environmental processes including crop selection, rates and timing of litrex application, timing and intensity of rainfall events, recharge of streams by groundwater, proximity of agricultural fields to the sù€etr, hydrology, topography, vegetative cover in riparian ar€Írs,and chemical properties of litrex (potency and persistence). An economic model is used to determine the relationship between input use, crop yield and farm income, and a biophysical model is used to simulate how litrex influences crop yield and contamination of surface nrnoff and stream water. Several policies can be used to reduce litrex pollution of the reservoir. These include imposing a tax on litrex, a charge on emissions of litrex, restrictions on the use of litrex, mandating the use of specific production methods, cost sharing (subsidies), and tradable errission permits. Some of these policies were evaluated in the ,previous section dealing with point source pollution. The remainder of this section evaluates the strengths and wealnesses of these policies in reducing litrex pollution of the reservoir. InputTax. An input tax is a tax on an input that contributes to nonpoint source pollution. Agriculnrral input taxes are more popular in Europe than the United States.Iowa, Wisconsin andlllinois have taxes on fetilizers. Consider a uniform tax on litex. Farrrers are likely to respond to the tar in three ways. Firsq they might

9. Economics of Environmental Pollution

substitute another herbicide for litrex. This response would increase production cost and/or decrease crop yield, both of which reduce net farm income. Second, farmers might reduce their use of litrex and increase tillage operations. Tillage reduces weeds. This response increases production cost because tillage operations require additional labor, fuel and equipment. Third, farmers might switch to crops that do not require litrex. The third response is the least likely because it requires major changes in farming operations. Maintaining the same production level while reducing herbicide emissions requires that input use be increased as demonstrated by the movement from a to b on isoquant Qo in Figure 9.6. Increasing input use with the same level of production causes marginal cost of production to increase. Under pure competition, a higher marginal cost of production reduces the profit-maximizing level of production. Therefore, a tax on litrex has the desired effect of reducing litrex pollution. Unfortunately, crop production and fann income are likely to be reduced by the tax. At what level should the tax be set? The answer depends on the desired level of pollution abatement. Recall from Figure 9.7 that the socially efficient pollution abatement occurs where marginal cost equals marginal social benefit of pollution abatement. The optimal tax on litrex would reduce litrex pollution by the socially efEcient arrrount. Marginal socidl benefit of reducing litrex pollution in the reservoir can be estimated with various non-market valuation methods (see Chapter l2). Marginal cost of pollution abatement can be estimated by combining biophysical simulation and economic analysis. Most taxing authorities are not in a position to undertake such sophisticated analysis. Therefore, the ta;
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Natural Resourceand Environmental Economics

acceptablelevel is typically definedin terms of ambientconcentrationsof the pollutant. Ambient drinking water standardsin the United Statesare clurently 10 parts per million for nitrate-nitrogen and 3 parts per billion for atrazine, which is a herbicide. Drinking water standardsare applied to qr:arterly samples drawn from drinking water sources.If the averageconcentrationof the pollutant during the previous four quarten exceedsthe standard,the water sourceis in violation of the standard.

!-J

Acharge on emissions of litrex can be determined as follows. Suppose the last four quarterly sarnples taken from the water supply reservoir have the following concentrations of lirex: 8, 8, 10 and 6 parts per billion. Let the drinking water standard for litrex be 5 parts per billion. Because the average concentration of litrex is 8 parts per billion, the wator in the reservoir violates the drinking v/ater standard. Bringing the reservoir into compliance with the standard would require reducing the average concentration of litrex by 3 pars per billion. The following procedure can be used to determine the optimal emission charge for achieving the desired reduction in litrex pollution of the reservoir. First, the watershed is divided into subwatersheds, each containing a group of farms that affects water quality in a particular segment of the stream. Second, a biophysical-economic model is used to estimate the minimum losses in net farm income from reducing linex concentrations in surface runoff from each subwatershed. Third, the income losses associated with specific reductions in linex pollution are used to determine the marginal cost of pollution abatementin each subwatershedtMCAt for i = 1,...,n, where n equals the number of subwatersheds). Fourth, the marginal abaternent cost curyes are suntmed across subwatersheds to obtain the aggregate marginal cost of abatement in the watershed MCAJ. This procedure is illustrated for three subwatersheds in Figrrre 9.15. The efficient charge on litrex emissions is m and the efficient pollution abatement levels àr€ tr1'a2and a3for subwatershedsl, 2 and 3, respectively. Note that the marginal cost of pollution abatement is difFerent in all three subwatersheds and the anount of abatement is higher (lower) in subwatersheds having a lower (higher) marginal cost of abatement. Subwatershed 3, which has the highest marginal cost of abatement, is allocated the lowest abatement and subwatershed I, which has the lowest marginal cost of abatement, is allocated the highest abatement. Because pollution is expressed in terrrs of thè concentration of litrex, the weighted average'of àt, tz and a3, namely, \, equals 3 parts per billion where weights are equal to the flow of water in each subwatershed. Input Reshictions. Input restrictions limit the rate and/or location of application of an input. For example, Mississippi and Nebra.skarestrict the use of fertilizers. Input restrictions are effective in areas where soil, climatic and hydrologic con,,:ditions favor nonpoint source pollution- For exarrrple, claypan soils have much higher mnofr rates than sandy soils. If the objective is to reduce litrex concentrations in runoff, then -lower rates of application could be required in cla5pan soils than in sandy soils. Locational restrictions would limit use of litrex in environmentally sensitive areassuch as wellheads and along streams,lakes and other water bodies that supply drinking water. Locational restrictions typicatly take the form of setback restrictions such as no application of litrex within 10O feet (30.5 meters) of a water body. Input restrictions are more limiting than taxes. Ata:( simply increases the price

9. Economicsof EnvironmentalPollution

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uiÈ É{5 6i? q)È

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of the input, but does not restrict its use. Farmers are likely to reslnnd to restrictions on the use of litrex in much the same way they respond to a tax on litrex, namely, employing substitute herbicides and"/orincreasing tillage operarions,or switching to crops that do not require the use of litrex. Input restrictions increase the marginal cost of production, which decreases production. Unlike a ta)q which reduces production in all areaswhere litrex is used, restrictions on the use of litrex would onlv

2v

Nafural Resource and Environrnsar*l

Economics

affect production in areaswhere the restrictiolrs are imFosed.In this respect,input restrictions are effective in reducing nonpoint source pollution in specific areas.This feature of input restrictions makesthem potentially more efFcient in reducing nonpoint source pollution than ta,r.es. sharing of Cost Sharing. Nonpoint sourcepollution can be reducedby c_o,st practices.Abest managementpracticeis a producd6nmethoddebestmzunagement signed to alleviate a specific type of pollution. With cost sharing, a federal and/or state agencyreinburses farmersfor part of the cost of installing one or more best managementpractices. Cost-sharingsubsidiesarejustified on the grounds that pollution is an external diseconomy,which meanssomeoneother than the polluter is the primary beneficiary of pollution reduction. With cost sharing, society pays for part of the cost of pollution abaternenlExamplesof bestmanagementpractices for reducing nonpoint sourcepollution include terracesand conservationtillage for reducing sedimentin strearns,and soil nitrogen testing and split application of pesticides for reducing nitrate and pesticidepollution of water. Best managementpracticescanbe quite effective in reducing nonpoint source pollution. Selecting nitrogen application rates basedon crop growth requirerrents and soil nitrogen levels has allowed nitrogen application ratesin some statesto be reducedby as much as 30 percentwith no loss in crop yields. Adoption of best managementpracticeschangesthe input mix. For example,integratedpest management substantially reducespesticide application rates but requires more intensive managemenlAdoption of a bestmanagementpractice can increaseor decreasemarginal cost of production (after cost sharing).Increases(decreases)in marginal production cost causeproduction to decrease(increase). Cost sharing of best managementpractices on a voluntary, first-come, fistservebasisis not an efficient way to reduce nonpoint sourcepollution. T1risoccurs becausecost-sharing funds are not allocated to areasaccording to the severity of pollution. Consequently,pollution reduction per dollar of cost sharingis likely to be low. Nevertheless,farrners and agenciesstrongly favor voluntary cost sharing becauseof its nonregulatorynature.Oneway to improve the efficiency of cost-sharing subsidieswithout losing the appeal of a voluntary approach is to allocate costsharingfunds to areaswherepollution darnagesarehigh and bestmanagementPractices are effective in reducing pollution. Mandated Production Methods. In this approactr, a regulatory agency rnandates the use of specific production methods for reducing nonpoint source pollution. At one time, the U.S. EPA required point sources of pollution to use the best available technology for reducing emissions. Mandated production methods can be used to reduce litrex pollution of runoff by requiring farmers to use alternative production methods, such as split application or integrated pest rnanagemenl Mandatinp the use of specific production methods is likely to be unpopular with farmers because it restricts their freedom. Another drawback of mandaory production meth' ods is the high adrninistrative cost. Not only would the regulatory agency have tt keep track of whether the mandatedproduction methods are being used, but it woult have to rronitor new abatement methods to identify the least-cost abatementmethor for reducing pollution. Finally, mandatory production methods reduce the incentiv, for polluters to invest in new abatement technologies.

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Tradable Emission Permits. Using a tradable emission perrnit to control nonpoint source pollution would require the regulatory authoriry to establish an upper limit on either the ambient concentration or total emission of the litrex. It would then issue enough TEFs to eusure that the limit is not exceeded. The upper limit on linex emissions from the watershed would be set at a level that provides reasonable assurancethat the drinking water standardis not exceeded. Farnrers would then buy and sell (trade) TEPs based on the price of the permits and thet marginal costs of abatemenl Theoretically, TEPs are an efficient way of achieving an emission standard because the regulatory agency does not have to set emissions for each source. There are several reasons why it can be costly to administer TEPs for nonpoint source pollution control. First, there are a potentially large nrmrber of pollution sources. Each source would need to be monitored for comFliance with its perrnits. Second,the agency would need to keep track of the ownership of permits. Third, the number of pèrmits would need to be changed whenever the ambient standard is changed. Such changes generate uncertainty forpolluters. Fourth, the agency would need to determine whether to allow permit trading between sources in the same watershed or between sources in different watersheds. Some tntes of nonpoint source lnllution are especially difficult to control with TEPs. For example, suppose sourceAin the upper end of a wate,rshedholds five permits and source B in the lower end of a watershed holds eight permits. Each permit allows an emission of 1,000 tons of sediment per year. Because source B is located in the lower end of the watershed, a 1,00Gton reduction at source B achieves a grcater reduction in-sediment delivery to the strealri than a 1,00Gton reduction at source A. Therefore, there is a greater reduction in sediment pollution when sonrce A buys tbree permits from source B, than when source B buys three permits from source A. This means the value of a permit in reducing sediment pollution depends on how the permits are distributed among pollution sources. In this case, there is no assurancethat the desired reduction in emission will be achieved. While it is possible to develop TEPs that are location sensitive, it would be more complex and could reduce the efEciency advantages of TEPs. Other Considerations. Several other factors need to be considered in designing effective policies for controlling nonpoint source pollution. Care must be taken to avoid pollution policies that reduce one tylle of pollution but increase another type of pollution. For example, if taxing or restricting a target heròicide causes farmers to substitute another herbicide, then the substitute herbicide could become a source of pollution. Similarly, if taxing or restricting the use of a herbicide causes farmers to increase tillage operations, then soil erosion and sedimentation of streams would increase. Another consideration in designing nonpoint source pollution policies is the potenúal tradeoff between surface and groundwater pollution. Allowing farms in sandy soil to use higher rates of herbicide than farms in claypan soil makes sense when the objective is to reduce herbicide pollution of surface iunoff. It is likely, however, to increase the risk of groundwater pollution in the sandy soil. Providing cost sharing and other subsidies for conservation tillage in order to reduce erosion and sedimentation would increase the use of herbicides to control weeds. Because conservation tillage reduces mnoff, more of the unused herbicide percolates through the soil into groundwater, especially in porous soils. Therefore, while conservation

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tillage is likely to decreasepollution of surface runoff and increase groundwater pollution, accountingfor the complex interactions betweendifferent types of nonpoint sourcepollution is a najor challenge in designing effective nonpoint source pollution policies. a

Summary Residualloads from consumptionand production are either recycld which reducesthe demandfor natural resources,or emitted to the environment.Residual emissionsaccumulatein or are assimilatedby the environment. Environmental pollution is an extetnal diseconomythat results from the accumulation of nondegradableresiduals and/or residual emissions in excess of the environment'sassimilativecapacity.Pollution can reducethe supply of exhaustible resources,the productivity of natural resources,and the amenity and ecological services provided by the environment. Pollution-related darnages 1s tru6ans and ecosystemsare influencedby the pollutant's potency and persistenceand the vulnerability of human and ecological systernsto pollutants.A major goal of environmental economicsis to detersrine socially efficient levels of environmental pollution and to evaluatepublic policies for poilution abatemenl Static analysisof environmentalpollution is appropriatewhen current pollution damagesdependonly on curreut residual emissions.Dynarric analysis is ap propriate when current damagesare influenced by currentand past emission levels. Economically efficient levels of pollution are deterurinedbasedon the productionrestricted and the pollution-restricted models. The production-restricted model requires a fixe{ proportionalrelationship between residualemissionsand production rÍúes.This relationshipis nonlinear in the emission-restrictedmodel becauseemission levels can be reducedby varying input use and/ortechnology. In the static production-restrictedmodel, householdutility or satisfaction is a function of constmrptionand pollution" production is a function of input use, emission is a funcÉonof production,andpollution is a functionof ernissions.This model indicatesthat a) the privately effrcient production rate exceedsthe socially efficient production rate, b) the socially efficient production rate approachesthe privately efficient production rate as the production rate beyond which pollution occurs increases,and c) zero pollution is generally not socially efficienL The most generalstatic emission-restrictedmodel specifiesthat production is a function of input use,residual emission and pollution. îhis specification implies that input use and emission levels are substiflrtesand pollution adversely affects production. Utility is a function of consurnptionand pollution e)qtosure.Pollution exposuredependson pollution levels and defensiveexpenditures.The latter ar€ expendituresthat reducethe risk of pollution damage.The emission-restrictedmodel indicates that the socially efficient rate of pollution abatementoccurs where the marginal social benefit equalsthe marginal cost of pollution abatementand that the socially effrcient abatementrate exceedsthe privately efficient abaternentrate. IJnder theseconditions,the privately efEcient rates of production and levels of pollution under pure competition are greater than under imperfect competition. Similar

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results hold for the dynamic model of efficient production and pollution abatemenl Several factors reduce the likelihood of a property rights solution to pollution externalities: high hansaction costs, inability to trace certain pollution damages to specific residual emission sources, damages from different pollutants being multiplicative rather than additive, and nonrivalry in consumption of pollution. The theory of environmental pollution indicates that pollution occurs because the residual assimilation services provided by the environment are unpriced. The socially effrcient price for pollution is a Pigouvian tax on Sesidual ernission equal to the difference between marginal social benefit and marginal private benefit at the socially efficierit level of abatement. Due to high information requirements, Pigouvian taxes are diffrcult to implement. Alternative apprcaches include ernission charges, emission standards, tradable emission permits, and environmental liability rules. Emission charges establish an environmental standard and a uniforrn charge per unit of emission for each emission soruce.While eurission charges do not generally result in the socially efficient level of emission reduction, they require considerably less information than do Pigouvian taxes, are cost effective in achieving an environmental standard, provide an incentive for polluting sources to invest in new abatement technologies, do not require monitoring of emissions from all sources, intemalize part of the cost to society of utilizing the environment's residual assimilation capacity, are a solrrce of public revenue, and are consistent with the .polluter-pays principle Emission standards set environmental standards for each emission source, sometimes specfy the pollution control technology used at each source, and monitor sources for cornpliance with the standards. Major advantages of emission standards are achievement of the desired level of emission at each source and reduction of emissions to acc,eptablelevels during eurergencies. Tradable emission permits restrict total ernissions by issuing permits that can be traded among sources of emissions and other parties. Permits confer the right to use a certain portion of the environment's residual assimilation capacity. Tradable emission permits are cost effective in achieving an environmental standard and automatically adjust for inflation and economic growth. Environmental liability makes acting parties financially responsible for pollution dam4ges incurred by àffected parties, Environmental liability allows affected parties to sue acting parties for damages transrnitted through the environment. Advantages of EL are that it does not require collective action; substantially reduces the need for information by a central environmental authority; does not require a large nurnber of pollution sources to be in compliance with a standard, to pay taxes sn ernissions, or to incur the cost of purchasing and trading emission permits; reduces information and transaction costs by not requiring the monitoring of emissions; and is effective in limiting emissions of toxic residuals. All four policies for reducing pollution have advantages and disadvantages. TypicallS a combination of policies is more effecdve and efficient in reducing pollution than is any single policy. Control of nonpoint source pollution can be achieved using a tax on the polluting input, a charge on emissions, restrictions on the use of the inp,rt, cost sharing of best management pracÉces, mandated production methods and tradable emission permits. Taxes are the easiest policy to adminislsr. Input taxes, however, a) do not account for the extent to which a firm contributes to pollution, b) need to be peri-

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odically adjustedto accountfor changesin the marginal benefit and marginal cost of abate,urent,and c) penalize finns whose emissionsdo not causepollution. An emissionchargeis an economically efficient way to reducenonpoint source pollution. Determining the socially optimal level of nonpoint sourcelrcllution requires inforrration on the marginal cost of abatementfor all sources.Input restrictions allow theregulatory authority to targetÍlreaswhereuseof the input causespollution. While more limiting than input taxes and emissioncharges,inlruúrestrictions allow better targetingof nonpoint source pollution control efforts. Cost sharing of best managenent practicesis an effective way to reducenonpoint sourcepollution. The voluntary natureof cost sharingcatrsesthe cost per unit of pollution reduction to be high. Mandatory production methodsare a heavy-handedway of reducing nonpoint sourcepollution. Not only are they likely to be unpopularwith polluting firrrs, but they entail a high administrativecost becausethe regulatoryagencyhas to moniior abatementmethodsto ensurethat the most cost-effectivepollution control methods are being mandated.Tradableernissionpennits for nonpointsourcepollution would be costly to administer.In addition, some rypesof nonpointsourcepollution are difficult to control with TEPs.

Questionsfor Discussion 1. Why is it important to distinguish betweenresidual emissions and pollution? Of what value is this distinction in developingefficient policies to reduce environmental damages? 2. What typesof residual emissionsare especiallythreateningto humans and the environment? 3. Supposethe demandfunction (D), margrnalproduction cost CMPC)function and marginal pollution darnages(MLD) function are as follows: D:P=40-05Q MPC=20+0.4Q MLD = l.6Q Calculate a) the privately and socially efficient rates of production, b) net social benefit with socially efficient production, and c) the Pareto-relevantexternality. 4. Marginal private benefit of pollution abatement(MPBA), marginal social benefit of pollution abatement(MSBA) and marginal cost of pollution abatement G{CA) are asfollows: MPBA= 5 -A MSBA = 12 -2A MCA= 0.75A A is the level of pollution abatement.Calculate a) the privately efficient pollution abatemengb) the socially efficient pollution abatemenfand c) the Pigouvian tax.

9. Economicsof EnvironmentalPollution

239

5. Consider nvo pollution sources(X andY) that havethe following marginal costsof pollution abatement: MCA1 = 1.5A MCA' = 0.5A A is the level of pollution abatemenl Supposea uniform emíssioncharge of 2 is levied on both sources.Calculatethe efficient level of pollution abatementand the correspondingcost of pollution abatementfor each source_ 6. Consider an emissionstandardthat requires the two sourcqsin question 5 to reducepollution by an amouutequalto one half of the total amountof abaùement achievedwith the uniforrr emissioncharge.Show that the emissionchargeresults in lower total cost than the emissionstandard7. An environmentalauthority distributesfor free just enoughTEPsto sources X and Y (in question 5) to restrict total emission to the socially efficient level attained with a Pigouvian tax (in question4). What is the efficient distribution of perrnits between the two sourcesafter trading? 8. Countries such as France, Germany and the Netherlandsfavor emission charges,whereasthe United Stateshas relied on nontradableernissionpennits to control point sourcesof water pollution. Why are two different approachesused.to deal with the sane type of pollution? 9. Why is nonpoint source pollution more difEcult to control than point sourcepollution? 10. Is a regulatory agency interestedin reducing nonpoint source pollution more apt to f,avor a ta>ron the polluting input or an emissionsrandard?Why?

Further Readings Anderson,Fredrick R, Allen V. Kneese,Phillip D. Reeù SergeTaylor and Russell B. Stevenson.198'7.EnvirorunentalImprcvententThrough Economicbcentives. Washington, D.C.: Resourcesfor the Future. Baumol,William J. and WallaceE. Oarcs.L988.Thc Theoryof EnvircranentalPoliq, 2nd ed. Canrbridge,England:CambúdgeUniversity press. Cropper,Mar:reenL. and Wallace.E.. Oats. 1992.'EnvironmentalEconomics:A Survey-"Journal of EconornbLitemtwe 3O(2):675a4. Dales, J.H. 1968. Pollutio4 Property srd Prices. Toronùo,Canada University of Toronto Ress. Duttweiler, D.W. and H.P. Nicholson. 1983. "Enrrkonrnentalhobtems and Issuesof Agriculnrral Non-Point SourcePollution-" In Agrìcutturat Managemcntand Waer Qwttty, F.W. Schaller and G.V/. Bailey, eds.Ames:Iowa SteteUniversity press. Forsund, Finn R., and Steinar Strour. 1988. Envùonmenal Economicsattd Mutagement: Pollution and Natural Resowees.New York Croom Helm. GriffirL RC. and D.W. Bromley. 1984."Agriculhrral Runoff as a Non-PointExternality: ATheoretical Development-"ArnertcanJournal of Agriculnral Economics66:547-55L Maler, Ikrl-Goran. 1974. Envircwtuntal Economù,cs: A TheoreticalInquiry.Baltimore, Maryland: The JohnsHopkins University hess.

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Milon, J. Walter. 1987."Optimizing Nonpoint SourceControls in Water euality Regglations." WaterResourcesBulletin 23:387-396. Setia,P. andR. Magleby. 1987.*An EconomicAnalysis of Agriculturat Non-point pollution Control Alternatives."Journal of SoiIutdWater Consemation42:427431. Taylor, Michael L., Richard M. Adams and Stanley F. Miller. 1992.'Farm-I-evel Responseto Agriculhrral Effluent Control Srategies:The Caseof the Mllameue yalley.', Anrcr. ican Journal of Agriculuml Economlcs17:173-185. Tietenberg,T. 1985. EmissionsTîading: An Exercise h Rejormins Pfrt*6n policy. Washington,D.C.: Resourcesfor the Future.

Notes 1. ThomasE- Drennenand Harry M. Kaiser, "Global Warrning and Agriculnre: The Basics,"Choices,SecondQuarter1994,pp. 3840. 2. NationalWildlife Federation,"26th Annual EnvironmentalQuality Index," Nationat Wildlde, Feb.-March 1994,p. N. 3- U.S. EnvironmentalProtectionAgency, The Qualíty of Our Nationb Waten 1994, EPA 841-5-95-004(Washington,D.C.: EPA 1995). 4. Ibid, p.41. 5. V/orld Resourcesln$inrte, World ResourcesInstitate, 1992-93:A Guid.e to the Global Envircnmett(New York Oxford UniversityPress,Inc., 1992),p. 194. 6. Dina L. Umali, Inigation-Induced Salinity, World Brnk TectrnicalPaper Number 215 (Washington,D.C.: WorldBanlq 1993). 7. T. LAnderson and D. R. Teal,Free Marlcethvircranentatism (San Francisco,Califonia: Pacific ResearchInstitute for hrblic Policy, 1981). 8. R Collinge and W. E. Oates,'EfFciency in Pollution Control in the Short andLong Runs: A System of Rental Emission Pennits," Canadian Economics Assocíation 15(1982):346-354. 9. Jean-LucMigue andRichardMarceau,'?ollution Taxes,Subsidies,and Rent Seekil:g," Coudìan EconomicsAssociation26(1993):35G365. 10.RichardB. McKenzieandGordonTulodq "Rent Seeking,"chapter15 of TheNew Worldof Economics:Erylorwions into theHwnantEryeríence,3rded-(Homewoo4Illinois: RichardD. Inrin" 1981). 11.A Palmer et al., Ecotwmic Implications of Regulating Chlorofluomcarbon Emissionsfor NonaercsolApplications (SantaMonica" California: The RandCorporarion, 1980). 12.David Terk4 '"Ihe EfFrciencyValueof Effluent Tax Revenues,-foumal of EnvironmentalEconomicsI 1(1984):1Ù7-123. 13.Michael A. Toman""Using EconomicIncentivesto ReduceAir Pollution Emissions in central andFasternEurope:the caseof Polanù" Resources, Fall 1993,pp. 18-23. '"TaxingPollution: 14. Y/'allace E. Oates, An Idea WhoseTime has Coure?' Resources, . Spring1988,pp.5-7. '; 15. Scon F.Atkinson andT. H. îetenberg, ''Itre Errpirical Propertiesof TVyoClassesof Design for TransferableDischargePermit Systems,"Journal of Envircrunental Economics od Managencnt9(1982):l0 l-f 2 t. 16.Palmeret al. (1980). 17. Martin L Weizman" "Prices vs. Quantities," Revfew of Economic Studies 41(1974):477491. 18. John T. Weitzman,"Oi)timal Rewardsfor Economic Regulation," ArnericantEcononrícReview 68(1978):68H91.

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ut

19- This section draws heavily from Peter Zwerfel and Jean-RobertTyran, .Environmental Impairmeni Liability Íu! arTnsuument of EnvironmentalPolicy,* Ecological Econo mics 11( 1994):43-56. 20. Rick.Steiner,'?robing An Oil-Sained Legacy,nNationat fiÌîldliÍe, April_May 1993, j pp. zl-11. 21. Karen Schmidt, *Can Superfund Get on Track?,- Natbnal Wîldlìfe, April-May 1994,pp. 1G17. 22. Puú R. Portney and KattrerineN. Probst, 'Cleaning Up Superfrrn{" Resources, Winter 1994,pp.2-5. 23. James J. Opaluch and ThomasA. Grigalunas,"Controlling Stochasticpollution Events through Liability Rules: SomeEvidence Aom OCS Leasing- Rotd Joutzat of Economics15(1984): 142-151.

Missing Chapter 10: „Natural and Environmental Resource Accounting“ Pages 242 to 264

CEAPTER

11

Benefit-CostAnalysisof Resourcefnvestments we are spending $9 billíon more per year to comply with the Clean Water Act than we are benefiting fro* that complìance. -U.5.

Water News,March 1994

rivate and public invesúnents are made to develop, preserve, enhance, restore and protect natural and environmental resources. Whether to increase oil and gas exploration and development on private land is a private investrnent decision. Charging higher fees for livestock grazing on public rangeland is designed to protect the quality of rangeland and to increase the rate of return on publicly owned resources. Expanding the boundaries of a national park or wilderness ar€a to reduce encroachment by private development is a public resource inveshÍrent in nanral area protection. Private resource investrnents are usually guided by the goal of maximizing profit subject to financial and technical constraints. Pub-lic resource invesùnents are typically undertaken with the goal of advancing social, economic, culnrral and environmental conditions. The primary objective of this chapter is to develop and apply economic efficiency criteria for evaluating public resource investments. Such evaluation is referred to as public investment or benefit
---

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Socially Efficient Investment An investment in natural and/or environmental resonrcesis socially fficient if it has a positive net social benefit and socially inefficient if it has a negative net social benefit. Social efficiency is inaximized by selecting the resource invesfrnent with the highest net social benefit. This rule ensures that society achieves the modmum social gain per unit of throughput of-material and energy resources. Private individuals evaluate resource investrnents in tenns of profit or net private benefit rather than net social benefit. A resource investment is privately eficient when it has a positive net private benefit. Private efficiency is maximized by selecting the investment with the highest net private benefit Privately efficient investments are not necessarily socially efficient, and vice versa, for several reasons.First, net private benefit typically excludes the environmental costs associatedwith an investrnent. Second, a private investment decision is unlikely to account for potential adverse consequenceson human health and welfare. For example, the decision to increase coal mining on private land is likely to ignore whether land disturbances caused by mining are within the assimilative capacity of the environment or whether the health and welfare of nearby residents are adversely affected. Ignoring potential environmental and human costs of resource investments causes net private benefit to exceed net social benefit" other things equal. Third, private firms commonly use a higher discount rate than public agencies to calculate the net present value of an investment. A higher discount rate lowers the net present value of future resource extraction, which accelerates depletion of exhaustible resources. Divergence between private and social net benefits has signifisanl implications for renewable resources. Ponder the consequences of rapld expansion in tiger shrimp production in southern Thailand. Shrimp production, processing and exportation Íre very profitable. Rapid expansion in shrimp production has boosted the value of agricultural income and exports and accelerated economic development in rural areas of Thailand. Shrimp production involves the pt'mping of sea water into shrimp ponds. Ponds are intensively managed (very high stocking densities and feeding rates) and higNy concentrated along the southeastern coast of Thailand. Wastewater from shrimp ponds has very high concentrations of organic matter and other contaminants. Untreated pond wastewater is drained to the sea Shrimp production in southern Thailand is adversely affecting social and environmental conditions. Large areas have been converted from rice production tc shrimp production, salt water intrusion has reduced the productivity of remaining riceland, mangrove forests have been destroyed to make way for shrirnp ponds anc marine ecosystems have been degraded by pond wastewater. Accounting for thest externalities causes the net social benefit to be less than the net private benefit ot production. Finally, rapid expansion in shrimp production has advenely af' ', shrimp fected the incomes, culture and livelihood of fishermen and rural residenB not in' volved in shrimp production.

Basing resourcc investment decisions on social rathe NET SOCIAL BENEITL than private efficiency criteria is more consistent with achieving sustainable re source development and use. This section addressesthe applicaúon of social effi ciency criteria to resource investrnentsdecisions. Net social benefit CNSB) of a nal

11. Benefit-Cost Analysis of ResourceInvestments

2tl

ural resourceinvesúnentis defined in a similar way as the NSB usedto derive the efficient intertemporal allocation of an exhaustibleresource(Chapter 7) and a renewableîesource(Chapter8). For simplicity,NSB is evaluatedfor discretetime periods. The undiscountednet social benefitofq, is: B( q J = v ( q J - C (q J, where q, is the quantity of the resonrceusedin timrcperiod t, V(qJ is the total value of q. and C(q) is the total cost of producing q, with the investment.V(q) equalsthe area under the demandcurve up to qr. The demandcurve includes all the benefitsof the resource.C(q) equalsthe areaunderthe supplycurveup to qr-The supplycurve accountsfor the full social cost of production.The areaunderthe demandcurve minus the areaunderthe supplycurve equalsconsumersurplusplus producersurplus. Therefore,B(q) equalsconsumersurplusplusproducersurplusfor q" NSB of a specificpatternof intertemporalresourceuseis: =Éo"tQ(t NSB(q,,c12,...,9r)

+ r)+,

where (q,, qr,...,qr)are the quantitiesof the resourceusedin all time periods,T is the length of the evaluation period and B(q)(l + r){ is the presentvalue of net social benefit of q" The surnmationoperator(X) surnsthe presentvaluesof net social benefits over the entire evaluation period. A more detailed explanation of present value is given in Chapter2. 'When severalinvestmentsare being evaluated,NSB is calculatedfor eachinvesunent.Investnents for which NSB > 0 are economicallyfeasible.The investment with the highest positive NSB is judged to be economically superior to all other investments-If a choice is being madebetweentwo invesbnenB(asin the timber harvestingexarnplepresentedbelow), thenthe decisionrule can be expressedin terrns of the difrerencebetweenthe net social benefitsfor the two investments.For exarnple,if NSBAis the net social benefitfor invesúnentA, NSBBis the net social benefit for investrnentB andboth investmentshavepositive net social benefits,then investmentA is selectedwhen NSBA > NSBBand investmentB is selectedwhen NSBA< NSBB.

TIMBER HARVESTING EXAMPLE. The expressionfor net social benefit given aboveis likely to overestimateor underestimatethe true net social benefit of a resourceinvestrnentwhen changesin the price of the resourceinfluence theprices of substitutesor complementsfor that resource.Considerthe decision of whetherto invest in a new or conveqtionaltechnologyfor removing timber from mountainous areas.The new technolofr, udlizes helicopiersandthe conventionaltechnologyuses tnrcks and roadsto removefelled timber Becauseloggrng roads are a major source of erosion and water contarnination in conventionallogging operations, the new technology is expectedto have a lower marginalenvironmentalcost of timber harvesting.A lowermarginalenvironmentalcostresultsin alower marginalsocialcost of timber hawesting, which reducesthe price of timber. When the price of timber declines, the demandfor wood substitutessuch as

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plastic is reduced.As demand for plastic decreases,the price of plastic falls and that reduces consumer plus producer surpluses for plastic. The net social benefit of investment in the new technology includes changes in consumer and producer surpluses for timber as well as changes in consumer and producer suqplusesfor plastic tiggered by the change in timber price. . The change in net social benefit between the conventional (c) and new (n) technology is illustrated in Figure 11.1 in terms of the timber (m) and plastic (p) markets. Marginal social cost of timber production in period t is MSC", with the conventional technology (trucks and roads) and MSc,t with the new technology (helicopters). The decreasein marginal social cost between the conventional technology and new technology reduces timber price from pm., to pm* and increases timber production fro* qtt\, to qmnr. Becausc wood and plastic are substitutes in certain uses, the reduction in the price of timber causesthe demand for plastic to decrease from D* to Do,.As a result, plastic production declines from qs", to qso.and the price of plastic decreasesfrom ps", to psor Changes in technology induce second-order price effects. A lower price for plastic causes the demand for timber to shift downward because timber and plastic are substitutes. The downward movement in timber demand reduces net social benefit from timber. Eventually, new equilibrium prices are established for timber and plastic. For simplicity, second-orderprice effects are not shown in Figure 11.1 and not considered in the evaluation of NSB. Consumer surplus,producer surplus and total surplus (consumer plus producer surpluses) for the demand and supply curyes in Figure 11.1 are reported in Table I 1. I . The "net change" column in Table 11. I indicates whether the price change "increases" or "decreases"surplus. The direction of change in surplus values due to shifts in the demand and/or supply curves depends on the slopes of the two curves. For this reason, the net changes stated in Table 11.1 are only valid for the demand and supply curves illustrated in Figure 11.1. The economic feasibility of the two technologies is basedon the following net social benefit:

NSB = (cSB"- cSB")- Gq - KJ), where GSB. is the present value of gross social benefit with the new technology, GSB" is the present value of gross social benefit with the conventional technology,

Îable

11.1.

Consuner surplus, producer surplus and total surplus resulting from a decrease Ín timber price

Ttniber Consumer surplus Producersurplus Total Plastic Consumer surplus Producer surplus Total lRefer to Figurc ll.l

Before Price Decreaser

After Price Decreaser

Net Change

abc bcf acf

ade deg aeg

Increases Increases Increases

hij ktm jin rnln hin kln for a gfaphical explanation of these nagnitudes.

Decreases Decreases flecreases

11. Benefit-Cost Analysis of Resourcefnvestments

Value

Der

269

thít .È

%c

Prod,ucÈion,

B

Figure 11.1. Change in net social benefit between a conventional (c) and new (q) technolory for timber harvesting in timber (m) markets (A) and plastic (p) markets (B) in period t. D = demand; and MSC : marginal social cost.

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I( is the present value of fixed cost with the new technology and Iq is the present value of fixed cost with the old technology. If GSB" - GSB" is positive (negative), then present value of gross social benefit is higher (Iower) with the new technology than with the conventional technology. Likewise, if Iq - Il is positive (negative), then irresent value of fixed cost is higher Qower) with the new technology than with the conventional technology. Social efficiency increasesby selecting the new technology when NSB is positive and the conventional technology when NSB is zero or negative. The first term (GSB. - GSB") in NSB is calculated as follows. First, the difference in gross social benefits is determined for each time period. For the demand and supply curves given in Figure 11.1,the difference in gross social benefits in period t is: GSBot- GSB* = (aeg - acf) - (hin - kln), where (aeg - acf) is the increase in total surplus for timber and (hin - kln) is the decrease in total surplus for plastic in period t. This difference is: positive if (aeg - acf) > (hin - kln), negative if (aeg - acf) < (hin - kln), or zero if (aeg - acf) = (hin - kln). The second terrn in NSB (K" - Iq) is the difference in the present values of fixed costs for the two technologies. Only the difference in fixed costs of harvesting appears in the second term becausedifferences in variable costs are already accounted for in the calculation of GSB' - GSB". NSB can be used to evaluate the social efficiency of a variety of natural and environmental resource investrnents. In addition to comparing resource extraction technologies, NSB can also be used to evaluate the social effrciency of employing an emission charge versus tradable emission permits to reduce air pollution from coal-fired power plants (environmental policy analysis) or of expanding a national park or wilderness area (natural resource management). rWhile NSB can be used to evaluate any number of investment options, the calculations become more ssmplex and time consuming as the number of investment alternatives increases.

Special Topics in Investment Analysis Application of resource investurent criteria requires consideration of severalfactors, including continuous versus discrete time, length ol inveshent evaluation period (T), selection of discount rate (r), treafirent of capital and operating costs, local versus global efficiency, independent versus interdependent investments, capital rationing, primary and secondary benefits and costs, anc risk and uncertainty. This section exarnines each of these topics.

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7:t1

CONTII\UOUS YERSUS DISCRETE TIME. The formula for calculating net social benefit dependson whetherthe benefits and cost occur continuouslyover time or at discrete points in time. As indicated earlier in the chapter,NSB for discrete time is: NSB(qo,er,...,9r)=,!on(q)(l + r)-t, where q, is the amountof the resourceextracted or the servicesprovided by the resourceat the end of time period t, B(qJ is the undiscountednet social benefitderived from q,, r is the discountrate and (l + r)+ is the d.iscretediscount factor in period r NSB in conrtnuoustíme is: T

NSB[q(1),q(2),...,q(T)j= ntqttl]erq { wherethe integral operatord) accumulatesthe presentvaluesof Btq(t)l over the entire evaluationperiod. It is the continuouscounterpartof the summationoperator (X). eo is the continuousdiscountfactor in period t. Money flows in discretetime are calculated asof the end of eachtime periodFor example, if t standsfor quarters,then all benefitsand costsare evaluatedas of the end of each quarter and r is the quarterly discount rate. If the annual discount rate is 0.08, then the quarterlydiscountrate is .02 (0.08/4).Fixed costis usuallyincured in the very beginning of the evaluation period, designatedas time period zero. Let V(q) and C(q) take on the following valuesat the end of eachquarter:

v(qJ C(qJ

a 0 100

123.4. 50 0000

Quqrer 75

75

50

For an annual discount rate of r = 0.08: N S B = ( 0 - 1 0 O X l+ . ù 2 ) - o + ( 5 0 - O X l + . 0 2 ; - t + Q 5 - O X l + . V 2 y + (75 - OXl + .02)-3+ ($50 - 0X1 + .02)+ = $138.01.

IhIVESTMEI\IT EVALUATION PERIOD. The inveshnent evaluation period (T) is the period of time during which the investrnent yields benefits and costs. This period can be less than, but not greater than, the economic life of the investnent when a single invesmenl is being evaluated. For example, supposethe timber comPany wants to decide which of the two technologies (trucks and roads versus helicopters) is superior for harvesting a timber stand over a lGyear perid. The evaluation period for this investment is 10 years even if the physical life of one or both investments exceeds 10 years. Any benefits and costs that occur after 10 years are not relevant to this investment decision. Suppose the timber company wants to compare the two technologies over a 15year period by considering the benefits and costs of using the roactsfor other pur-

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poses such as timber management and recreation and of using the helicopters to harvest timber stands in other Íreas. Because the physical life of the helicopters is 12 years and that of the trucks and roads is 15 years, the life of the two investrnents is different. The two investrnents need to be evaluated for the same period. One way to handte the unequal life of the investments is to include the annual benefits and costs for three years (13, 14 and 15) from reinvesting in the helicopters in year 13. Annual benefis and costs for helicopters in the reinvesEnentperiod are based on the expected life of the helicopters purchasedin year 13. This procedure ensures that the length of the evaluation period is the same (15 years) for both technologies.

Etr'FrCrENCy AND EQUfry TMPLICATTONS OF THE DTSCOUNT RATE. The discount rate is important becauseit influences the economic effrciency of resource invesEnents and intergeneraúonal equity. First, consider how the discount rate influences economic feasibility of renewable resource investrnents. A low discount rate increases the economic feasibility of renewable resource investments, such as hydroelectric power facilities, which have high initial capital costs and revenues (benefits) that are spreadout over many years.For such investments, the present value of benefits increases as the discount rate decreases. Historically, the United Statesgovernment has used low discount rates to justify water resource development projects such as hydroelectric power generation. This policy has accelerated the development and use of water resources, particularly in the western United States. While these projects have been instnrmental in economic development of the western United States, they have taken a major toll on natural and envilonmental resources.Aprime example of this is the dramatic reductions in salmon populations causedby hydroelectric dams on the Columbia River.r Second,consider how the discount rate influences the extraction of exhaustible resources. A low discount rate makes it more profitable to shift resource extraction from the present to the future, which causesthe stock of the resource to be extracted more slowly. This intertemporal shift in resource extraction benefits the future generation relative to the current generation. Conversely a high discount rate makes it more profitable to shift rqsource extraction from the future to the present, which causes the stock of the resource to be extracted rnore quickly. This intertemporal shift in resource extraction benefits the curent generation relative to the funrre generation. Changes in the discount rate can affect the total amount of an exhaustible resource that is extracted.Ttiis is called a stock effect of changes in the discount rateSpecifically, a low discount rate makes it rnore profitable to extract marginal deposits of the resource, which increasestotal resource extraction. If the stimulating effect of a low discount rate on total resource extraction offsets the shifting of ex,trractionfrom the present to the future, current extraction rates can be higher. Conversely, a high discount rate makes it less profitable to extract marginal deposits of the resource, which decreasestotal resourceextraction. If the depressing effect of a high discount rate on total resource extraction is offset by the shifting of extraction from the future to the present, crurent extraction rates can be lower. Hence, the effects of changes in the discount rate on intertemporal extraction of an exhaustible resource and intergenerationalequity are ambiguous. Third, changes in intertemporal use of natural and environmental resources

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have implications for intergenerational equity. The precerling discussion indicates that the effect of the discount rate on intergenerational equity is likely to be different depending on whether the resource is exhaustible or renewable. In the case of renewable resources, a lower discount rate favors current development and raises the risk of overexploitation, which can adversely affect funrre generations.Acase in' point is the extinction of plants and animals due to human activities such as deforestation. In comparison, a low discount rate can delay the extraction of an exhaustible resource, which benefits future generations. Because changes in the discount rate can have opposite effects on the allocation of exhaustible and renewable resource between curent and future generations, it is not clear whether future generations gain or lose by higher or lower discount rates. Perhaps, something as important as the intergenerational allocation of exhaustible resources and use of renewable resources should not be subject to the whim of changes in the discount rate. A more prorictive approach to intergenerational allocation of natural resources was proposed by Howarth and Norgaard.2 They suggest that an equitable intergenerational allocation of resources can be achieved by assigning future generations specific rights to exhaustible and renewable resources.This approach is based on ethical considerations becauseit implies that future generations should have the same rights of access to natural resources as the current generation. Much of the literature on sustainable development and preservation of biodiversity discuss various mechanisrns for achieving sustainable resource use. El Serafy3 argues that only a portion of the net revenue generated by an exhaustible resource is true income that can be consumed in perpetuity. The difference between net revenue and true income, so-called user cost, should be invested in a renewable resource. In this manner, when the exhaustible resource is used up, a rencwable resource will be available as a substitute. Fourth, the discount rate influences the weight given to social benefits and costs in efficiency calculations, which has a direct bearing on intergenerational equity. Consider two resource investments.The first investrnent has relatively high future social cost and the second investrnent has relatively high future social benefit The decommissioning cost for a nuclear reactor is an example of high future social cost- The long-terrn reduction in carbon dioxide emissions and global wamring resulting from investments in conservation practices and more efficient combustion technologies are examples of high future social benefits.Ahigh discount rate favors acceptanceof the first investrnent and rejection of the second investment- Acceptance of the first investrnent causes future generations to bear a disproportionate share of the social cost of the invesEnent. Rejection of the second investrnent deprives future generations of important benefits. In both cases, a high discount rate benefits the current generation at the expenseof future generations. Conversely, a low discount rate favors rpjection of the first investrnent and acceptanceof the second investrnenf which bénefits the future generation at the expense of the curent generation.

SELECTION OF DISCOUNT RATE. The preceding discussion indicates that the discount rate influences not only the economic feasibility of resource investments but also the intertemporal use of nanrral and environmental resources. For

Val.ue

per

lh,it A

ProducÈioa.

€fnct

B

gsct

Pro'dugtiorr

Figure 11.1. Qhangein net social benefit bebweena conventional (c) and new (p) technolory for timber harvesting in timber (m) markets (4) and plastic (p) markets (l3) in period t. D = demand; and MSC = matginal social cost.

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this reason,considerableattentionhas been grven to the selection of the discount rate in benefit+ost analysis.This sectiondiscussesthe theoreticalbasis for selecting the discount rate. There are two primary contendersfor the discount rate, the nwrginal rate of time preferenceandmarginal opportmiry cost of capital. The argumentfor usingthe marginal rate of time preferenceis basedon Figure I1.2, which depictsefficientintertemporalconsumptionfor a household.The household hasan indifference map composedof individual indifferencecurves (Ir, 12and Ir) for current consumption(C,) and frrture consumption(q). Each indifference curve containsall combinationsof C1and C2that provide the sarnelevel of household satisfaction.Higher indifference curves contain more preferred combinations of current and future consumption. îhe marginal rate of commodity substitution (MRCS) meÍ$rres how much future consumptionthe householdrequires to compensatefor a decreasein currenr consumptionwithout alteringtotal satisfaction.The MRCS equalsthe slope of a line tangentto the indifferencecurveat a given point. When currentconsumption is high relative to future consumption,like at point a, only a relatively small amount of future consumptionis neededto offset a one unit loss in currentconsumption.The MRCS is low at a. When currentconsumptionis low relative to fuhrre consurrrption, like at point b, a relatively large amountof future consumptionis neededto offset a one unit loss in curent consumption.MRCS is high at b. BecauseMRCS increases from a to b, the indifferencecurve is convex (v). MRCS is definedas follows: MR C S =d C z/dCr ={ I +v) , nrÈuî€

CoaarryrÈioa

(Cz)

Y(1+i/p,

Y/Pt CrrrEaBÈ

cqsqrtloa

(Cr)

Figure 112. Efficient intertempoml consrrmption for a household.I = indifference curre; and BL = budget line.

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275

where dcl/dctis the ratio of the changein futureconsumptionto the changein current consumption,v is the marginal rate of time preferencebetweencurrent and future consumption.v increases(decreases) asthe ratio of future consumptionto current consumptionincreases(decreases).The expressionfor MRCS indicatesthat the householdis willing to give up one unit of curent consumptionas long as it receives(l + v) units of future consumption.Altèrnatively,the householdis indifferent betweenone unit of currentconsumptionand (l + v) units of funrre consump tion. Hencó,v is the household'spersonaldiscountrate.For v = 0.07, the household is indifferentbetween$1.07worth of consumptionin the futureperiod and$1 worth of consumptionin the currentperiod.As v increases(decreases), the absolutevalue of MRCS increases(decreases). The budgetline for the househol4labeledBL in Figure 11.2,containsall combinationsof Cr and C-2ttrat canbe purchasedwith ahouseholdincomeof Y. It is assumedthat all of the household'sincomeis receivedat the beginningof the current period-If the entire income is spentin the currentperiod, the householdcan purchaseY/pt units in the currentperiod, wherep, is the price of goodsin the current period. If income not spent in the current period earnsinterest at an annualrate of i, thenthe maximumconsumptionin the futureperiodis Y(l +i)rlprunits, where(1 + i)t It the compoundinterestfactor, p2is the price of goodsin the future period and t is the time interval betrpeenthe current and future periods, for example, three years. In the simple casewhere there is only one time period separatingthe current period from the future period (t = 1), the budgetconstraintfor the householdis BL in Figure11.2.BL is a straightline that containsall affordablecombinationsof consumption in the current period and consumptionin the funre period. The C1intercept of BL is the maximurn amount of current consumptionand the Q intercept of BL is the maximum amountof funrre consumption.The slopeof the BL is: dc2ldcr = -[Y(1 + i)lp:]/(Y/pJ, The numeratoris the.interceptof BL on the vertical axis and the denominatoris the interceptof BL on the horizontalaxis of Figure l1-2. When the prices are the samein both periods(p, = p): dc2/dCr= -Y(l + i/Y = -(l + i). This implies that increasingcurrent consumpúonby one unit requires future consumptionto be reducedby (1 + i) units.Conversely,reducingcurrentconsumption by oneunit allows future consurnptionto be increasedby (l + i) units.The slopeof the BL gives the rate at which current consumptioncanbe exchangedfor future consumptionbasedon the marketdetermined interestrate (i). Householdequilibritm occursat C* (C*, in the currentperiod and C*2 in the future period) where the BL is tangent to the highest possible indifference curve, namely 12.At c*, the MRCS equalsthe slopeof thè BL. BecauseMRCS equals {l + v) and the slope of the budget line equals{l + i), bouseholdequilibrium requires: {1 +v)={1

+i)orv=i.

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When a householdmaximizessatisfactionsubjectto the budgetconstraint, the marginal rate of time preference(v) equalsthe market interest rate (i). Therefore, if the marginal rate of time preferenceis selectedas the discount rate, then the market interest rate is the appropriatediscount rate. Typical firm-level product transformationcurves for current (Qt) versusfuture (Q) productionaregiven in Figure 11.3.Eachtransformationcurve (Tr, Tt and Tr) represents the maximum amounts of current and futrue production that can be achieved with a given arnountof manufacturedand natural capital and a given technology. Higher transfonnationcurves require greater capital investment and indicate greaterproduction.Considertransformationcurve Tt. When most of the capital is invested in current production, diverting capital from current production to funrre production increasesfuture production more than it decreasescurent production, as indicatedby the slopeof the line tangentto Tr at c. Conversely,when most of the capital is investedin future production, diverting additionalcapital from currentto future production decreasescurrentproduction more than it increasesfunrre production, as indicated by the slope of the line tangent to T, at d. The slopeof the product transformationcurve equals the marginal rate of technicalsubstitution(MRÎS): MR T S =d e z/der =- ( l*m ) , where dQ2/dQlequalsthe slopeof a line tangentto the product transformation curve at a particular point and m equals the marginal oppornrnity cost of capital. m decreases(increases)as the ratio of funue production to current production increases

hrÈurs

ProducÈLoa

(Q1)

K(1+i/w.

Vw. Curo|rÈ,

frodtrcÈ:loa

(Q1)

f igure 113. Efficient intertemporal prcduction for a firm. T = transfornation cur:ve; and KC = capital constrainl

11. Benefit-CostAnalysisof ResourceInvesfinents

277

(decreases).Becausethe increasein production per unit increasein capital (marginal productivity of capital) decreasesas the level of production increases,the absolutevalueof MRTS declinesfrom c to d. Elence,theproducttransformationcurve is concave(n). The firm's most efficient combinationof curreni and future productionis determined by maximizing the anrountof current and future production that can be achievedwith a grvenamountof capital.Supposethereis a fixed amountof capital (K) available to the firm at the beginning of the current period. All possible allocations of capitalbetweencurrentandfuture productionperiodslie on the capitalconstraint line labeled KC in Figure 11.3.This constraintis derivedas follows. The maximum level of currentproductionequalsK divided by the per unit cost of current production (wr). If all capital is allocatedto future production, then the original arnount of capital (K) plus the interest on capital (Ki) are available in the future. This assumesthat capital canbe investedat the market interestrate of i. Hence,he maximum amountof capital availablein the future period is K(l + i)t *O maximum future productionis K(1 + i)tdivided by the per unit cost of future production(w). When there is only one time period separatingthe current period from the future period t = l, the maximum capital availablein the funrreperiod is K + Ki = K(l + i), where Ki is the interestearnedon K in one time period.For t = l, KC is a straight line connecting current mudmurn production to future maximum production as shown in Figure 11.3.The slopeof KC is: dQr/dQr= -K(1 + i)/K = {l

+ i).

This slope indicatesthat increasingcapital use by one dollar in the current period reducesthe amountof capital availablefor usein the funue period by (1 + i) dollars. hoduction equilibrium occursat Q* (Q*t in the currentperiodand Q*zin the future period) where KC is tangent to the highest product transformation curve, narnelyT2.At the tangencypoinf MRTS equalsthe slopeof KC. BecauseMRîS = {1 + m) and the slopeof KC equals{l + i), productionequilibriumimplies: -(1 +m)={1

+i),orm=i.

Therefore, in production equilibrium, the marginal opporhnity cost of capital (m) equalsthe market interestrate (i). Hence,if the marginal opportunitycost of capital is'selectedas the discountrate,then the market interestrateis the appropriatediscount rate. When the householdandfirm arein equilibrium, the marginalrate of time preferenceand the marginal oppornrnitycost of capital both equal the market interest rate.This joint equilibrium is illustratedin Figure 11.4.Householdsmaximize satisfaction by equating their marginal rates of time preferenceto the market interest rate. Firms maximize profits by equatingtheir marginal opporilnity cost of capital to the market interest rate. In practice, the marginal oppornrnity cost of capital is likely to exceedthe marginalrateof time preferencebecauseof taxes,subsidies,externalities,uncèrtaintiesand imperfecúonsin capital markets.Moreover,there are numerousinterestratesin an economythat can be usedas a basisfor selectingthe discountrate. One way to handlethe ambiguity regardingthe appropriatediscount

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Natural Resourceand Environmental Economics

rate is to evaluate the economic feasibility of resource invesùtents for a range of discount rates. Discount rates used in the evaluation of public resource investments are typically less than discount rates used in evaluation of private resource investments. This occurs because public agencies often require that a certain discount rate be used in evaluating the social benefrts of investments. In addition, the private discount rate tends to be higher than the public discount rate becausc the private rate is often adjusted for risk (to be discussed later) and taxes. Public agencies can spread the risks of different investrnents over a larger number of invesftrents, and they do not pay taxes. For the same discount rate and stream of net benefits, the net present value of an investment is higher, with zero taxes. Thus, public agencies do not have to use as high a discount rate as do private companies to achieve the same net present value. The preceding example involves two time periods, current and funre. Hence, only one discount rate is needed.Benefits and costs of resource invesbmentsgenerally occur over several time periods during which interest rates, and hence discount rates, are likely to vary. Most benefit
Productioa Ftrture ald, Coasuqttf.on,

Prodlrctioa Ctrlr€rlt and Cougrqltlon

Figure 11.4. Equality of maryinal rate of tine preference and marginal opportunity cost of capital I = indifference curye; and T = h'andormation cur3e.

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279

CAPITALAND OPERAIING COSTS. Resourceinvestrnene normally involve a capital cost and an operating cost. Capital cosr is the lump sum payments made to acquire, develop and produce the resource. In the timber hanresting example, the conventional technology requires capital to construct roads and purchase tnrcks. The new technology requires capital to purchase helicopters. Other capital costs, such as machinery and equipment for felling Eees, salaries for management staff, housing for workers, and property taxes or stumpage fees, are common to both technologies. Operating cost for both technologies includes the cost of fuel and oil, labor, replacement parts, insurance and other items. There is no need to distinguish between capital and operating costs in present value calculations. Both are treated as outlays in the time period in which they occur. One offset to capital cost is salvage value which is the expected market value of capital assetsat the end of the investment evaluation period. In the timber harvesting example, the expected value of the land (which includes the roads), trucks, helicopters and other capital assetsare included in salvage value. Salvage value is treated as a benefit. Sorne capital assetsmight appreciate in value (land) and others might depreciate in value (machinery and equipment) due to wear and tear and/or obsolescence. While normal accounting procedures treat depreciation or arnortization of cap ital and interest payments on borrowed capital as expenses, such expenses are not considered in benefit
The last example leads ECONOMIC VERSUS F"INANCIAL F'EASIBILITY. to the distinction between ecorwmic feasíbility andfinancial feasíbiliry. An investment is economically feasible when net social benefit is positive where net social benefit includes all relevant benefits and costs generated by the investrnent and the discount rate is basedon social rather than private considerations. An investment is financially feasible when gross monetary rehrns received by the investor are sufFrcient to cover all monetary costs incurîed by the inyestor where costs include interest on borrowed funds and the discount rate is the interest rate paid on borrowed funds. It is possible for a resource investment to be economically feasible but not financially feasible and vice versa because a) gross benefis and./orcosts for society differ from monetary returns and/or costs for the private investor and b) the social discount rate differs from the private discount rate. For example, supposethat an investrnent generatesan external diseconomy. While the social cost of the investment includes the external diseconomy, the private cost excludes it.

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When resource managers are deLOCAL \fERSUS GLOBAL EITICIENCY. termining how best to allocate their capital budgets among alternative resource invesfrnents, they often limit their attention to investment opportunities in their particular region. For example, Grand Teton National Park and Yellowstone National Park, both located in northwestern Wyoming, each has an annual budget for resource invesúnent within the park. If resource investnents in each park are independently chosen based on efficiency criteria, then the net social benefit for each park is maximized. Local efficiency is achieved. Selecting investments in each park based on its local efficiency does not necessarily achieve the greatest overall gain in regional net social benefit, which is the sum of the net benefits for the two parks- Investmerts selected on the basis of local efFrciency are likely to differ from investments selected basedon regional efficiency. Global efficiency takes a broader geographic view which entails looking at efficiency for substate,state, multistate or national areas. Simultaneously evaluating the economic feasibility of resourceinvestments for all publicly managed natural resource areas including national parks, forests, wildlife refuges, wild and scenic rivers, wilderness areas,roadless areas and recreation meas in the United States is an example of resource investment analysis from a global perspective. If efficiency is increased by rnoving from the local to the global level, what is the rationale for making resource investrnent decisions at the local level? First, it is less costly in terms of resource planning and econornic analysis and more politically acceptablefor local managers to identify, evaluate and select resource investrnents within their specific management rirea. Asking resource managers from different regions and/or agencies to evaluate and select resource investments in areas managed for different objectives is likely to result in conflict. While such conflict can be resolved, the transaction costs would be high. Second, the regional distribution of resourceinvestments is likely to be inequitable when resource investrnent decisions are based on a global evaluation. For example, if public investrnent in soil conservationis allocated only to areashaving the rnost serious erosion problerns, inves0nent would be concentrated in just a handful of states or regions.

ApplicaINTERDEPET\DENT II\IVESTMENTS. IhÍDEPEI\DEhI"MRSUS investfor independent and interdependent tion of investment criteria is different ments. Independent investrnentssatisfy two conditions. First, selection of one invesbnent does not alter the net social benefit of the other investrnent. Second, selection of one investment does not prevent selection of the other investrnent except for financial reasons(capital rationing). Consider two investments: expanding a national park and creating a new wildlife refuge. These investments are independent, provided that a) expansion of the park does not alter the net social benefit of cieating the wildlife refuge, b) creating the wildlife refuge does not affect the net social benefit of the park, c) selection of the park does not prevent creation of the wildlife refuge, and d) creation of the wildlife refuge does not prevent selection of the park. Conditions c and d can be violated, however, when investment funds are insufficient to undertakeboth investrnents. Investrnents are interdependentwhen one or both of the conditions for independence are violated. Expanding a national park and expanding a wildlife refuge are interdependent investments when a) expanding the park (wildlife refuge)

Investments 11. Benefit-Cost Analysisof Resource

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changesthe net social benefit of the wildlife refuge (park) or b) expanding the park (wildlife refuge) interferes with the expansion of the wildlife refuge (park) for other than financial reasons. Condition "a" implies the two investrnents are competing. If the park and wildlife refuge are in the same general are4 then net social benefit from park expansion is likely to be greater without exparision of the wildlife refuge because both resource investments provide wildlife viewing and outdoor recreation. Condition "b" is relevant when the proposed expansions occur in the same area. In this ssss, the investrnents are mutually exclusive. Selection of the scale of an investment is also a mutually exclusive decision. Supposethree national park expansions are under consideration: 5,000, 10,500 and 3O,000 acres(2,O25,4,253 and, 12,150 hectares). Selection of any one scale precludes selection of the remaining two scales.

CAPITALRAIIOI{ING. Capital rationingl occurs when the decision makerhas a fixed capital budget that limits resource investrnent. The budget constraint is assumed to be effective only in the current period. In funre periods, the decision maker is assqmed to have the flexibility to acquire additional capital. There are two forms of capital rationing: maximum and specific. Maximum rationíng requires that the decision maker not exceed the current budget. This form of rationing allows the decision maker to allocate surplus (uninvested) funds to noninvestment activities such as consumption in the case of households and dividends in the case of firms. Surplus govemment funds can be returned to the treasury.Specific rationing is more restrictive than maximum rationing. It requires the decision maker to spend all of the current budget on resource invesEnents-Maximum rationing is more efficient than specific rationing when the return from investing additional funds is less than the value of those funds in noninvestrnent activities. Capital rationing is a problem when the amount of current funds available to the decision maker is less than the amount of funds that can be invested at a reasonable retum. This problem does not occur when the decision maker has the ability to request and./or borrow additional funds for worthwhile investments. A fixed and inadequate capital budget implies that the decision maker cannot borrow capital to increase current funds even when the projected future earnings from investment are sufficient to pay back the principal and interest on borrowed capital.

PRIMARY AND SECONDARY BEII-EFITS AltD COSTS. Resource investments generate primary benefits and secondary benefits or costs. Aprimary benefit is the change in consumer plus producer surpluses in the primary market, which is the market most directly affected by the investment. A secondary benefit or cost is the change in consumer plus producer surpluses in secondary markets caused by changes in demand andy'orsupply in the primary market.s In the example of investing in a new timber harvesting technology (Figure 11.1), the prirnary benefit is the present value of the increasein consumer plus producer surplusesin the timber market. The secondary cost is the present value of the decreasein consumer plus producer surpluses in the plastic market. Net social benefit of investing in the new timber harvesting technology is the primary benefit minus the secondary cost. 'When primary and secondary markets are complementary rather than competitive, net social benefit is the sum of primary and secondary benefits. There are no

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Natural Resourceand Environmental Economics

secondarycosts.An exampleof a secondarybenefit is the flood protection benefit (decreasein potentialflood damages)associatedwith the constructionof a dam and reservoir to supply drinking water for a rural community.Flood protection is a secondary benefit as long as the dam and reservoir are constructedfor the primary purpose of supplying drinking water. There are two.typesof secondaryecononic benefitsor costs: technological spillnvers andpectutiaryspíllovers.Technologicalspilloversare real increasesor decreasesin productivity causedby resource investments.Improvements in water quality resulting from the new timber harvesting technology and the reduction in flood danages from the water supply reservoir are technological spillovers. Pecuniary spillovers are changesin capital values and/or incomes induced by resource investments.Increasesin the recreational value of mountainousforested areasresulting from the newtimberharvestingtechnologyor increasesin local labor wages causedby the constructionof the dam and reservoir arepecuniary spillovers. Technological spilloversareincludedand pecuniaryspilloversareexcludedfrom net social benefit.6 by a resourceinvestrnentis sometimestreatedastechLabor incomegenerated nological spillover when the workers hired to support the resource investment would be otherwiseunernployed.This procedurehastwo potential drawbacks.First, it is inappropriateto úeat the wagespaid to previously unemployedworkers :rsa national benefit when the proposedinvestment simply displacesanother investrnent that might have employedthe sarneworkers. Second,it overstatesbenefits when the employment of surpluslabor contributes to inflation. The latter condition is very coÍrmon when resourceinvesEnentoccurs in areashaving a relatively small economic base. When there is completeknowledge about how a RISK AI{D I]NCERîAINTY. resourceinvestrnentaffectsdemandand supply for the resource,the net social benefit of the investmentis known with completecertainty(asassumedin Figure 11.1). Complete certainty is very rare. Normally, changesin demand and/or supply are Aresourceinvestmentdecisionis risky when thereare subjectto risk br uncertainty. several possible outcomesfor changesin demand and/or supply and probabilities can be attachedto theseoutcomes.Uncertainty prevails when probabilistic statements cannot be maderegardingdemandand/or supply outcornes.A common way to handle risk and uncertaintyin resourceinvestmentanalysisis to increasethe discount rate. This approachhas several disadvantages.Firs! the amount of the increaseis arbitrary.White the difference in the borrowing rate.betweena riskless and risky invesfinent might be usedfor this purpose,the uniquenessof most resourceinvestmentstends to invalidate this procedure. Second,when the interest rate is incrementedfor risk, the incrementgets compoundedover time. Such compounding 'overcompensates for risk when there is year-to-year variabilor undercompensates ity in risk. Finally, not all benefits and costs are subjectto the same degree of risk or uncertainty.Incrementingthe discount rate for risk assumesthat all benefits and costs exhibit the sane degreeof risk and uncertaintyThe preferredway to handle risk is to adjust benefitsand costs separatelyfor risk and to discountthemusing a risklessdiscountrate.Introducingrisk in the timber harvesting examplerequiresthe decision rnakerto assign a probability to each and every possiblereductionin marginal social cost (MSC) of harvesting with the

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Benefit-CostAnalysisof ResourceInveshents

28

new tecbnology.Table ll.2 illustrateshow to determinethe expecteddecreasein MSC for three hypothetical reductionsin MSC and their respectiveprobabilities of occurence.The first column gives the possibledecreasesin MSC, and the second column containsthe respectiveprobabilitiesof a decrease.The expecrcddecreasein MSC (third column) is the decreasein MSC multiplied by irs respecriveprobabilitv. Summingthe figures in the third column of Table 11.2gives the overall expecteddecreasein MSC, namelS $19.50per unit The latter is usedin calculating the expectedchangein consumerandproducer surplusesin the tinber market due to the new technology.A similar procedureis usedto estimatethe expecteddecrease in net social benefit due to a fall in the demandfor plastic. In this óase,risk arises in termsof the extent to which the decreasein timber price reducesthe demandfor plasticand,hence,consurnerplus producersurplusesfor plastic.

Alternative fnvestment Evaluation Criteria This section addressesthe strengthsand weaknesses of the following financial or economiccriteria for evaluatingth" feasibility of resourceinvestrnents: Paybackperiod Averagerate of return Net presentvalue Annual npt benefit Benefit-cost ratio Internal rate ofreturn

PAYBACK PERIOD. T\e paybackpertod is a financial rather than an economic criteria. The payback period is the numberof yearsit takesto recoup an initial investment,narnely: P = V/APR,

Tabte 112.

Decreasein MSC

Probability ofDecrease

10 l5 25 Susr nDecreasein MSC times probability. bOverall expected reduction in MSC.

Expected Decrease inMSC.

2.00 3.75 13.75 l95S

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2A

where P is the payback period in years, V is the initial investment cost, andAPR is the average annual private rentrn, which equals the average monetary return on the investrnent minus average monetary costs of the investrnent excluding investrnent cost. lnvestrnents with a shorter payback period are judged to be superior to investments with a longer payback period. The payback period is a very crude financial criterion because it a) does not consider the economic life of the investrnent and b) ignores the time value of money. Regarding the first criticism, consider two projects that cost $25,000 and yield an APR of $5,@0 per year. The payback period is five yefrs ($25'000/$5,000). Based on the payback period, both investments are equally attractive. Suppose the fust investment has an economic life of 8 years and the second has an economic life of 15 years. The second investrnent is more profitable because it yields a return for 10 years beyond the payback period compared with only three years for the second investrnent.Total net return is $50,000 (10 x $5,000) for the first investrnent versus $15,000 (3 x $5,000) for the second investment' Turning to the second criticisnU supposeboth investrnents have a lO-year economic life, the annual maintenance cost is $3,000 higher with the first investrnent and the salvage value is $30,000lower with the second investrnent. When the time value of money is ignored, the $30,N0 higher maintenance cost over the lGyear economic life of the first investrnentjustequals the $30'000 (10 x $3'000) lower salvage value for the second investrnent. The two projecS have the same cash return; however, for an 8 percent discount rate, the present value of the higher maintenance cost (g20,130) exceeds the present value of the lower salvage value ($13,896)' which means the first investrnent has a lower present value than the second investment. After accounting for the time value of money, the second investment is preferred to the first investment despite the fact both investrrents have the same payback period.

The cverage anrutal rarc of retun is also a fiAYERAGE RAIE OF RETIIRN. nancial criterion. It equals the average annual net private return as a percentage of the initial investment cost, namely: R = (APR/V)100. The average annual rate of return has a similar deficiency as the payback periodThese deficiencies are illustrated for three investrnentsin Table 11.3.Inves. entsA, B and C have an average annual rate ofreturn of20 percent. The first deficiency is that the average annual rate of return is positive despite the fact that each investrnent generatesa cash loss of $4,000 ($6,ooo - $10,000). A cash loss implies a negative of return. This inconsistency arises because the average annual rate of return ,.iate ' does not consider that part of the cash return must be used to pay back the initial investment. The second deficiency of the average annual rate of return is that it ignores the time value of money. For any positive discount rate, investment A has the highest investment B has the second highest and investrnent C has the lowest present value of annual net cash return. While the average annual rate of return shows that al

11. Benefit-Cost Analysis of ResourceInvestuents

2E5

Table 113. Averagerates of r"eturn for thrce inveshents Year trnvesErent A InvesfirentB Inveshent C (t) ($) ($) ($)

-10,0ft) 0 I 3,000 2 2,0ffi 3 1,000 Rateof Return(%) 20

-10,000 2,000 2,000 2,000 20

-10,0(x) l;000 2000 3,000 20

three investnents are equally preferred, accounting for the time value of money by discounting the cash flows indicates that A is more profitable than B and C and that B is more profitable than C. The average annual rate of return is a valid financial criterion (the two deficiencies are not present) in very restrictive cases where the investrnents being compared have uniforrn cash flows, like investrnent B, and there is either a 100 percent salvage value or a perpetual cash flow.

NET PRESENTVALIIE. in discrete time is: T

NPV=ÈoN,-CJ(l

The net present value (I.[PV) of a resource invesunent

*r)*,

where V, equals the primary and secondary benefits and C, equals the secondary cost generated by the investrnent at the end of time period t, r is the discount rate or interest rate conesponding to the length of each period (if t is a year, then r is an annual rate) and T is the length of the evaluation period. V, - C, is called the net benefit in time period t. Resource investments are economically feasible when their NPV is positive and economically infeasible when their NPV is zero or negativeThe primary benefit of a resource investrnent is the change in consumer plus producer surpluses in the primary market. A secondary benefit (cost) is the increase (decrease) in consumer plus producer suqplusesin secondary markets. When there is insuffi.cient information to estimate consumer and producer surpluses, benefits and costs are defined differently. It is quite common to define V, ffi the total economic value of production and C, as the total cost of production in primary and secondary markets with the investrnent.An example of how net present value is calculated based on this definition is given in Table I1.4. Net benefit in each period equals (V - C) and discounted net benefit in each period equals (V - C) times the discount factor (f). The NPV of the investrnent is the sum of the discounted net benefits over the four-year evaluation period, namely $923. Because NPV is positive, the investment is economically feasible. An example of benefit-cost analysis is Freemanls evaluation of the Clean Y/ater Act (CV/A). He estiniàted CWAs annual benefit to be bet\ileen $5.7 billion and $27.7 billion, with a most Iikely estimate of $14 billion (as of 1985). Annual benefit included enhancement in recreation, aesthetic and property values and cornmercial fishing as well as the reduced cost of treating wastes and supp-lying drinking water. Cost of complying with the CWA was estimatedto be $17.4 billion in 1979 and $33.4 billion in 1988, with an annual average cost for the decade oî $23.2 billion.

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îable 11.4. Calculation of net pr=sentvalue of an investment Net Bencfit Benefit (V) ($)

Cost (C)

0

3,0(x) 3,000 3,000 3,0m +2,(XXF 14,0CX) "(l + 0.05){. bSalvagevalue.

(v-c)

Discount Factor'

Discounted Net Benefit

(v- cxf)

)

10,000 500 5m 500 0

-10,m0 2,500 2500 2500 5,000

11J00

2500

1.000 o.952 0.907 0.8&t 0.823

-10,000 2"380 4268 2,160 4,115 v23

Esticrated net benefit of the CWA is -$9.2 billion ($14 billion - $23.2 billion).7 Basedon Freeman'sanalysis,the cost exceedsthe benefitsof the CWA. AFINUAL I\[ET BEI\.EFIT. A variant of net presentvalue is the annunl netbenefr (ANB). The ANB equals the uniform annual payment over the life of the investrnent,which hasa net prsent valuejust equalto the net presentvalue of the invesEnent.ANB is the solution to the following eqwltion: T

,E'ANB(1

+rF=NPV

namely: ANB = NPVr(1 + r)r/[(1 + r)r - l]. An investment is deerned economically feasible when AIIB is positive and economicallyinfeasiblewhen ANB is zero or negative.Becausethe expression r(l + r) r/[(1 + r) r - 1] is positive, Al.[B has the sarnealgebraic sign as NPV provided r is positive.Therefore,any investmentthat is economically feasible basedon the NPV criterion is economicallyfeasible with theANB criterion. The two criteria areequivalent.For the benefis andcostsgiven in Table11.4,ANB = $260.30($923 x 0-282), which implies that the investmentis economicallyfeasibleThe benefit--costratio (BCR) for a resource investBEI{EXTI-COST RAIIO. ment is the ratio of the presentvalueof benefrtsto the presentvalue of costs.Specifically: T

)oV,(l + r){ BCR =

T.

XoC,(l + rf An investrnent is economically feasible if its BCR is gfeater than 1 and economically infeasible if its BCR is less than or equal to 1. For the benefits and costs given in Table 11-4,BCR = 1.08. BecauseBCR exceeds1.,the investrnent is economically feasible.

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Benefit-Cost Analysis of ResourceInvestnents

8I

To show the equivalenceof the BCR, NPV andAl.{B criteria NPV is rewritten as follows: TT

NPV = ,!_ov(t * t)* -,?o C,(1+ r){, where the first term on the right of the equality is the present value of benefits (pVB) and the second term is the present value of costs (PVC). When NPV is positive (negative), PVB is greater (le.ss)than PVC, which implies that BCR is positive (negàtive). In addition, when Al.{B is positive (negative), NPV is positive (negative), which makes BCR positive (negative). Therefore, the NPY ANB and BCR criteria lead to the sarne conclusions regarding the economic feasibility of resource investments provided the discount rate is positive.

INTERÌ'IALRATE OFRETIIRN. The internal rate of return (RR) is defined as the discount rate that makes the NPV of an investment just equal to zero. The IRR is found by solving the following equation for p: T

,ì'ff,-

CJ(l + P)* = 0.

p is also the discount rate that makes ANB equal to zero and BCR equal to l. An investrnent is economically feasible (infeasible) when p is greater than Qess than or equal to) the disgsun, rate. For the benefits and costs given in Table 11.4, p = 0.0847. For the 5 percent discount rate used in Table 11.4, the investrnent is economically feasible because IRR exceedsthe discount rate (0.0847 > 0.05). In this example, the IRR criterion leads to the same conclusion (economic feasibility) as the NPV ANB and BCR criteria'When capltal costs occur early in the evaluation period and benefits are spread out over the entire evaluation period (such as in Table 11-4), the IRR is usually unique and leads to the same investrnent decision as the NPV AIIB and BCR criteria. This is not always the case. The presenr value of the net benefits -100, +210, -ll0 is zero for pr = O ffid pr= 0.10. There are two solu_ tions for p. If the discount rate is greater than zero or less than l0 percent, then the invesfrtent is economically infeasible based on pr but economically feasible based on Pz. Some net benefits do not have a nonimaginary solution foq p.8 For these rea_ sons, the IRR criterion is not a reliable criterion for evaluating the economic feasibility of resource investrnents.

EXAMPLE. Resource investrnent analysis involves calculating present values for a wide variety of netbenefits. This section employs the financiul f*too given in Table 11.5 to calculate net present value. The financial factors are for an 8 percent discount rate (r = 0.08) and a L5-year evaluation period (T = l5). For ease of calculation, cash values are in relatively small denominations. Suppose the conventional timber harvesting investment generates the cash flows given in Table 11.6. Net present value of the investment is the present value of cash benefits rninus the present value of cash conts.Becausethe $50,000 in invesunent cost occurs in the beginning of the evaluation period, it does not need to be discounted. present value

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Table 115. trinancial factors for calculating net presentvalues, r - 0.08and T = 15 PV of Increasing PV of Decreasing Anruity of PresentValue Amonization PV of Annui$ of Annuity of 1 peryear ofl Factor I peryear I peryear 56-44514 0.31s25 8.55948 0.11683 E0.50652 PV = pfEsent value.

Table 11.6. Cash flows for conventional timbcr halwesting lnvestment ($) Invesment cost Annual benefit Annual O&M cost Salvage value O&M = operating and maintenance.

50,000 8,(X)O 3,(n0 10,000

of the Íìnnualbenefitof $8,000equalsthe benefit times the presentvalue of an annuity of 1 per year (column3 in Table 11.5).Therefore: = $68,475.84PV($8,000)= ($8,000)(8.55948) Likewise, the presentnaloeof the rinnual operating and maintenance(O & M) cost of $3,000is: = $25,678.44. PV($3,00O)= ($3,000)(8.55948) The presentvalueof the salvagevalue is $10,00Otimesthe presentvalue of 1 (column 1 in Table11.5): PV($10,000)= ($10,000X0.3 1525)= $3,152.50. NPV of the invesEnentis: + $3,152.50- $25,678.M- $50,000- -$4,050.1O. NPV = $68,475.84 ANB of the investrnentequals NPV times the amortization factor (column 2 in Table11.5): ANB = (-$4,050.10X0.1 1683)= -$473.17. BCR is presentvalueof benefitsdivided by presentvalue of costs: BCR = ($68,475.84 + $3,152.50)($25,678.44 + $50,000)= 0.946. Finally,IRR = 0.03 for this investnent. In conclusion,the conventionaltimber harvestinginvestrnentis not economically feasible from a private viewpoint becauseNPV and Al.[B are negative, BCR is less than 1 and IRR is lessthan the discount rate. In this example,the IRR criterion is consistentwith tbe other three criteria.

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Benefit-Cost Analysis of ResourceInvestments

2E9

Changes in the benefits and costs, discount rate and evaluation period can change the investrnent decision. For example, instead of being constant at $3,000 per year, suppose O & M cost increasesat a constant rate from $500 in the first year to $4,000 in the 15th year as indicated by line C in Figure 11.5. Present value of the increasing annual O & M cost is the sum of the present value of $500 per year for 15 years as indicated by tine A in Figure 11.5 ptus the present value of a cost that increasesfrom $0 in the first year to $3,500 in the 15th year as indicated by line B in Figure I l -5. The present value of $500 per year is $500 times the present value of an annuity of I per year (column 3 in Table 11.5): PV($500) = ($500X8.55948)= $4,279.74. Present value of the increasing portion of O & M costs is the average annual increasein O & M cost times the present value of an increasing annuity of 1 per year (column 4 of Table 11.5): = $13,170.53. PV(increasingO & M cost) = [($3,500y15][56.,+4514] Presentvalue of the increasing O & M cost (line C in Figure 11.5) is $17,450.27 ($4,279.74 + $ I 3, 170.53). Net present value of the timber harvesting investrnent with increasing O & M cost is: NPV = $68,475.84+ $3,152.50- $17,450.27- $50,000= $4,178.07.

Ilnnua]-

o&M Cost ( $ )

4,000 3,500

Figure 115. Increasing operating and maintenance (O&M) cost for conventional timber harvesting investment. C = O&M cost.

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The invesnnenthasa positiveNPV when O & M costincreÍNesfrom $500 to $4,000 per yezìrbut a negativeNPV when O & M cost is constantat $3,0O0per year.Therefore, the investnent is economicallyjustified from a private viewpoint with this increasingpatternof O & M cost. Considerthe net social benefit of the conventionaltimber hanrestinginvestmenL Supposethe conventionaltimber harvestinginvestmentcausessedimentation of streamsthat adverselyaffects fish reproductionand growth. Let the annualenvironmental damage(ED) from sedimentdecreaseover time from $1,00Oin the first year to $0 in the l5th year. Presentvalue of environmentaldamage(PED) equals the annualaveragedecreasein damagestimes the presentvalue of a decreasingannuity of onedollar per year (column 5 in Table 11.5): - $0y15]t80.506521 = $5,367.10. PED = [($1,OOO Net socialbenefitof the invesùnentwith increasingO & M cost is: - $5'367.10= -$1'189'03' NSB = NPV - PED = $4,178.07 The conventionaltimber harvesting technology is not socially effrcient becauseit has a negativeNSB. Therefore,the investmentin the conventionaltimber harvesting technologyis privately efficient but socially inefEcient.

Evaluation of Independent and Interdependent Investments Caution must be used when applying the NPV ANB, IRR and BCR criteria. One caution has already been mentioned in connection with the IRR. The IRR can be ambiguous regarding economic feasibility when it is applied to investments that do not have a nonnal cash flow. The laner has a capital cost that occurs early in the evaluation period and benefits that are spread throughout the evaluation period. This section exarrines in detail the application of the NPV IRR and BCR criteria to independent and interdependentinvestments.

An independent investrnent is economiII{DEPENDEIYT INVESTMENTS. cally feasible when NPV is positive, IRR is greater than the discount rate or the BCR is greater than 1. In other words, all ttre evaluation criteria are appropriate for independent investrnents'When there is no capital rationing, independent investments that are economically feasible are justified. With specific or maximum capital rationing, there is unIikety to be suffrcient funds in the current period to undertake all economically feasible invesunents.Supposea capital budget of $40,00Ois to be allocated among six indepeúdentinvestrnents.The evaluation period is five years (t = 5) and the salvage valuè is 100 percent. Table 11.7 summarizesthe investrnent cosL annual benefit, net present value and internal rate of feturn for the six independent investments.

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291

Table 11.7. Investuent cost, annual benefif net present value and Ìnternal rate of retun for six independent investments Annual Net Present Value ($) InvestInvestment for a discountrate ment Cost Benefit IRR (%\ ($) ($) Option 4358 28 5,768 2,900 6,824 A 10,000 4549 2,682 ?s 3,749 2,(X)0 B 8,(XX) 4,326 20 25r4 15,000 558s 3,000 c 793 402 l8 4,000 1,2t3 720 D 2,379 0 4,t70 l5 E 22,OOO 3,300 -&9 -r508 g,(x)o 10 0 F 900 IRR = internal rate of retums.

The NPV criterion is applied by raising the discount rate until the cost of the economically feasible investments just exhausts the capital budget. For a 10 percent and 12 percent discount rate, investments A through E are economically justified, but the total investurent cost exceeds the capital budget ($59,000 > $40,000). When the discount rate is increased to 15 percent, investments A through D are justified and the total investrnent cost is less than the capital budget ($37,000 < S40,00O). There is $3,000 of unused capital budget. With maximum capital rationing, the $3,000 surplus can be dispensedas a dividend in the caseof private investrnent, or returned to the treasury in the case of public investrnent. ff there is specific capital rationing, then a $3,000 investrnent must be found in order to exhaust the current budget. The opportunity cost of capital or the loss in net return from capital rationing is the IRR on the next investment that would be selected without a capital constraint, narnely, 15 percent for investrnent E. The IRR criterion is applied by first ranking all investments in descending order of IRR. fnvesEnents are then selected in the order of their IRR until the capital budget is just exhausted (specific capital rationing) or nearly exhausted (maximum capital rationing). InvesÍnents A through D satisfy this decision rule. While not shown here, the same five investrnents are selected with the ANB and BCR criteria. Suppose a seventh investrnent (G) is identified that costs $7,000 and has an IRR of 19 percent. By not selecting investment D, $4,000 is freed up, which, together with the $3,000 surplus, is just sufficient to undertake invesrnent G. Investment G is superior to investment D because it has a higher IRR (19 percent > 18 percent).

Interdependent investrnents are cateII{TERDEPEI{DENT IhIIIESTMENTS. gorized as type I or type tr. For a type I investrnent, choosing A influences the net benefits for B, or vice versa For a type tr investrnent, choosing A prevents selection of B, or vice versa, which means the projects are mutually exclusive. Tlpe I Investments. Five cases of a type I interdependent investment are examined using the NPV criterion in Table 11.8-The NPV of B is increasedby $50 in Case I and reduced by $75 in Case 2 when A is undertaken.Because the NPV of B is still positive after A is uudertaken ($tSO in Case I and $25 in Case 2), B is still economically justified. The $50 increase in B's NPV in Case I is credited to A's NPV and the $75 loss in B's NPV in Case 2 is charged against,{s NPV. In Case 3,

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A causes the NPV of B to become negative, which means B is no longer economically justified when A is undertaken. The $100 present value loss from abandoning B is charged against the NPV of A. In Case 4, B is not economically justified before or after A, so there is no need to adjust the NPV of A. In Case 5, B is not economicatly justified before A but it is economically justified after A. The $35 NPV of B, which occurs when Ais undertaken, is credited to the NPV of A. Ilpe tr Investments. Application of the economic criteria need to be modified when investments are mutually exclusive. Specifically, the investment criteria have to be applied to incremental benefits and costs rather than to the absolute level of benefits and costs. Economic feasibility of two mutually exclusive investments (A and B) are evaluated for T = 5 and 10Opercent salvage value in Table 11.9. Comparing the overall NPVs for the two investrnents leadsto the same decision as comparing the NPVs for incremental net benefits. First compare the overall NPVs. For r < 18 percent, both investmentshave a positive NPV and NPVB > NPV^, which implies B is superior to A. When r is between 18 percent and 24 percent, both investments have a positive NPV and NPVA > NPVB, which implies A is superior to B. For r between 24 and 30 percent, NPVA > 0, but NPVB < 0, which makes B econornically infeasible. Hence, when r is between 18 percent and 30 percent, investmentA is superior to invesfnent B. Second, supposethe investment decision is based on incremental NPVs. Incremental NPV equals the present value of the incremental benefit minus the present value of the incremental cost. The first possible increment of investrnent is $1,000 on A. InvestmentA results in an incremental NPV equal to the NPV of $300 for five years plus the NPV of $ I ,000 of salvage value in year 5 minus $ 1,00O of investment cost. The secondpossible increment of investrnent, designated as B-A, is to invest an additional $1,000 to achieve B. The NPV of the second increment, designated NPVB-A,equalsthe present value of $180 ($480 - $30O) for five years, plus the present value of $1,000 of additional salvage value in year 5 minus $l,Om of incremental invesEnent cost. For r < 18 percent NPVg-e > 0 and increment B-A is economically feasible.

TlIrc I interdependence between investmmts A and B prerent Value of B ($) Adjustment to Present Value of A ($) AfterA Before A

Table 11.&

100 100 100 -s0

I 2 3 4 5

150 25 -10 -100

-50

Table 1t-9. Invesùnent A B

50 15 -100 None 35

Inveshent cost and annual benefit for two mutually erclusive investments Annual Benefit lnvesEnent Cost

1,000 2,000 'l(X) percentsalvagevalue. bFor5 years.

300 480

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eftt-Cost Analysis of ResourceInveshents

293

SelectingincrernentB-A meanschoosinginvestrnentB. For r betweenl8 percent and 30 percent,NPVB-A< 0 and incrementB-A is not economicatlyfeasible.Only investmentA is selected.Therefore, the sameinvestmentdecisionsare reachedregardlessof whether overall NPV or incrementalNPV is utilized. This is not the case for the IRR and BCR criteria. Straighdorward application of the overall IRR criterion leads to incorrect investrnentchoices.'Whenthe annualbenefitis constantand salvagevalueis l0O percent of initial investmentcost, as in Table 11.9,overall IRR is the ratio of the annual benefitto the investmentcost times 100.The overall IRR for investmentsA and B are 30 percent[($300/$1,000)x l00J and 24 percent[($480/$2,000)x l0O], respectively,which implies A is superiorto B for a discountratelessthan24 percent. As theNPV criterion indicates,Ais superiorto B only when ris between18 and 30 percent. To obtaincorrectdecisions,the IRR criterion mustbe appliedto invesúment incrernentsA'and B-A. Increment A yields an incrementalannualreturn of $30Ofor five yearsand entailsan incrementalinvestrnentcostof $1,000.IncrementB-A provides an incrementalannualbenefit of $180 ($+gO- $30O)for five yearsand requiresan incrementalinvestrnentcost of $1,000($2,000- $1,000).The incrernental IRRs (IIRRs) for A and B-A are: IIRRA= ($300/$1,0mX00 = 30 percent,and = 18percent. IIRRB-A= ($180/$1,000)100 The IIRR-baseddecisionrule is: Accept (B-A) when r < l8 percenl AcceptA when 18 percent < r S 30 percent, and Reject both A and (B-A) when r > 3O percent. This is the same decision rule used with the NPV criterion. The overall benefit-cost ratio (BCR) leads to incorrect decisions regarding the selection of mutually exclusive investnents. The overall BCR is the ratio of the present value of annual benefit plus salvage value to investrnent cost. For r = 0.16, the BCRs of investments A and B are: BCRA = $1,639/$1,000= 1.64,and BCRB = $2,813/$2,000= 1.41. For r = 0-2O,the BCRS for invesffircntsA and B are: BCRA = $1,299l$1,000= 1.29, and BCRB =$2,2391$2,000= L.12. These BCRs indicate that both investments are economically feasible because BCRA > I and BCRB > 1; however, investrnent A is superior to investment B because BCRA > BCRB. This result is inconsistent with the NPV criterion, which

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294

r is shows that B is superior to Awhen r < 18 percent and A is superior to B when valid for mubenveen18 percentand 30 percent.Therefore,the overall BCR is not tually exclusiveinvestments. valid results for economic feasibility can be achievedby using the incremenBCRA = 1'69 and tal BCR criterion.When r = 0.16, which is less than 0'18, r = 0'2O' ;èR"-" = l.24.It is efficientto investin B becauseBCRB-A> 1''When = implies that which is beween 0.18 and 0.30,BCRÀ= 1.3andBCRt-n 0'94' which r > 0-30, investmentin A is efficient but investrnentin CB-A) is inefficienl For The efficient are BCRA and BCR"-r ile both lessthan one and neitherA nor B-A the incremenincrementalBCR criterion leadsto the saÍie investment decision as is: tal IRR and NpV criteria. The decisionnrle basedon the incrementalBCR AcceptA whenBCRA> l, Accept (B-A) when BCRB-A> l, and Rejectboth A and (B-A) whenBCRA< 1 and BCRB-A< 1' investrnentsfor In summary,applying the invesÍnent criteria to mutually exclusive adds which incrementalIRR > r or incrementalBCR > I ensuresthat the increment more to benefitsthan to costs,which increasesNPV'

Evaluation of Muttiple ResourceInvestments Theincrementalinvestmentcriteriaformutuallyexgeneralized to more than two investments' An exameasily clusive investments are The example assumes ple of the incremental IRR criierion is given in Table 11.10' there is no capital constraint. cosl The Multiple invesúnents are listed from lowest to highest investment incremental IRR analyoverall IRR is highest for A and lowest for D. Results of the investment cost increases sis are given in the last two columns of the table. Because no investment and A from A through D, incremental IRRs are calculated between B and D (A-0), berween A and B (B-A), between B and c (c-B) and between C-B is less than any reasonable discount ip-gl. Because the incremental IRR for means this increment is rate, it is not economically feasible to invest in C-8, which bypassed.In this case,the increment D-C is irrelevant'

exclusive investmentsr Investment Overall IRR Annual Benefit Incrernent ($)

Table 11.10. Incrernental IRRs for four I"*tt-*t A B C D

l""esment Cost

981,800 I,178,160 t374,520 1J70,880

400,000

432,m0 434,000

N.7 36.6 31.4 30.4

A-O FA

c-B

D_B 480,0@ -value' salvage p"tioa 1f Z0) and l@ percent "T-."tJ"y"* rate of renm. IRR = intemal"""I""tio"

Incremental IRR (%)

n.7 163 1.0 12.2

295

fnvestments 11. Benefit-Cos{Analysisof Resour.ce

Incremental IRRs are calculated based on the increment in investment cost and the increment in annual benefit. For example, the incremental IRR for B-A is determined using the increment in investment cost of $196,360 ($1,178,160- $981,800) and the corresponding increment in annual benefit of $32,ffi0 ($432,000 - $400,000) between A and B. The incremental IRR for B-A is 16.3 percent. For an 8 percent discount rate, A-0 is efEcient becausethe incremental IRR of 40.7 exceeds 8, B-A ís efficient because 16.3 > 8, C-B is inefEcient because 1.0 < 8, and D-B is efficient because 12.2> 8. BecauseB-A and D-B are efficient, investrnent D is selected.In fact, investment D is economically feasible when the discount rate is less than 12.2 percent, which is the incremental IRR on the last increment selected, namely, D-4. Incremental BCRs for the same four mutually exclusive investrnents are given in Table 11.11.The calculations are based on an 8 percent discount rate and a2Fyear evaluation period. The incremental BCR equals the present value of the incremental annual benefit plus tbe present value of the incremental salvage value divided by the present value of the incremental investment cost.As long as the BCR for an increment is greater than l, it is efFrcientto invest in that increment. A-0 is efficient because BCRA{ - 4.22 > 1, B-A is effrcient becauseBCRB-A= 1.85 > l, C-B is not efficient because BCRc-s = O.32 < 1, and D-B is efficient becausethe BCRos= 1.42 > 1. Selecting increments A-0, B-A and D-B results in investment D. This is the same investrnent selected using the incremental IRR criterion. Capital rationing can prevent the selection of some investments.For the four mutually exclusive investments given in Tables 10.10 and 10.11, a current capital budget of $1.2 million only allows investments A and B to be selected.Investrnent D is not financially feasible, even though it is economically feasible, becausethe cost of D exceeds the capital budget ($1,570,880 > $1,20O,00O).However, if there exists an investnent E that costs less than $1.2 million and for which IIRRE-A> 16.3 percent or BCRE-A> 1.85, then investing in E may be economically superior to investing in B. Because the NPV incremental IRR and incremental BCR criteria lead to selection of the sarnemutually exclusive investment is there any basis for preferring one of these criteria? Provided the decision maker can specify a rate of discount or a range of discount rates, the NPV criterion has the advantage of being direct and easy to aIF ply, especially when multiple invesbnents are being evaluated. To apply the NPV criterion, the NPVs are calculated for the alternative investments and the invesEnent with the highest NPV is selected.

Table llJl. Inves8rent

Increment A-O B-A

c-B

D_B

Incremental BCRs for four mutually exclusive invcshentsr Incremental Incrcrnental PV of Incremental Investment Cost Benefit Arnual Benefit

($) 981,800 196360 196360 392,720

($) 4(X),(X)0 32,q)O 2,000 rE,000

($) 2lO,&5. + 3,W,2W 42,129+ 314,176 42,129 + 19É36 84'258 + 47r,264

Incremcutal BCRb

"TWenty-year evahration perio4 8 percent discountrate and 100 percent salvage value. bColumn 3 divided by column l. "Prtsent value of incremental salvage value (column 1). dPresentvalue of incremental annrral benefit (coluurn 2). BCR = benefit-rost ratio; and PV = present value.

4-22 1.85 o32 t-42

296

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Summary Public agencies and private firms make invesùnents to develop, preserye, enhance, restore and protect natural and environmental resources. The primary objective of private resource investments is to maximize net private benefit (usually profit) subject to a capital constraint. Public resource investments are selected so afi to maximize rLetsocial benefit subject to budgetary, ecological, equity and other constraints.Private and public resource investrnentscan be evaluated in terms of their economic efficiency. Net social benefit, which is a measure of social economic efficiency, equals the present value of the changes in consumer plus producer surpluses in all markets affected by the investment minus the present value of the incremental fixed cost of the investment. Net social benefit is expressed in either discrete or continuous time. Calculations made in discrete (continuous) time utilize a discrete (continuous) discount factor. The evaluation period for an investrnent is the period of time during which the investment yields benefits and costs.An investrnent is deemed socially efFrcientwhen it has a positive net social benefit, and, socially inefficient when it has a zero or negative net social benefit. The discount rate influences the economic efEciency of a resource investment. Lowering (raising) the discount rate increases(decreases)the net present value and economic feasibility of investrnentsthat provide benefits over an extended period of time. Economic theory provides justification for selecting a discount rate that equals the marginal rate of time preference or marginal opportunity cost of capital- Both rates are equal to each other and to the rnarket interest rate when households maxirnize their satisfaction subject to a budget constraint and firms maximize their returns subject to a capital constraint in the absenceof taxes, subsidies, externalities, uncertainties and imperfections in capital markets. Because there are many interest rates in the economy, benefit--cost analysis is often based on a range of discount rates. Discount rates used to evaluate public investments are generally lower than discount rates used to evaluate private investments becausepublic agencies are often mandated to use a specific discount rate that is generally lower than the private rate, they can spreadrisk over many invesúnents, and they are not required to,pay taxes. In determining the economic efEciency of an investrnent, there is no need to distinguish between capital and operating costsor to consider depreciation or amortization of capital and interest payments on borrowed capital. An investrnent is economically feasible when net social benefit is positive, but it is financially infeasible when gross monetary returns are less than capital and operating costs. Investments may be efficient at a local level but inefEcient at a gtobal level. Resource investments can be either independent or interdependent. Investrnents are independent when selection of one investrnent neither alters the net social benefit of any other investrnent nor prevents selection of other investments except for financial reasonsInvestrnents are interdependent when selection of one investment alters the net social benefit of other investments (type D or prevents other investrnents from being selected for nonfinancial reasons(type ID. Specific capital rationing implies that all of the curent budget must be spent on resource investments. Maximum capital rationing only requires that the current budget not be exceededResource investrnents generate primary benefits and secondary benefis or costs. A primary benefit is the increase in consumer plus producer surpluses in the

11. Benefit-Cost Analysis of ResourceInvestments

2n

prirnary rnarket, which is the market most directly affected by the invesùnent. Asecondary benefit (cost) is the increase (decrease)in consumer plus producer surpluses in secondary markets. The preferred way to handle risk and uncertainty is to adjust individual benefits and costs for risk s1 snssrtainty and to discount risk-adjusted benefits and costs using a riskless discount rate. Four economic-based criteria are commonly used to evaluate resource investments: net present value, annual net benefit, benefit-cost ratio and internal rate of return. Net present value is the present value of primary and secondary benefits minus the present value of secondary costs.Annual net benefit is the uniform annual payment over the evaluation period, which has a net present value just equal to the net present value of the investment. Internal rate of return is the discount rate that makes the NPV of an investrnent just equal to zero. The benefit-cost ratio is the ratio of the net present value of benefits to the net present value of costs. With the possible exception of the internal rate of return, economic-basedinvestment criteria generally lead to the sameinvestment decision when applied to independent investrnents. Applying investment criteria to an investnent with type I interdependencerequires adjusting the present value of that investment for changes in the present value of related investrnents.Correct assessmentof type tr (mutually exclusive) investrnents requires applying the criteria to incremental rather than absolute benefits and costs.

Questions for Discussion l. What are some of the major differences between private and public economic evaluation of resource investrnents? 2.T\e United States Environmental Protection Agency (U.S. EPA) has the authority to regulate the use of pesticides in areas that are critical habitat for endangered species.The U.S. EPAproposes a regulation that would ban the use of insecùcide X in region Z. Cotton farmers in region Z use insecticide X to control insect d4mage. EPArecommends that cotton farmers switch frominsecticide X to insecticide Y. Insecticide Y is less effective and more expensive than insecticide X, but it is not regulated. Synthetic fibers, whose production does not involve insecticides, are a substitute for cotton. How would you evaluate the social efficiency of this regulation? 3. Explain'the theoretical basis for selecting the market interest rate as the discount rate. 4. Consider the exploration and development of a 3O0-million-barrel oil deposit in two offshore areas.The first deposit is located in the Gulf of Mexico, which has a mild climate and is close to workers and facilities. It would take about one year to complete exploration and l0 years to develop and produce the Gulf of Mexico deposit. The second deposit is located in the Bering Sea west of Alaska which has a severe climate and is far from workers and facilities. It would take about ttnee ye^rs to cornplete exploration and 15 years to develop and produce the Bering Sea deposit. The likelihood of environmental damages from oil development is much higher in the Bering Sea than in the Gulf of Mexico.

298

Natural Resourceand Environmental Economics

a. Does a high discountrate favor oil exploration and developmentin the Gulf of Mexico or the BeringSea?Why? b. Which of the following two proceduresis the better way to handle the differencesin potential environmental damagesof exploration and development in the Bering Seaand the Gulf of Mexico: Use a higher discount rate in the Bering Seaevaluationthan in the Gulf of Mexico evaluation?Include expectedenvironmentaldamagesin the benefit+ost analysis?Explain. 5. What are the drawbacksof using the paybackperiod and averagerate of renrn to evaluatethe feasibility of resourceinvestments? 6. InvestrnentAhasaninitial costof $200 and investrnentB has an initial cost of $300. The invesùnentsareindependent.Net benefitsin dollars for both investmentsover nine years are: Year

I A B

100 225

z3

110 230

120 235

456799 130 130 230 240

130 220

125 2t0

120 2W

n5 190

Determinethe net presentvalueof eachinvestmentwhen the discountrate is 8 percent.Which investmentwould you selectwhen thereis no capitalrationing?Why? 7. Considerthreemuhrallvexclusiveinvesfrnents: Annual Net Return ($) 300 450 600

A B

c

a. Use the incremental IRR criterion to select the most efficient invesfttent when the discount rate is 15 percent. b. Would you select the same investment with the incrementalBCR and the NPV criteria? Explain.

Further Readings Brennarl Timothy J. 'Discounting the Future: EconomicsandEthics." Resoarces,Summer 1995,pp.3-6. Analysis:An Introùrcfian.New York Praeger. Mishan"E. L lnl. Cost-Benefit Pearce,David W., EdwardBarbier, and Anil Markandya-1990. 'Discounting the Fuh$e." Chapter 2 in &tstainahle D*elopment: Economicsand Environment in the Thid World. London: Earthscanhrblications Ltd., pp. 23-56. Pearce,David W., andR. Kerry Turner.1990."Discountingthe Future." Chapter 14 in Economicsof Narural Resorrcesand the Envirorunenr.Baltimore:The JohnsHopkins UniversityPress,pp. 211-225. Randall,Allan. 1987."BenefitCostAnalysis." Chapter73 tn ResourceEconomics:An EconomicApproach to Namral Resourceand Envircwruntal Políq. New York John S/iley & Sons,pp.23?-?59.

11. Benefit-CostAnalysisof ResourceInvestments

299

Notes 1. Kris Wernstedt, Jeffrey B. Hyman and CharlesM. Paulsen, "EvaluatingAlternatives for Increasing Fish Stocks in the Columbia River Basi-D,"Resources,No. 109, Fall 1992, ppl0-16. 2. Richard B. Howarth and Richard B. Norgaard, 'lntergenerational Resource Rights, Efficiency, and Social Optimality," Land Economics 66(1990):1-11. 3. Satah El Seraff, 'The Proper Calculation of Income from Depletable Natural Resources," in Environmental and ResourceAccounting and Their Relevanceto the Measurement of Sustainable Income, Ernst Lue and Salah El Serafy, ed. (Washington, D.C.: World Bank, 1988)4- Jack Hirschleifer, James C. DeHaven, and JeromeW. Milliam, 'lnvesEnent in Additional Water Supplies" ild, *The Practical Logic of InvestrnentEfficiency Calculations," in Water Supply: Teclmology and Poticy (Chicago, Iilinois: The University of Chicago Press, 1969). 5. Roland N. McKean, Efficiency in Goverrunentthrough SystemsAnalysis (New York: Johr Wiley & Sons, 1958), pp- 151-167; and Otto Eckstein, Multiple Purpose River Development @altimore, Maryland: John Hopkins hess, 1958), pp.2O2-21,4. 6. Hirschleifer et al., Chapter VII (1969). 7. Paul R. Portney, Public Policies for Environmental Protection (Baltimore, Maryland: Johns Hopkins University Press for Resourcesfor the Fuhre, 1990). 8. Hirschleifer et al. (1969) indicate that net benefitsof -1, 3 and -2.5 do not have a nonimaginary solution for p.

CHAPTER

t2

Nonmarket Valuationof Natural and Environmental Resources The idea of putting a money value on datnage done to the environment strikes many as íllicit, even itnmoral. Jrmcr

nun Tunxm' 199O

fEcient use of natural and environmentalresourcesrequires knowledge of the value of theseresourcesin various uses.The epigraph suggests that some individuals (not Pearce and Turner) object to placing monetary values on environmental damages (as well as benefits) associated with alternative uses of natural and environmental resources. Except for the fact that market prices do not reflect the fuIl social cost of resource use, there appearsto be little objection to using market prices as a measure of the scarcity value of resources. Many uses of natural and environmental resources, however, cannot be valued in the markelplace becauseof incomplete or nonexistent markets. Considering the value of natural and environmental resources for which markets exist and ignoring benefits from and/or damages to resources that do not have markets result in a socially inefficient use of resources.This chapter exarnines the importance of rwnmarket vahntion in efEcient use of natural and environmental resources, the theoretical basis for nonmarket valuation and alte,mative nonmarket-valuation methods.

Importance of Nonmarket Valuation Suppose a parcel of public land can be utilized for coal extraction or cattle grazing. The best use of the land from an economic viewpoint is the use that generates the highest net social benefit (total social benefit minus production costs minus environmental damages). Total social benefit of the land in coal and cattle production depends on market prices for coal and cattle. Production costs are based on labor and capital costs, royalty palmrents and severancetil(es on coal, and public grazing fees. Unfornmately, there are no markets that determine

3V2

Nahrral Resource and Environmental

Economics

the environmental darnagescausd by coal extraction and cattle grazing. For this reason,it is difficult to deterrninewhetherusing the land for coal or cattle production is the more socialty effrcient. Similarly, the net private benefit of commercial timber harvestingin a rain forest should be weighed againstthe benefit of preserving the forest's biological diversity in determiningsocially efEcient rates of timher harvesting.While net private benefit of commercialtimber harvestingcan be determined basedon market pric"s for timber and inputs usedin timber harvelfng, there is much more limited and uncertaininformation availablefor estimatingthe benefit of preservingbiological diversity. Someprogresshasbeen madein developingmarketsfor certainnatural and environmental resources.ConsideraA, water and fish or wildlife. The Congressof the United Statesincluded a market-basedscheme for reducing air pollution in the usesnadableemissionpermits to CleanAirActAmendnents of 1990.This scheme 'While water marke8 are being used in sources-r curtail air pollution from industrial parts of the United States to allocate water betweencompeting commercial, residential and agricultural uses,most of the world's free-flowing and stagnantwaters are allocated using nonrnarketschemes.There are private marketsfor fishing and hunting. Unpriced benefitsand/or damagesassociatedwith the useof natural and environmentalresourcescan be handledthreeways. First, they can be ignored. Ignoring benefitsaaddamagesis Likelyto result in socially inefficient resourceuse. Privately efficient ratesof coal production, cattle grazing and timber harvestingare likely to exceedthe sociatly efficient ratesv/hen environmentaldamagesare ignored- Second, physical natural resourceandenvironmentalÍrccountscanbe usedto keep track of resogrcedepletion (see Chapter 10).While this appnoachis better than ignoring depletion,it is dfficult to comparethe monetarynet private benefitsof resourceuse with the physical depletion or overexploitationof resources.Furthermore,when tesourceimpactsare notmeasruedin monetarytems, it is diffrcult to evaluatethe effectivenessand efficiency of resourcepolicies designed to influence production ratesand environmengt 'larnages,suchasroyalty rateson energyminerals and public grazing fees for livestock. ThirE the monetar5rimpactsof resourceusecanbe estimatedusing nonmarket valuation methods.While suchmetlods are notperfecf they provide monetary valuesfor determiningthe net socialbenefitof different interternporalratesof resource use.Basing nahrraland environmentalresourceuseon net social benefit rather than net private benefit contributesto the achievementof sustainableresource develop ment and use. The remainderof this sectiondiscussesthe importanceof nonmarketvaluation in a) determiningefÉcient useof exhaustibleresources,b) implementing natural resource-rnvironmentalaccounting,c) evaluatingresourceprotectionpolicies, and d) evaluatingthe feasibility of alternativeresourceinvestnents. E1rI1CIEIYT USE OF EIGAUSTIBLE RESOURCES. ChErter 7 derives the following criteriorr-for efficient intertemporaluseof an exhaustibleresourcc: MB =MEC +MUC +MNC,

12. NonmarketValuationof Natru:aland Environnental Resources

30:l

where MB is marginal benefit of exhaustibleresourceuse,MEC is marginalextraction cost,MUC is marginal user cost and MNC is marginal environmentalcost.All four termsin this complete efEciency criterion are monetary.If MNC is measured in physical units, such as the number of fish and wildlife adverselyaffectedby coal extraction, cattle grút1 or timter harvesting,rather than in monetary units, then MNC cannotbe included in the efEciency criterion. Excluding MNC from the completeefEciencycriterion results in the following private efEciencycriterion: MB = MEC + MUC. Figure 12.1comparestheprivately efficient extraction rate with the socially efficient exùaction rate. If resourceextraction is basedon the private efficiency criterion, then the firm choÒsesan extraction rate of Q., which exceedsthe socially efficient extraction rate of Q.. Specifically, equality betweenMB and MEC + MUC occursat a higher extractionrate than equality betweenMB and MEc + MUC + MNC. when MNc is measuredin monetary terms, the socially efficient extractionrate (QJ can be determinedand public policies can be developedto reducethe privately efficient extraction rate to the socially efEcient extraction rate- While knowing the physical impacts of different resourceextractionor userates and managementpolicies is bener than ignoring these impacts, determinationof socially efficient extractionrates requires monetaryestimatesof marginal environmentalcost

Val.ua

per

llait

MEC+MI]C+MNC

EÈracaim

Figure 111.1. Privately efficient (QJ and s6r"iallyefficient (QJ resource e#action rates. MB = narginal benefit; MEC - narginal extraction cost; MNC = marginal envíronrnsntal cost; and MUC = marginal user cost

Rate

3M

Natural Resource and Environmental Economics

ChAPRESOT]RCE ACCOUNTING AFID EF{VIRONMEI\NAL NAÎI]R.{L ter 10 discusses two ways of accounting for resource depletion and environmental degradation. Firsl it can be reported in a systern of accounts that measures depleof tioir and degradation in physical units, such as area in deforestation and extent the ozone depletion. Physical accounting makes it possible to determine whether timber hanesting rate in a particular rain forest is at or below the rate of regeneration. While choosing a harvesting rate above the rate of regeneration cÉuses longterrn yields to decline, it is not clear whether it decreasesnet socialbenefit- Second' expressing resoqrce depletion and degradation in monetary terrns allows them to be direct ittÈ$at"d into national income accounts. The rnonetary approach enables of the net social benefit of different rates of resource extraction and use.o-l*iron Daly and Cobb2 developed a natural and environnental resource accounting admethod óun"a the Index of Sustainable Economic Welfare CISEV/). The ISEW justs ttre United States'gross national product (Gl'{P) for monetary losses due to natpero*l ."rouoe depletion and environmental damages. Growth in GNP was 0.80 lower in centagepoints lower in the 1970-1980 period and 0.42 percentagepoints for rettre tg80-f 986 period after these adjushents. Downward adjustment in GNP counin significant source depletion and environmental damages is expected to be resources. For tries whose economies are highly dependent on extraction of natural dornestic gloss example, Repetto et al.3 found that annual growth in Indonesia's 4.0 perproau* tCpÈl during the 1971-1984 period decreasedfrom 7.1 percent to cent after adjusting for natural resorrce depletion' Chapter 10 shows that when there is RESOLIRCE PROTECTION POLICIES. associated pollua proportional relationship between the production of a good and marginal net tioo àarnuges, the socially efficient rate of production occgrs where (MPD)' Provided that the private benefit (MNPB) eiuals marginat pollution damage be achieved by needed information is available, socially efficient production can efficient imposing a Pigouvian-like ta)( on production equal to MPD at the socially the environproductión *t". to determine the socially efEcient rate of production, can require mental authority must know boù MNPB and MPD. While the authority dafnpollution firrns to report their MNPBs, it is puch more difficult to determine ages. proportional' When the relationship between production and pollution is not controlled' to be needs the rate of pollution abatement, not the level of production, when marginal soIn this cas{ polution abatement is at the socially ef6cient level pollution abatement cial benefit of abatement MSBA) equals marginal cost of achieved by levying a Pigouvian tax on MCA). The socially efEcient rate can be benefit of polpollution equal to tnl difference betrreen MSBA and narginat private Even if the enlution abatement (MPBA) at the socially efficient rate of abatemenL tax cannot vironmental authority has inforuration oD MPBA and MCÀ a Pigouvian prices are not be determined without knowledge of MSBA. Unforhrnately, market available for estimating MSBA. how beneEEF.ICIEhIT RESOLIRCE II{VES',TMEhITII Chapter 1l discusses resource fit-+ost analysis is used.to evaluate the economic feasibiliry of alternaúve

12. Nonmarket Valuation of Natural and Environmental Resources

305

investments. Benefits and costs of mostresource invesEnentscontain elements,such as the value of the extracted resource or capital investment, which can be determined from market prices. Other elements, such as reduction in environmental damages, are more difficult to measure due to nonexistent or incomplete srarkets. Consider, once again, the benefits and costs of investing in nvo technologies for removing timber from mountainous arcas. The conventional technology employs trucks and roads and the new technology employs helicopters. The new tecbnology results in significantly less soil erosion and sedimentation of stretrns and rivers than the conventional technology. Reduced sedimentation improves fish and wildlife habitar Comparing the net social benefit of the two technologies requires estimating soil erosion and sedimentation damages with each technology. The preceding discussion shows that a) marginal environmental cost is necded to detennine the socially efEcient use of exhaustible resources, b) monetary damages from resource depletion and environmental degradation are essential for developing monetary natural and environmental resource accounts, and c) either marginal pollutisa damage or marginal pollution abatement costs are required to determine the socially efEcient level of production or pollution abatement. Most of these ele,nents are not subject to market forces. Nonmarket valuation is the primary method ;e1 gsrimating the monetary value of these elernents.

Theoretical Basis for Nonmarket Yaluation Chapters 7 and 8 indicate that resources are being used efficiently when net social benefit is maximized. Net social benefit equals the present value of total surplus (consumer snrplus plus producer surplus) over some planning horizon. Total surplus in each time period equals the area between the demand and supply curves up to the equilibrium production rate. For natrual and environmental resources having well-established markets, such as coal and timber, total sr:rplus can be derived from estimated market demand and supply curves. For this procedure to be reliable, the supply curye should include the marginal environmental cost of production.

TO PAY AND ACCEPT COMPENSATION The primary WILLINGIIESS theoretical constnrct used in nonmarket valuation of natural and environmental resources is willingness to pay (WTP) and willingness to accept contpensation (WTC). Willingness to pay and V/TC for changes in the price, quantity or quality of a resource can be measured by compensating surplus, compensating variation, equivalent surplus and equivalent variation. Because compensating surplus and equivalent surplus assumethat households are entitled to their current levels of satisfaction and because public rcsource management policies typically deal with potential benefits relative to current levels of satisfaction, the surplus measures are more relevant to policy analysis than are the variation measures. Willingness to pay pertains to a) paying a lower price or receiving a higher quantity or quality of the

306

Natural Resourceand Enviro.mental Econonics

resourceor b) avoiding a higber price or lower quantity or quality of the resource. Willingness to acceptóompensationpertains to a) forgoing a lower price or higher quantity or quality ót m" resourceor b) tolerating a higber price or lower quantity of the resourceor quality If the entity valuing the changesin price, quantity or quality is a firrn, then WTp and WTC are rneasuredby changesin profits. There is no difference between a firrn,s WTp and WTC for change, ú p.i"l, quantity and quality. Wiffigness to pay is typically different than WTC for householdsbecausethe value of changesin i"ro,ro" ptice, quantityor qualiry dependson the assignmentof property rights' The remainder of this sectionexaminesa household'sWT? and WTC for changesin resourceprice, quantitYor qualitYConsider measuring a houseVALIJING CHANGES IN RESOLIRCE PRICE. If hold's WTp and WTC for a decrease in the price of water pollution abatementis approthe household does not have a property right to unpolluted water' then it priate to ask the household's WTP for a lower price. The gain in consumer surplus if the houseLom paying a lower price is the maximurn WT?. On the other hand, U/TC hold has a property rignt to unpolluted water, then it is appropriate to ask the The loss in consumer surplus from forgoing the price for giving ip u f"*"iprice. decrease is the minimum WTCMllingness to pay or WTC for a cbange in resource price is measured using price is varthe Hícpsian demand curve.Along a Hicksian demand curve, resource are held conied wbile utility Qevel of satisfaction) and ttre prices of other resources price stant. The Ilicksian demand curve is used to estimate how changes in resource and influence consumer surplus, Algng a Marshallinn dematú ctttve,money income are held constant. The Marshallian demand curve is the prices of other *róu."o difused to determine how changes in resource price affect quantity demanded- The curve demand Hicksian ference between a Marshallian demand curve CDr) and a 12.2. Both demand curves in@j for pollution abatement is illustrated in Figure and the dicate the quantity demanded of pollution abatement on the horizontal axis price of pollution abatement on the vertical axis' DeÀand cgrves are deterrrined by the household's preferences for pollution abatement, incorne and the prices of substitutes for and complements to trnllution polabatement. Anegatively sloped demand curve implies that the per unit value of marginal lution abatement decreases as abatement increases. In other words, the For a re' benefit of pollution abatement decreasesas pollution abatement increases. abateduction in price fu*p, to p2, the increase in quantity demanded of pollution Hickthe along (A, A3) than to ment is gre-ateralong ttre Marstrallian demand curve sian demand curye (A1 to A) because the latter is steetrrr. demand Why is the Hicksian deurand curve steeper than the Marshallian price can be cgrve? In general, the change in quantity demanded from a change in effect is aldivided into a sabstitutíon i6""t and an income fiect. The substihrtion when ways negative, which means that quantity dernanded increases (decreases) in price decreases (inceases). The inóome effect of a price change is the cbange in real income. Real income is cash inàuantity demanded with respect to a change income come adjusted for inflation or deflation. As price increases (decreases), real

t2. NonmarketValuationof Nafural and EnvironmentalResourres

3W

Prica

Pol.].utioa

Figure 122. abatemenL

ÀbaÈeueat

Iìtfarshaltian @d and Hicksian @j) de"'and crrrrresfor pollution

decreases (increases). Norrnal goods have a positive income effect, which meàns quantity demanded increases as income increases.Therefore, the income effect of a price change for a normal good causes quantity de,mandedto increase (decrease) when price decreases (increases). As quantity demanded insreases (decreases), utility increases (decreases). The Marshallian demand curve holds money income constant, which means that the increase in pollution abaternent resulting from a price decrease consists of both a substitution effect and an income effecl Real income is constant along the Hicksian denand curve, which has the same effect as holding utility constanL As Figure 12.2 shows, the decrease in price from py to p causes abatement to increase from A1 to A3. The substitution effect is the increase from A, to A2 and the income effect is the increase from A, to &. Because the Hicksian demand crrve excludes the income effect, it is steeper than the lVln6[alli6 demand curve. The smaller (larger) the proportion of income spent on a good" the smaller (larger) the income effect and the more similar (dissimilar) the Hicksian and Marshallian demand curves. Hicksian and Marshallian demand curves are identical when the income effect is zero. Suppose a household is asked its WTP for a decreasein the price of abaternent from p1 to pz. The change in quantity demanded is found by tracing the price de-

?-

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creasealong the Marshallian demand curye (DrrJ as shown in Figure 12.3. Quantity demanded of abatementincreasesfromA1 to Ar.The household's IV'TP for this price decreaseis the increase in consumer su4tlus between pr and p2 along the Hicksian demand cgrve Ds, namely, p1adp2.Note that the increase in Hicksian consumer surplus is less than the increase in Marshatlian consumer surplus (pradpz< ptaep) bethe Hicksian demand curye is steeper than the Marshallian demand curve. "uns"The household's WTC for payrng a higher price (p, instead ofpJ is the-decrease in consumer surplus between 15 and p, along the Hicksian demand curve D's, namely, prbepz.Willingness to accept cornpensationexceedsMarshallian consumer surplus, which exceedsWTP (Prbep, ) PraePz> PradpJ. The difference between y11.P and WTC for price changes is attributed to the income effect. When the income effect is zero, the Marshallian and Hicksian demand curyes are identical and WT" and WTC are equal. Mllig4 concluded that a) Marshallian consumer surplus is a good measureof changesin household welfare becauseit lies between WTP and q1TC and b) the difference between Marshallian and Hicksian constuner surplus measures of WTP or WTC is frequently less than 5 percent. Hence, Marshallian consumer surplus is a good approximation of the value of changes in resource prices.

Pol.].uÈion

.àbàÈene t

to Figure 123. Sillingness to pay for a decrease in price (p, to pr) and willingness pollution abatement' acóept compensation-for a higher price ft11instead of pJ for

12- Nonrnarket Yaluation of Natural and Environnental Resources

3(D

VA,LUING CEANGES IN RESOURCE QUALITY. Consider estimating the value that a householdplaceson an increasein waterpollution abatement.Willingnessto pay and WTC for water pollution abatementare evaluatedin Figure 12.4. The horizonal axis is householdexpenditureson abatement@A) and the vertical axis is householdexpenditureson other goods(EO). Becauseprices of abatement and other goodsare being held constant,changesin expendituresùanslate directly into changesin consumption.AII combinationsof expenditureson abatementand expenditureson other goods along an indifferencecurve provide the sane level of total utility or satisfactionto the household.Expendinuecombinations along U, provide greater utility than expendinue combinationsalong U1. The indifference curves are convex ('u). This meansthat the householdfu yilting to glve up smaller and smaller amountsof the other goods to gain additionalunits of abatementwhen utility is held èonstant.Conversely,the householdis willing to give up less andless abatementto gain anotherunit of other goodswhenutility is held constanl If the householddoesnot have a property right to clean water, then W'Tp for an increase in water pollution abatementis the appropriatemeÍNnreof the change in consumer suqrlus.The maxiurum amount the householdis willing to pay for an increasein abatementfrom EA, to EAq while naintaining the originut t"u"i of utilnr'tr'aA,ei

Otber

gl3eg

OD,

Goods

&qnodJ.Èrrras orr Pollution ÀbaÈqent' 'Willingness Figure 12-4. to pay for an incnease in pollution abatenent and willinguess to accept comlrcnsation for a lower level of pollution abatement hotding prices constant U = utility.

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Natural Resourceand Environmental Economics

ity (UJ is the reduction in expenditures on other goods, namely, EOr - EO2. In other words, WTP - EO, - EOr. S/hy? Increasing abatement from EA, to EA, causes utiliU to increase unless consumption of other goods is decreased. Therefore, maintaining utility at U, when abatement increases requires the household to decrease consumption of other goods. Therefore, between a and b, the household must offset the increase in abatement from EA1 to EAz by decreasing consumption of other goods from EO, to EOr. Due to the convexity of the indifference culVé, the offset amount decreases (increases) as abatement increases (dec:reases).Therefore, W'IP for water pollution abatement decreases (increases) as abatement increases (decreases). 'When the household has a property right to clean water, WTC for a lower level of abatement is the appropriate measure of the change in consumer surplus. If the household has a right to EA2, then the starting point for valuing changes in environmental qualiry is at c where pollution abatement is EA2 and expenditures on other goods is EO1. Because point c provides higher pollution abatement (EA2 > EAr) but the same expenditure on other goods (EOr) as point a, it must lie on a higher indifference curve, narnely, Ur. The smallest arrrount of compensation the household is willing to accept for EAr instead of E Ao is the additional expenditure on other goods required to maintain the original level of utility (U). Therefore, WTC - EOr - EOr. When expenditure on other goods is increased from EOr to EO3 and abatement is EAr, the household is at point d on U2. Comparing WTP to WTC for a change in water p,ollution abatement shows that WTC > WTP (Eq - EO, > EO, - EOr). This relationship holds when the indifference curves are convex (u). The magnifirde of the difference between WTC and WTP depends on the size of the income effect and the degree of substitutability between pollution abaternent and other goods. If the income effect is zero or there is another good that is a perfect substitute for the resource, then WfP and WTC are identical.5 Income effects are negligible whenever a small proportion of household income is spent on the good. A similar procedure is used to determine the value of changes in resource quantity.

TO PAY AI{D \MILLINGI\TESS II\IEQUALITY BETlryEED{ WILLINGNESS Not surprisingly, empirical estimates of WTC TO ACCEPT COMPENSATION. are generally higher than estimates of W"IP. Hanmack andBrownd found that'WTC was Òver four times greater than WTP for changes in waterfowl benefits. In addition to the theoretical argument just presented, there are several other rearions why WTP is less than WTC. First, WTP is constrained, whereas WTC is unconstraine4 by income. Asking a household their WTP for pollution abatement is appropriate when the household does not have a property right to an unpolluted resource and the reduction in pollution represents a potential gain in welfare. Like the purchases of any other good' WTP for environmental improvements is constrained by the household's income. This is not the case for WTC. ffitlingness to accept compensation represents the household's willingness to accept compensation for the loss in welfare from forgoing an environmental improvemenL Courpensation required by the household would be paid by someone else, perhaps the entity whose actions deny the improvement in environmental quality. Because WTC is not constrained by the household's income, it is likely to be greater than WTP. Secon{ WTC is likely to exceed S/TP when households view the welfare loss

lz

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311

from a reduction in environmentalquality as more serious than the welfare gain from an improvement in environmentd quAity.'When the household has the right to-environmental quality, as implied by wTC, denyrng that right reduceswelfare. 'When the householddoesnot havethe right to environiental quairy, asimplied by 'WT?, improving the environmentprovidesa welfare gain. Third wTC is likely to exceedwTPwhen nousÀolas believe they should not have to glve up their rights to environmentalquality. Households *igrrt express their unwillingness to up such rights by placing ligh values oo wrc. Fourth, Flve high wrc values could result from cautiouJ b"hat ior on the part of households. True WTC is likely to be overstatedby householdsthat arenot sure how to respond, are adverseto risk, or have lirnited experiencewith wTC questionsInequality between WTP andWTC suggeststhat care needsto be taken when these values are used as a basis for allocating resources.As shown in Chapter 11, resource investment and policy decisionsinvolve a comparison of benehts ano costs' It is quite possible for benefitsto exceedcostswhen benefits un"-"**"aiy WTC and for costs to exceedbenefitswhen benefits are measured by WIp. [1 this case,the best strategy is to postponea decision regarding the investment or policy until a more detailed assessmentof benefitsand costsis inoertaken.

Use and Nonuse Values The preceding section expleins how WfporWfC are used to measure changes in consumer surplus brought uuoot by changes in resource price' guantitr or quality. Total social benefit of chLges in resource price, quantity or quality in a given time period is determined by uaaiog up wlp or wrc for all households who place a value on the resource. rf the preslent value of the strean of total social benefis minus total social costs is positive (negative), then the change is socially efficient (inefEcient). overestimation of social benefits and/or underestimation of costs can lead to acceptanceof resource price, quantity or quality changes that are socially inefficient. Conversely, underestimation'of benefits and/or overestimation of costs can lead to rejection of changes that are socially inef6cient Both types of elrors are reduced by properly measuring all relevant benefits and costs. While rneasurement of benefiB and costs is equanf importanE most nonmarket val_ uation studies concentrate on social benefits. Four resource values comprise total social benefit usevalue, option value, existence valuc arrd bequcst value- option, existence and bequest values are nonuse values that are independent of resource use. This section discusses how use and nonuse values un" to evaluate a policy for reducing the frequency and acreage ":d. of federal timb€r sales in a national forest. The policy is-éxpected to reduce both the acreage available for timber harvesting and the rate of ti-b* harvesting and ro euhance recreational opporhrnities

(Jse value is the value of the UsE VALIIE forest to those who use it for timber harvesting, fishing' hunting, hiking, canping and wildlife viewing. Timber harvesting, fishing and hunting are cousumptive uses. Hiking, carnping and.wildlife view-

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ing are nonconsumptive uses of the forest. In addition, fishing, hunting, camping and wildlife viewing are recreational usesof the forest. Suppose timber harvesting and recreation are competitive uses of the forest at current timber harvesting rates. Then, reducing timber harvesting rates decreasestimber values and increases recreational value. Specifically, the proposed policy lowers income, employment and local taxes from timber harvesting and raises income, employment and local taxes from recreation. One way to evaluate a reduction in timber harvesting is ffterms of an increase in the supply of recreational opportunities, which lowers the price of recreation. The effect on consumer surplus of a lower price for recreation is illustrated in Figrue 12.5. When the price of recreation decreasesfrom Pr to Pz, consumer surplus increasesby a + b.

Option value is a household's WTF to preserve the option of OPTION VALIIE. having an ireplaceable resource available for future use. Option value is a legitimate resource value when resource supply and/or demand are uncertain, use is infrequent, and converting the resource to an alternative use makes it very costly to restore the resource to its original use (irreplaceability)-7 Consider the option value for a unique natrual resotrrce such as Grand Canyon National Park or Everglades National Park. Demand uncertainty arises when a household is not sure whether he or she or others (children, grandchildren) will ever

Príce

QrraaÈit'Y

Figure 125. Qhangesin consumer surplus from a demeasein the price of forest recreation from p1to Pz.D = flglarnd-

12. Nonmarket valuation of Natural and EnvironmentalResources

3tt

visit the park- Supply uncertraintyarises when there is a possibility that the park might be developed for other purposes or that land uses outside the park mighi reduce the recreational and ecological benefits of the park. Infreqo"rrìy of use is a source of option value. Irreplaceability becomes an issue when alternative uses of the park make it very costly tro return it to its original use or value. Irreplaceability wasthe basis for rejecting a proposal to build a courmercial jetport in Everglades National park. Op. ponents argued that the proposed jetport would cause severtr and irreversible ecological damage to an irreplaceable natural asset. Option value is applicable to prlvate as well as public resources. For exarnple, high rates of commercial timber harvesting in rain foiests have the potential for destroyirig potentially valuable plant and animal species.This is especially tnre when there are few, if any, testrictions on the location andrate of harvesting. There is sup ply uncertain$r because, quite often, no inventory is made of potentiaily valuable plant and animal species before harvesting. Demand uncertainty exists bécause relatively linle is known about the potential pharrraceutical, medicinal and ecological value of afFectedspecies. When the conditions necessary for option value are present, households might be willing to pay a fee to ensure the option of gainilg *ó"r, to the resource. Weis_ brod (1964) argued that the most socialty benéficial use of Sequoia National park should be deterrrined by comparing the recreational value (including use and option values) to the value of harvesting the park's redwood nees. lgnoriig option value for the park leads to underes"mation of its recreational value and increases the likelihood of choosing the hanresting alternative. Option value becomes relevant in decision making when there is a threat that the unique services provided by a resource are in dangei of being lost. For exarnple, the option value of Everglades National Park was relevant to the decision of whether or not to constnrct a commercial jetport in the park. The jetport would have done irreversible darnage to the Everglades'delicate ecosystems.Furthermore, there are no good substitutes for the Everglades. After the decision was made not to build the jetport' option value was no longer a relevant part of the total social benefit of the park. As long as the ecological services of the park are preserved by current management practices, provision of the option to preserve the park is automatically provided at no a
3L4

Natural Rmource and Environmental Economics

EKSTNCE VALIIE. Existencevalueis the amounta householdis W'TPfor the in a particular state-Existencevalue is based that a resourceis prreserved rui$11ance on the knowledge that the resourceexists and is completely independentof use or option value. People derive satisfactionfrom knowing that humpback whales are not harvestedto extinction; AusÚalia's Great Barrier Reef is preservedin perpetuity; and lion, elephant,rhinocerosandgiraffe are protectedin SouthAfrica's Kruger National Park The membershipsof many organiz3lisns, such as ttrsrNational Wildlife Federation, Audubon Society, Sierra Club and Wilderness Society, are made up of householdswho value wild animals and wild places.The closest many of the mernberscome to wild animalsand placesis,n magazinearticle or documentary film. Yet, they arewilling to supporteducational,scientificresearcb,habitat and breeding programs that protect a wide rulngc of wild places and animals. These householdsderive saúsfactionfrom the mere knowledge that wildness is being preserved.Prctection of certain speciesis sometimesconhoversial,such as the reduction in timber harvestingratesin old growth forestsof the Pacific Northwest to protect the habitat of the northern spotted owl, inhoduction of tirnber wolf in YellowstoneNational Park and the preservationof gnzz;lybearsin Idaho, Montana and'Wyoming.

BEQTIEST YALIIE. Knrtillae identifies another nonuse value called bequest value-Bequestvalue is the satisfactionthat a householdderivesfrom knowing that a resouroewill be availableto future generations.Krutilla usesbequestvalue to algue for public protection of uniquenahral areas.Bequestvalueis like option value in that it representsa willingness to pay for future availability of a resource. It differs from option valuebecausewhat is being preservcdis funre use, not by the person holding the value, but by someoneelse. Bequest value is similar to existence value becauseboth valuespertain to satisfaction derived fron simply knowing that a resourceexists.Both usersand nonusersof a resourcecanhavebequestvalue, although it is likely to be higher for householdswho have usedthe resource.Option, existenceandbequestvaluesarerelevantonly when the resourceis being tbreatened or dauraged. 1qsuminary,the effect of a changein resourceprice, quantity or quality on total social benefit includesuse andnònusevalues.While the value of many uses can be esrimaredfrom market prices and quantities, use and nonusevalues are usually estimatedwith nonmarketvaluation methods.

Estimation of Nonmarket Values There are two major approachesto estimating the to' tal social benefrt of changes in resource price, quantity or quality: indirect marl
72. Nonmarketvaluation of Nafurar and Environnental Resources

315

different timber haniesting rates. Indirect market methods include averting betwntior, weak cornplementurtry (which includes the trantel cost methoù andlwdonic pricing. The direct questioning method asks households theiryTp orWTC for specific changes in price, quality and/or quantity of a resource. The primary direct questioning technique is the conrtngent vahnrton method-This section discusses the estimation of the value of changes in resource price, quantity and quality using indirect market and direct questioning methods.

IhlrlrREcr MÀRKE:I METHODS. Economists prefer to estimare chanses in consumer surplus from statistícally estirnated demand.curves. Because estimaton of dernan6 curves requires inarket data on pnces and quantities, it worls well for marketed resources. Indirect market methods allow the estimation of use and nonuse values of nonmarketed goods based on the market for related goods. Ind.irect market methods exploit the fact that changes in the price, qu*tity *d quatity of nonrnarketed natural and environmental resources influence the value of marketed goods. This section exarnines three indirect market rnethods: cost of averting behavior, weak complementarity and hedonic pricing. Cost of AveÉing Behavion This approach recognizes that households respond to changes in the price, quantity or quality of a nonmarketed resource by modifying their purchases of related marketed goods. Smith and Desvousgesro póint out that households can avert some of the damages from polluted drinting water by purchasing bottled water. Dickie and Gerkingu indicate that households install ui, ditioners to reduce the adverse effects of poor air quality. Consider averting "onbehavior for a rural community whose drinking water has nitrate-nitrogen conceitrations that exceed the safe drinking water standard.The stand.ard.is exceeded in the spring when nitrogen fertilizer is applied to nearby farmland. Apossible averting behavior is for households in the community to switch from well *uto to bottted watef, in the spring.The cost of bonled water is an e,stimateof the maximum total willingness to pay for improving well water quality. The cost of averting behavior has certain drawbacks. First, expendihrres are likely to underestimate the surplus value of an improvement in resource quality. If, in addition to reducing their exposure to polluted tap water, a household swirches to bottled water because it tastes bener, then the cost of bottled water is likely to overestimate the household's WTP to reduce pollution of tap water. Seconà, the approach only works when there is an appropriate averting behavior that can be valued in the marketplace. For example, an appropriate averting behavior for reducing the negative impacts of high timber harvesting rates on recreation in a national forest is to increase recreation in a state forest. Unfornrnately, there is no market for estimaliag the value of resreation in a state forest weak Complementarity. This approach estimates the value of a resource attribute in ternrs of the differerice in values of the resource with and without the attribute- The weak complementarity approach is cornmonly used to estimate the value of altering the attributes of a recreational site, such as a forest or park. Validity of the approach requires that accessto the site is not free and that weak complementarity exists.

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How well do these conditions apply to the timber harvesting-recreation oXsrrt: ple? Access to national forests is not free. There is a public access fee as well as the out-of-pocket aqd time costs of traveling to the site. The relationship betrveen the reduction in timber harvesting and the recreational value of the forest satisfies the nvo conditions for weak complementarity given by Maler and by Bockstael and McConnell.12 Specifcally a) recreationists' rnarginal utility of reducing timber harvesting in national forests is zero when no visits arc made to the forest, anFÚ) there is a choke price above which consumption of forpst recreation is zero. The weak complementarity method for measuring the recreational value of reduced timber harvesting in a national forest is illustrated in Figure 12.6.ln this figure, the vertical axis measures the cost per visit and the horizontal axis measures the number of visits in a particular national forest. The demand curyes represent the sum of the Hicksian demand curves for all usen of the site. With policy l, timber harvesting is maintained at the current high rate and the Hicksian recreational demand curve for the forest is Dt. ff use of the forest requires payment of a daily fee of pr, total consumer surplus for the forest with policy I is p1ab.'With policy 2, timber hanresting is lowered, which enhancesrecreational opportunities causing recreational demand for the forest to increase from D1 to D2. If the access fee remains at p1, then total corunrmer surplus with policy 2 rs Prdc. Therefore, reducing the harvesting rates in the forest increases total consurner sur-

Value

per

VisiÈ

Vigits

f igure f1.6. Incrrased vahle of forest recreation from a reduction in tinber harvesting D = demand.

A

Nonmarket Valuatíon of Natural and Environnental Resources

317

plus from recreation by an amount equal to the area above p, between D1 and Dr, namely, abcd. The net social benefit of reducing timber harvesting equals the increase in consumer surplus due to enhancedrecreational opportunities minus the decrerrse in the value of commercial timber harvesting. Ibavel Cost Application of the weak complementarity method. 6f y4luing recreational sites requires estimation of the demand curve for the site. Demand is estimated by relating 1fugnnmfogr of visits to cost per visit. While number of visits varies across users, the access fee is the samefor all users of a particular site. Hence, the price variation needed îo estimate the recreational demand c'rve must come from another source. Tlne travel cost methodrecogmzes that visitors who reside farther away from the site incur a higher travel cost than visitors who reside near the site- In other words, the travel cost method uses the variation in the cost of Eaveling to the site (travel cost) as a proxy for variation in the cost per yisitThe theoretical basis for the travel cost method is the hàusehold production function theory developed by Becker, Lancaster, Hori, and Bockstaei and McConnell-r3 This theory states that households generate utility by combining external inputs (purchased goods) with internal labor to produce desired goods. Ii- terms of recreation, households produce recreational experiences by combining time, transportation services, rec:reational equipment and recreational sites. The basic travel cost method has its origins in the writings of Hotelling.r4 He theorized that the dernand curve for outdoor recreation at a particular site b. timated statistically by relating participation rates to îhe corresponding travel ""rcosts for different user groups. Recreational value of the site is ttren istimaien by the total areaunder the demand curve. Clawsonrsutilized the basic travel cost method to estimate demand functions for several national parks. Hotelling, and Clawson and Knetschr6 used surveys to determine the number of visits to a rec:reation site by users who reside in various concentric distance zones around the site- Total visits are divided by the population of users in each disrence zone to obtain average visits per person for each zone. Per capita visits to a site account for the two major components of arecreation decision, namely, whether or not to recreate at the site and, when recreatiou occrus, the nurnber of visits. Average round-trip distance between a zone and the site is multiptied by the average travel cost per mile to obtain an average travel cost for the zone. The demand curve for a site is estimated using a two-step procedure. First, a statistical technique called regression analysis is used to estimate the travel cost denand function for the site. A typical travel cost demand function is as follows: V.ir = f:@i., p;r, \,

Si),

average per capita visits from the jth distance zone to the kth site, Pjr = average travel cost from the jth disrance zone to the kth site, Pjr = average travel cost from the jth rtistance zone to the sth substitute site, Yj=

average income of households from the jth distance zone, and

Natural Resource and Environmental

31E

Economics

Sj = àverago socioeconomic characteristics of households frorn the jth distance zone. Second, the travel cost derrnnd curve for the site is derived from the Eavel cost demand function by holding all variables except \r and pg constant at their means and taking the inverse of the resulting function, namely: s Pjt = f:-t(ViJ' where f.i-t stands for the inverse of fl. A typical travel cost demand curve (D") is depicted in Figure 12.7. Several refinements have been made to the basic travel cost method to improve accuracy of consumer surplus estimates. These include adding income and other socioeconomic factors as demand shifters,lT accounting for the quality of the site,ls irnproving statistical accuracy of estimated demand curves by using data for individual recreationists,le treatrnent of on-site costs as a fixed cost,2oseparating the price variable into transportation costs, travel time costs and on-site costs,2r accounting for substitute sites,z and others- These and other aspects of the travel cost method are reviewed by Ward and Loomis.a

Av€raga Travel per VisiÈ Cost

visits per

CalliÈa

Figure 12.7. Estimated travel cost denand orve for a national forest (DJ and decreasein consurnersurplus (shadedarca\ fuom an increasein accessfee ftom Pr to Pz-

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Nonmarket valuation of Natural and Environmental Resources

319

Suppose the recreational demand curve for a national forest is D" in Figure 12.7 and that D. has been estimated with the trayel cost method. Recreational value of the forest equals consrrmer surplus, which is the total area under the demand curve. Because the travel cost method uses actual visits and travel costs, the resulting demand curye and consumer surplus .t" l4srshallian. A typical use of a recreational demand curve is to estimate the change in consumer surplus from an increase or decreÍrse in the access fee for the foresl For exarrple, suppose the access fee is increased from pt to pr. The estimated decreasein consumer surplus from the price increase equals the shaded area. As shown in Figure l2-7, changes in recreational value due to price changes are easy to evaluate with the Eavel cost method once the recreational demand function has been estimated. It is much more difficult to estimate the value of changes in recreational quality that shift the demand curye for the site. The basic travel cost method estimates the demand curve for a particular site at a given point in time when the recreational qualities of the site are fixed. One way to overcome this difficulty is to estimate simultaUeously the demand curye3 for multiple sites having dif_ ferent recreational qualities. Consider once again Figure 12.6-LetD, be the Hicksian demand curve for a national forest with high hanrest rates and D, the Hicksian demand curve for a different national forest with low harvest rates. ffother qualities of the two forests are similar, then area abcd is an estirnate of the increaseà recreational value of the site from reducing the harvest rate. The travel cost rnethod has certain limitations and ambiguities, some of which have been remedied. These include exclusion of nonuse values such as option, existence and bequest values, selection of the variable for measuring use rates (number of visits or visitor days), downward bias in es"mates of consumer surplus from omining time cost and the price of substitute sites from the demand function, valuing the oppornrnity cost of travel time and on-site time, accounting for multiple characteristics of a site and multiple reasons for visiting a site, and choice of the mathernatical form of the travel cost demand function. Thavel Cost Studies. Reiling et al.2aused the tavel cost method to estimate the recreational benefits of improving water quatity in Upper Klamath Lake, Oregon. Travel cost data for four lakes, including Upper Klarnath Lake, were used to esti_ mate a regression equation for the four sites. Separateequations were estimated for visits per capita and number of days per visit Results showed.that improving water quality in the lake increasesthe value of recrearionalvisits by $10 p"i"irit oi $:.SO per user day for visits that averaged 2.8 days (in 1968 dollars), The improvernent in water quality was projected to increase total visits by 158 percent and total benefits by $3.8 million per year. Smith et al-È used several travel cost models to estimate the increase in consumer snrplus from improving water quality on the Monongahela River. Survey data used in their evaluation covered 13 sites along the river. Estimated Marshallian consumer surplus for improving water quality from boatable to fishable ranged from $0 to $8.74 per household in 1982 dollars. Eedonic hicing Method. The hedonic pricing method is based on the premise that the observed market price of a marketed good is a function of the prices of the

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numerous attributes of that god. For example, the incrementalvalue of owning a housewith a scenic view is the price of a housewith a scenicview minus the price of a house without a scenicvieq provided all other attributesof the two housesare similar. Likewise, the monetaryvalue of the additional risk that iron workers take in installing the steel understnrctureof buildings is the averagewage received by iron workers minus the averagewage received by constuction workers who perform tasks involving lessris( such as phunbers. A typical hedonicprice function is as follows: P = E(ar,42,"',4, S) wherep is the price of a marketedgood (price of a houseor wagerate), g is the functional relationship betweenprice and attributes, à17L2,...,1arethe n attributes of the good and S representssocioeconomiccharacteristicsof thehousehold.'Wheng is an inverse function: p = co - ct(l/a) - c2(lla)

co(l/a),

where c6 is the intercept of the hedonic price function and ct is the change in the price of the good for a unit change in attribute i, holding all other attributes constanl ci is the marginnl prtce of attribute i. It equals the change in the price of the god with respect to a unit change in the value of attribute i when all other attributes and socioeconomic characteristics of the household are held constant. If p is the price of houses and attribute i is a scenic view, then ci is the marginal price of having a house with a scenic view. The hedonic price function is typically estimated using regression analysis. If a' is scenic view and the corresponding regression coefficient (ct) is $5,000, then a scenic view adds $5,000 to the value of a house when all other attributes are held constant. To ensure accuftrcy in estimating marginal prices, all relev'ant attributes of the goodmustbe included in the hedonic price function.In equilibriuur, households equate their marginal witlingness to pay for an attribute to its marginal price. Therefore, marginal prices are estimates of the marginal willingness to pay for atributes. The hedonic pricing method estimates the value of relatively small changes in the attributes of a good- For large changes in attributes, the estimates of ci represent upper limits on long-run changes in attribute values-6 Mitchell and Carsont identify several drawbacks of the hedonic pricing method. First, marginal prices are not accurate unless all the attributes of the good are included in the hedonic price function. Secon{ data for estimating the hedonic price function are often clifficult to acquire, especially for goods that have slow turnover rates. For example, it is difficult to acquire comparable prices for houses that have a scenic view becauseturnover rates for such houses are low. Third, even though different functional forrns result in dtfferent marginal prices, there is no theoretical basis for selecting a particular functional form G) for the hedonic price function. Fourth, households may not be aware of differences in the attribute being valued. This is especially tme of attributes that are not so obvious, such as the concentration of chemical contarrrinants in drinking water or air. Other attributes, such as a scenic view, are very noticeable. Fifth, expectations about how an attribute changes over time can affect the

n.

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value that households place on that attribute. For example, if residents of a community believe that the odor causedby a nearby animal feedlot is going to decrease because of new regulations on air pollution, then their WTP for a reduction in air pollution is likely to be low. While such expectations influence WT?, they are not directly observable. Sixth, it is difficult to estirnate simultaneously changesin marginal prices of an attribute at substitute sites. Finally, the assurnptions commonly used to identify demand and supply functions in the hedonic pricing mod.el are generally incorrecl Eedonic lbavel CosL The hedonic pricing method was originally used to estimate the marginal prices of atnibutes of marketed goods such as houses and labor. 'When the good under consideration is not marketed, there are no market prices and the hedonic price function cannot be estimated. Public recreation is a prime example of a good that does not have a market price. Unlike a house with a view, a public recreation site cannot be purchased. Hence, the marginal prices of auributes of recreational sites cannot be estimated with the hedonic pricins method. The hedonic ffavel cost metho4 which is a variant of the hedonic pricing method, was developed to estimate the marginal prices of anributes of recreational sites and other norunarketed goods.T Because the attributes of a given site are fixed, the hedonic mvel cost method must be applied to multiple sites with different levels of attributes. The demand equations for site attributes are: Y' SXi = 1,-..,n) 4 = g(Pr, P2,-.-,Pn, where q is the level of attibute i, n is the numher of attribut€s, pr, p2,...,p- are the respective travel costs per visit for the m sites, Y is household income and S representsthe socioeconomic characteristics of the household- When g is an inverse function, travel cost to site k is:

Pr=C-b/qft= where C is travel cost with an infinite anount of attribute i, b is a positive constant and q is the level of attribute i. C and b are influenced by other site attributes and. socioeconomic characteristics of the user.The inverse travel cost function illustrated in Figure 12.8 is aqmrptotic to C, which me^ns that p1 approachesC as ai increasesTravel cost functions for an attribute can be esrirnated using survey data on travel costs to various sites incurred by different households. The marginal price of attribute i (pr), also known as the marginal price function for attribute i, eqrrals the change in travel cost associated with a change in the level of the attribute. The marginal price function is: Pi = b/a1This function is illustrated in Figure 12.9. Marginal price is inversely related to the level of the attribute, which imptes rliminishing marginal utitity for the attribute. In equilibrium, the marginal price of an attribute equals the marginal WTP for the attribute. Therefore, the marginal price function is equivalent to the demand function for the attribute- Because the marginal price of an attribute in the hedonic Eavel cost

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Itlrawe1 Coet Èo SiÈe J

ÀttrilluÈa

Flgure let.

L

Inverse havel cost frrnction for site j-

method is not derived from market prices for recreation, there is no guarantee that it is positive. For example, ease of accessto recreation sites is Ukeiy to be better the closer the site is to an urban area. Travel cost to sites near urban areas is likely to be less than travel cost to more remotely located sites- la this case, Eavel cost is inversely related to ease of access, which mezns that the marginal price of Írccess is negative. Due to the equivalence of the marginal price function and demand function, the marginal price is an estimate of the vzrlueof changes in the level of an attribute. Sup pose the recreational attribute of interest is the degree of solitude experienced by baclqrackers in a wilderness area- Solitude is inversely related to the number and size of otherhiking parties encounteredwhile backpacking.In tems of Figure 12.9, the marginal price of solitude decreasesfrom pi1 to powhen solitude increases from Qr to fu. The value of more solitude eqrrals the increase in consumer surplus, namely, pircdprz.

DIRECT VALUATION METEODS. Indirect valuation methods have the limitations mentioned above and require estimation of Marshallian and Hicksian demand curves. Direct valuation rnethods do not have these limitations. The primary direct valuation lechnique is the contingent valuation metlnd (C\n!$- With the CVM, the value of a good is estimated by multiplying the average WfPor'WTC for that good in a sample of households by the nurnber of households in the relevant population. Willingness to pay and/or WTC for sample households are estimated

12, Nonmarket valuation of Natural and Environmental Resour.ces

based on their responses to a set of structured questions asked by phone, maíI or in person. The CVM is applicable to bothprivate andpublic goods.In the case of private goods, market data are available to estimate demand and supply curves and consumer surplus. This is not the case for public goods.For this reason, most applications of the CVM deal with valuation of changes in the price, quantity ana qùafiry of public goods, especially changes in environmental quality. Ttre neit section describes the theoretical basis and application of the CVM. Theoretical Basis for Contingent Valuation Method. As explained earlier, WTp and WTC are the main theoreúcal constnrcts underlying nonmarket valuation of public goods. Consider the following Hicksian demand function (Dj for a public good: P,, = Dn(9", q', F, LD' where pu is the price of the good, qo is the quantity consumed of the good, gn is a vector of quantities consumed of private goods, F representshouseholJpreferences for all goods and U is a constant level of utility. Hicksian demand funcùons of this type are depicted in Figures lZ.Z, lZ.3,l2-5 and12.6.

MarginaJ. Price of à,ÈÈribute i

Att=ibrrte

Figure 12.9. Marginal price function for attribute i.

i

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suppose the quantity of a public good is increasedfrom q, to qz. The Hicksian compensating surplus (CS) and Hicksian equivalent surplus @S) values for the increased quantity are depicted in Figure 12.10. Dnr (DHJ is the Hicksian demand function when utility is constant at U1 (U). Compensating suqplusis the area under Dgr between q1 and q2, namely, grabgz. Holding utility constant at u, implies that the household is entitled to the endowment of properry rights associatedryith qr. The Hicksian equivalent surplus CES)from the increasedprovision Ef the pubIic good is the area under Ds2 between qr and qr, namely grcbgz. Holding utility constant at U, implies that the household is entitled to the endowrnent of property rights associatedwith q2. In general, Ur * Uz. Compensating surplus and ES measures cen also be derived for a change in the price and/or quality of a public goodA second and theoreticalty equivalent way to define consumer su4llus is in terms of the expenditurefunction. An expenditure function indicates the minimum expenditure orminimum amount of income neededby a household to achieve a particular level of uúliry when prices and quantities are at certain levels. The expenditure function is defined as follows:

Y = e(p,q, u), where Y is expenditure,p is a vector of prices for private and public goods, q is the quantity and quality of the public good and U is utility. Based on îhe expenditure function, CS for an increasein the amount of the public good from qr to q2 is:

Quaa,Èity

rìgure L2.10. Hicksian compensationsurplus (qrabqJ and equivalent surplus (qrcbq) from an inqrase in the nrnount supplied of a public good from ql to ll2. D = demand.

t2.

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CS = e(p, gr, Ur) - e(p, gz,U,) = y, - yr. using cs implies the househordis entitled.to q1.Becausean increasefrom q, to q, makesthe householdbetteroff, the only way utility can be held constantat Uì is for the household to reduce total expenditures.Therefore,y, > y, which implies cs > 0. Yt - Y2 equals the maximum willingness to pay for the increasedqu*tity of the public goodThe corrcspondingES that makes the householdwiling to take q, instead of qzis: ES : e(p, er, U) - e(p, qz,Ut - y', -y,r. Using ES implies the householdis entitled to q,. Making the householdtakeq, when thereis an enritlementto q2reducesutility.The only way u$ity can be hià con_ stantat U2 is for the householdto increasetotal expenditure.Therefore,y,11y,2, which implies ES < 0- Y'r-Y'requals the smallestamountthehouseholdis willing to acceptto consumeq, insteadof qz.rn gene,ral, y, - % *y,, -y,2, which impties CS * ES. Two definitions have beengiven for CS and ES. The first definition, based on the area under the Hicksian demandfunction, is usedin indirect valuation methods suchas travel cost and hedonicpricing. The seconddefinition, basedon the differencebetween two expenditures,is the basisfor direct valuation,notably the CVM. While both definitions are mathematicallyequivalent,the CVM approactr has certain advantages-First, the cvM does not require estirnationof Hiìrcian demand functions. Second,the CVIVÍ only requires ttràt householdsbe askedtheir WTp or wrc for changesin the price, quantity or quality of a good, which avoids someof the difEculties encounteredin applying direct valuatiorimethods.The CVM has its shareof problemsas discussedin the next section. application of cYlì4 The CVM method has been usedto estimatethe value of improving water quality, increasingvisibility by reducing air pollution, protecting groundwater,presenring endangeredspecies,ieoucing congestionand increasing the harvestsuccessin big gamehunting,reducingthe likenhód of oil spills,and enhancingfish, wildlife and wildernessresources.A major concernwith the CVM is the reliability of WTP and WTC values. Efforts to e-nhance reliability have focusedon improving the design and execution of C\IM surveysand the statistical analysisof the results. A major criticism is that the WIP andWTC valuesfrom CVM surveys are derived from responsesto hypotheticalquestions.This criticism is often stated as:Ask a hypothetical questíon, get a hypothetical answer.Hypothetical questioniot ** therisk of grving unreliable resultswhen respondentsa.è oot well infomred enough to state their WrP or WrC becauseof inexperiencewith the good or misunderstandingregardingthe information being requestedin the survey.Surplus valuesestimated using indirect proceduresare less vulnerableto the reliability criticism becausethey are derived from observedmarket behavior.The tavel cost method.uses information on how far recreationistsactually fravel to reacha site and the average costof traveling. The hedonicpricing meùod employs actualdifferencesin marketdeterminedvaluesof a related good to estimatethe value of someattribute of that good.

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Proponents of the C\IM argue that reliability of CVM-based surplus values can be achieved by proper design of the survey questionnaire and carefuI analysis of the data Bishop and Heberlein2eidentify six design elements for maintaining the reliabilify of CVM surveys and results. A brief description of each element is given below. 1. Know whose and which values will be estimated. One advantf,ge of the CVM is that it can elicit both use and nonuse values of a good. The use and nonuse values cannot be differentiated in surveys, however, unless the corresponding pop' ulations are sampled in a statistically v4[id 6gnngL 2. Provide respondents with a clear and meaningful description of the good. The ability of survey respondents to provide accurate and reliable information is directly related to their understanding of the good being valued. Giving respondents a clear, concise and meaningful description of the good increases the reliability of their responses. For example, suppose a sample of recreationists are being asked their willingness to pay for a reduction in harvest rate that improves recreational opportunities in a national forest. Asking tliem to state theirWTP for reducing the harvest rate by 10,000 board feet per year is meaningless to most respondents.However, showing respondents several welllabeled, highquality, color pictures depicting the visual, aesthetic and recreaúonal impacts of successively lower harvest rates improves their ability to respond. 3. Use a realistic and neutral payment method for asking WTP and WTC questions. Tbe reliability of WIP and WTC values is increased by choosing a realistic and neutral payment method- For example, if respondents are being asked their WTP for specific reductions in harvest rates, then it makes little senseto ask them to resp,ondin terms of how much more they would be wiling to pay in the form of higher taxes on cigarettes and liquor. Such taxes are not a realistic payment method for this particular good. It is more realistic to elicit their WIP in terrns of a higher accessfee for national forests. Sometimes, it is diffrcult to select a realistic and neutral payment method. For example, if the good being valued is clean air and the payment method is higher property taxes, respondents who believe property taxes are already too high rnay understate their WTP for clean air simply ris a protest against further increases in property taxes. 4. Select a question format that gives reliable values. Several question forrnats are possible, including a) bidding games, b) open-ended questions, c) pa5rnrent cards, d) dichotomous choice and e) contingent ranking. A bidding game asks respondents whether or not they are willing to pay successively higher amounts above some starting point amount until their maximum WTP is reached. An open-ended question directly asks respondents their maximun WTP. Abidding gàme is appropriate when respondents have difEculty handling open-ended WTP questions. The payment card is a refi.nement of the open-ended question. Each respondent is shown a list of average expenditures made on related goods by households in the sarne income bracket as the respondent. After the card is shown, the respondent is asked the maximum WTP for the good. The payment card provides respondents with a reference point for making WTP bids. Both the bidding game and payment card can introduce bias into the WTP estimates by virtue of the choice of starting values. Dichotomous choice requires respondents to aoswer yes of no regarding their

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wTP specified arnounts. This format for eticiting wrp is thought to be easier for respondentsbecauseit does not require them to rtut" tt"i.yrupin absolute terms. on the negative side' it is more difficult to estimate maximurn wrp from dichotomous data than from continuous data provided by bidding gzmres, open-ended questions and payment cards. contingentranking derives the value that aiousehold jtu"", oo a nonmarketed good from the way that household ranks various combinations of environmental quality and expend'itures. comparisons of value estimates derived using these five payment methods indicate that no one method is superior to aII others. c_onsluently,_selection of the payment method is subjective. 5' Collect inforrnation on other factors that affect values. Because WIp and wTc are derived from Hicksian demand functions or expenditure functions, they are affected by the same variables that influence demand and expenditure. These variables, lumped together under the headi clude income, age, sex, education, housel and involvement with the good and locati WTC are typically expressed as a functi the estimated wlP and/or wTC functions are used to pred.ict suqrlus values for other resources and/or time periods than the ones used in the sunrey. 6' Analyze the data using valid statistical procedures. Most of the statistical techniques for estimating slrP or wrc functions are used in other stud.ies.These include regular regression analysis and probit l"gitr"grssion analysis. A few statistical problems are encountered, however, io"r esdmntiig wTp and./or wrc functions' such as the handling of extremely low or extremefi high wrp or wrc val_ uesEven if these six elements are incorporated in the design and execution of a to strategìc bias and hypotheticat bias. tentionally overstate or understate the tnre rle, upward strategic bias in WTp is likely high Y/T" increases the likelihood of an :ct what, if anything, he or she will be re_ ;ood. On the other hand, downward strate_ ent thinks the a:nount he or she will have pends on his or her stated WTp. nena respondentis unable to assessWTp tr even when the respondent has no inten_ rcthetical bias ispossible even in well{.e_ spondelts have very limited prior experience

-d; cianvvurnerabretohypotheticarbiasff#il*?i"ffil3,H:ffift:ff respondents to become familiar with their own preferen"". fo, the good- As a result, respondents may be unable to place a valu Unfortunatety, trying to reduce hypothetic the respondenf such as starting poìnts in tures on payment cards, can inhoduce ano Hypothetical bias is different from the criticism that cvM surveys are unreliable becausethey involve hypothetical questions. For example, asking respondents to value changes in a private good is rubi""t to the nypottretical question criticism

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but not to hypothetical bias because prior market experience is likely to exist for private goods. Like the hypothetical question criticism, strategic bias and/or hlryothetical bias reduce the reliability of W'TP and WTC values derived from CVM surveys. The CVM is wlnerable to two other measurement problems: the order fiect and embedding. When several items are being valued in the same suryey, the order of the questions can influence the magnitude of the V/TP or WTC values given by ,..pood"nts. Tolley and Randall30found that respondents'WTP for im!Éved visibitity in the Grand Canyon fell by a factor of 3 when the order of this question was changed from first to third. The embedding problem occurs when the value given by respondents varies depending upon whether the good is being valued sqtarately or as part of an inclusive good. For example, the CVM value of improved water quality at a lake is likely to be different depending on whether it is valued by itself or as part of a more inclusive good such as the recreational site where the lake is located or recreational sites in a region. If embedding is present, then WTP or WTC values are higher when the good is valued separately than when it is valued as part of an inclusive good. It is inappropriate to estimate the value of an inclusive good by simply adding up the values of the goods that comprise it. Empiricat Validity of CYIM. The validity of CVM-based WTP and WTC values have been examined by comparing them to values obtained using other methods. Generally speaking, the divergence between CVM and actual values depends on a) whether the good in question is public or private, b) the method used to elicit values and c) whether the value being compared is WTP orWTC. Studies show that differences between CVM and achral market values of WTP for strawberries and hunting permits are not statistically different.3r The CVM WTC for hunting pennits (private good) are statistically and significantly higher than actual \VTP in two out of three cases.32The CYM WTP and actual WTP values appear to be different for public gd.s.:: Several studies indicate that CVM-based values are similar to values obtained with the travel costs and hedonic pricing35 methods. Bishop and Heberlein36developed three simulated market experiments to cornpare CVM values to actual market values of WTP and WTC for hunting permits. These comparisons evaluated the extent of hypothetical bias and strategic bias. Sirnulated market values were deiermiged by observing how hunters exchanged a specific amount of money (provided by the experiment) for deer and goose hunting permits. Based on their analysis, Bishop and Heberlein concluded there is a considerable upward bias in CVM-based WTC values but not in CVM-based WTP values. Other studies have concluded that strategic bias is not significant. CYM Studies. In 1989 the F-nconValdezoil tanker hit a reef in Prince Williart Sound, Alaska causingnearly 11 million gallons of oil to spill into the Sound. About l,5OO miles (2,415 krn) of Alaska coÍrst were polluted as a result of the spill. The state of Alaska surveyed 1,043 households in 5O states to determine their willingness to pay for an escort ship program, which would virnrally eliminate another' large oil spill in Prince Mlliam Sound for the next 10 years. By the end of the 1G year period, single-hull tankers would be replaced by double-hull tankers and the program would no longer be needed. The prograrn requires oil companies removing oil from Alaska to pay a one-time tax and households to pay a one-time charge in ttre first year of the program. Only households who said they would never visit

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Prince Mlliam Sound were included in the survey.Hence,the resulting values are existenceand./orbequestvalues. Sampledhouseholdssupportingthe prograrnwere askedif they would be willing to pay a larger amount($30, $60, $120, $250).Householdsnot supportingthe programwere askedif theywould be willing to pay a srnalleramount($5, 910, 930, $60) for the program. The averageWTP was$94 andthe medianwillingness ro pay was$31 per household.Extrapolatingto all U.S. households resultedin a total willingnessto pay for the program of $2.8 billion basedon rnedianWTP and $8.6 billion based on averageWTP. Becausethese are existenceand bequestvalues, the stateof Alaska argued that Exxon Corporation should be held liable for the median total existencevalue of $2.8 billion. This amountis aboveandbeyondthe billions of dollars spentby Exxon and othergroups to clean up the oil spill- Exxon settled a Iiabiliry suit for $l billion before the survey was introducedas evidence.s?

SummarY F.fficient use of natural and environmental resources and economic evaluation of resource nunagementpolices require knowledge of the private and social values of these resources in alternative uses. For nahral or enyironmental resources that are subject to market forces, market prices should be used to evaluate private benefits, and where possible, social benefits of alternative parterns of resource use. When markets are nonexistent or incomplete, however, which is the case for public goods, nonmarket-valuation methods are often used to determine the social value of changes in resource price, quantity and quatity. Nonmarket values are useful in a) deterrrining efEcient use of exhaustible resources, b) implementing natural and environmental resource accounting, c) evaluating resource protection policies, and d) evaluating the econornic feasibitity of alternative resource investurents. There are two prirnary measures of the surplus value of changes in the price, quantity or quality of natural and environmental resources, namely, willingness to pay (WTP) and willingness to accept compensation (VITC). For firms, WTP equals WTC and surplus value can be measured in terms of profit. Willingness to pay and WTC are generally different for households and the correct value to use depends on the assignment of property rights. Willingness to pay is the correct s*"onsume, plus measure when the household does not have a property right to the good- Willingness to accept compensation is the correct consumer surplus measure when the household does have a property right to the good. Willingness to pay or WIC for changes in resource prices are mea$ued by changes in consumer surplus along the Hicksian demand curye. The latter indicates the change in quantity demanded associated with a change in price when real income is held constanl Whenever the income effect of a price change is not zerrc, the Hicksian demand curve is steeper than the Marshallian dernand curye and WTC exceeds WTp. Willingness to pay and WTC for improvements in environmental qtrality are measr:red with reference to the indifference curve, which shows all combinations of expendifures on other goods and expenditures on improvement in environmental

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'When the income effect is not zero, quality that provide the same level of utility. WfC exceeds WTP for improvements in environmental quality. Estimates of WTC generally exceed estimates of WTP. Total social benefit of a change in resource price, quantity or quality is determined by sumrning WTP or WTC across all households who place a value on the resource. Total social benefit has four elemenB: use value, option value-, existence value and bequest value. llse value is the value of the resource by thosErho use it. Option value is a household's W"IP to preserve the option of keeping an irreplaceable resource available for future use. Existence value is the amount a household is willingness to pay for the Írssurancethat a resource is preserved in a particular state. Bequest value is the satisfaction that a household derives from knowing that a resource will be available to future generations. Nonmarket values can be measured using indirect methods and/or direct methods. Indirect market methods include averting behavior, weak complementarity (including the travel cost method), and hedonic pricing. Averting behavior deterrnines nonmarket values in terrns of changes in the purchases of related marketed goods. Weak complementarity estimates the value of changing an anribute of a good in terms sf ghanges in the total value of the good. The most prominent weak complementarity method is the travel cost method. In this method, the value of a recreational site is measured by the area under the estimated travel cost demand curve for the site. Demand curves are estimated by relating average use of the site to the average cost of traveling to the site plus income and other socioeconomic characteristics for households residing in unique distance zones around the site. The hedonic pricing method determines the value of an attribute of a good by variation in the market price of a good that has that attribute. The hedonic travel cost method is based on the hedonic pricing method. The primary indirect valuation method is the contingent valuation method (CVM). The CVM deterrrines the value of a good by multiplying the average WTP or WTC for that good in a sample of respondents by the number of respondents. Willingness to pay and/orWIC values are estimated from survey responses to a set of structured questions. The theoretical basis for the C\IM approach is the expenditure function. Unlike dircct method$, the CVM does not require estimation of Hicksian demanti curyes. Indirect and direct methods of nonmarket valuation have certain advantages 'and disadvantages. The cost of averting behavior works when there is an appropriate averting behavior that can be valued in the marketplace. It can overestimate the value of a good when the averting behavior involves more than one good. Limitations of the travel cost method include its exclusion of nonuse values, ambiguity about how tg measure use rates, bias due to omission of time cost and the price of substitutes from the demand function, differences of opinion regarding the value of time spent traveling to the site and the value of time spent at the site, dtfficulty in accounting for multiple characteristics of a site and multiple reasons for visiting a site, and choosing a correct matherratical form for the travel cost delrrand functionT imitations of the hedonic pricing method are inaccurate marginal pri"es when some attributes of the good are not considered, difficulty in obtaining needed data, lack of theoretical justification for the functional forrn of the hedonic price function, inability of households to detect the attribute being valued, varying expectations about changes in atEibutes over time, difficulty in simultaneously estinating mar-

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ginal prices of attributes that erist at substitute sites, and incorrect assumptions about underlying demand and supply functions. Contingent valuation, which is the primary direct valuation metho4 has;beencriticized becauseit involves asking respondentshypothetical questions.rn addition, cvM-b3ssd esrimatesof wrp and WTC are subjectto hypotheticalbias, strategicbias, the ordereffect and embedding. Matty of thesepitfalls can be avoidedby proper designand executionof C\IIVI surveys.

Questions for Discussion l- What role doesnonmarketvaluationplay in the managementof natural and environmentalresources? 2- Use the Marshallian and Hicksian dernandcuryes to explain the difference betweenwlP and'wrc for an increasein the price of u oooro*k"t"d good. 3- What is the appropriatemeasureof an improvementin air quafity when a householdhas the right to clean air? When the householddoesnot have the right ùo clean air? 4. The cost of new safety featnresfor oil tankersis $2 million per year. The safety featuresare expectedto reducedauragesto fishery resourcesUi Sf .z million per year. Are the safety featuressocially efEcient?Explain. 5. A moderareoil spill causesauthoritiesto closedown Tarmin Beach,located miles (40-3 hn) from the city of Elmwood. The next best alternativeto Tamún 25 Beach is Raymond Beach, which is located 40 rniles (64.4 km) from Elmwood. How would you estimatethe loss in therecreationalvalueof Tarmin Beachfromthe spill? 6- What are the strengîhsand wea}rressesof the travel cost method and contingent valuation method?

Further Readings Adamowicz' w. L. 1991. 'Yaluation of Environnental Amenitie s." CanadíantJournal of A gricu lural Economics 39 :6@-6 I 8 Clopper' Maureen L. and Wallace E Oats. 1992. 'Environmental Economics: A Surv ey." J ournal of Econornic Literaure 3Ùe):6j 5-7 40. C'rmmings, R G-, D- S. Brookshire and S/. D. Schuttze. 1986. Valuhg Envùonmcntal Goods: An Assessmentof thc Conthgent Valu@ion Method. Toowa, New Jersey: Rowman and AllanhetdFlercher' J- J., W. L. Adamowicz and T. Gratrm-Tomasi 1990. '"Ihe Thavel Cost Model of Recreation Demand: Theoretical and Empirical Issues.- Leisurc Sciences l2zll9-L47. Freeman' A- Myrick m. 1993. T!rc Measuremcnt of Erwbotamental and Resource yalzes. Washington, D.C.: Resources for the Future. Greenley' Douglas A., Richard G. Walsh and Robert.A- Young. L982. Economic Benefits of Imprcved Water Quality: Public Perceptions of Oprton and Preserttuion Valzes, Stud-

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ies in WaterPolicy Management,No. 3. Boutder' Colorado:WesMew Press' 'Valuing the Environment through Contingent ValuaHanemanruW. Michael. lgg4. 8:19-43' tion." Journal of EconomicPerspectíves 'tfodeling the Demand for OutdoorRecreation" Water ReMendelsohn,Roberl 19&7. . sourcesResearch 23:961-967 p. Randall, A., J. Hoen andD. S. Brookshire. 1983."ContingentValuation Surveysfor 3 23'-635'&8Evalnating EnvironmentalAssets."Natural Resourceslourrul *Valuing Option,ExistenceandBeWalsh,R G., J.B. LoomisandR. S. GilfnarL 1985. 6O:7L29' Economics questDetrulndsfor Wilderness-"I-and

Notes 1. U-S. Envirorurental Protection Agency, Office of Air and Radiatiot. Implementation Strategy for the Clem Air Act Anlendments of 199O(Update' 1992), ANR443' 4OGK92-O@.(Washington, D.C.: July 1992). 2. Heruran E- Daly and John B. Cobb, Jr., Appendix The Index of Sustainable Economic Welfare, For tlrc Common Good: Redirecthg the konomy Towatd Community, thc Erwircnment, and a Sustainable Future @oston, Massachusefis:Beacon Press, 1989)' pp401-455. '"The Need for Naurral Resource Accounting," in wasrtng As' 3. Robert Repetto et al. sets, Natural Resourcesin National Incomc Accounts (WashingOn, D.C.: World Resources Instihrte, 1989), pp. 1-25. 4. Robert D. Willig, "Consumer's Surplus Without ApologyJ' Atncrican Economb Review 66(197Q:58f597. 5. Michael W. Hanemanp, "Willingness to Pay and Willingness to Accep[ How Much CanThey Differ?- Amertcan Economic Review 81(1993):63547' 6. Judd Hammack and Gardner Mallard Browg lr-,Waerfowl ud Wetlands: Toward Bioeconomic Anatysis (Baltimore, Maryland: The Johns Hopkins University Press for Resonrces for the Future, lnq. 'tollective-Consurnption Services of Individualized-Con7. Burton A. S/eisbrod snmption Goods," Quarîerly Jo unal of Ec ono mics 7 8(7964):47 L47 7 . 'tnTle Re8. Ctaude Henry, "OptionValues in the Economics of Irrcplaceable Assets," Resowtes oÍ Exhausrtble Economics the vícw of Economic Studíes: Symposiuin on (lg4):89-104; Kenneth I. Arrow urd Anthony C. Fisher,'Environnental Presewation' Uncertainty and Irreversibiliry- Quarterly Journal of Economìcs 88(197a)312-319. *Conservatipn Reconsiderù" American. Economìc Reviant 9. John !. !ftstiìla, 57(1967)|777:t86. 10. V. Kerry Smith and William H- Desvousges, "Averting Betravioc Does It Exist?" lztterc 20(1980:297-296Economics ' 'rùl/illingness !o Pay for Ozone Control: Infer11. Mark Dickie and Shelby Gerking, ences from thrcDemand for Medical Cate," Joumal of Ewirorvnental Economics and.Managenent 2f ( 1991):l-16. 12. Karl-Goran Maler, Envircnmental Economícs: A Tluoretical Inquirl @altimore' Maryland: Johns Hopkins University Press, 7974);Nancy E. Bockstael and Kenneth E. McConnell, "Welfate Measurement in the Household Production Frameworls"' Anerican Ecu rwmb Revizw 73(1983):806-814. 13. Gary S. Becker, "A Theory of the Alocation of Time," Ecotwmic fourmal 75(196$:a9 T517; trCLancaster, "A New Approach to ConsumerTheory,- Journal of Polit-

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