CHAPTER – 2

Resource Allocation and Optimization

 Topics
[Link] resource service
[Link] willingness to pay.
[Link] how much a person willing to pay to obtain something 4. Illustrated
willingness to pay with graph
[Link] willingness to pay with graph
[Link] demand / marginal willingness to pay for private goods
[Link] willingness to pay demand for public goods
8. willingness to pay and benefit
[Link] to pay overtime
10. Discounting
[Link] cost curve
[Link] Efficiency (optimization)
[Link] (Intertemporal) Efficiency
Field, B. C., Natural Resource Economics: An Introduction, 2nd Ed., McGraw Hill.
 Modeling Resource Services

There are several other ways of distinguishing among types of natural resource
goods and services. In order to discuss them, however, we will adopt a slightly
more formal approach.

Natural resource management decisions are complex because they involve

connections and trade-offs between the present and the future. The connections
stem from the characteristics of the resource itself, such as its biology or
chemistry, and the way they are impacted by human use. Consider a situation
in which there are just two time periods, period 0 and period 1. In effect,
period 0 could stand for today and period 1 for some time in the future, but to
keep it simple think of period 0 as this year and period 1 as next year.
 Modeling Resource Services

The basic structure of a general resource-use problem can now be set up in the
following way. Suppose that there is a certain quantity of a resource available
at the beginning of period 0. During that period the resource is "used" in some
amount. It is easiest to think of "use" in this case as extraction in the traditional
sense. But we can also interpret it in other ways. The other thing that may
happen during the first period is some amount of replenishment or growth of
the resource, the amount of which depends on the type of resource involved.
All these factors contribute to the quantity of the resource available in period
1.
We can express the basic relationship as follows:

S₁ = So - Qo + ∆S

Where,

S₁ = Amount of resource available in period 1

So = Amount of resource available in period 0

Qo = Amount of resource used in period 0

∆S = Increment to the resource in period 0

The critical term is ∆S , representing the added increment of the resource that becomes
available during period 0. By interpreting ∆S in different ways, we can use the basic
expression to describe many different types of resources.
For Nonrenewable Resources: We have ∆S = 0; that is, there is no replenishment or
increment of the resource. This being the case, the basic accounting expression becomes
S₁ = So-Qo; the quantity available in the next period (S₁) is the quantity that was available at
the beginning of the present period (So) minus the quantity used in this period (Qo).

For Recyclable Resources: Certain nonrenewable resources may be recyclable. A portion of

the resource used in period 0 can be recycled back to add to the available supply in period 1.
Here the basic expression may be rewritten as:
S₁ = So-Qo + αQo
Where α is a percentage indicating the proportion of the first year's use that is returned via
recycling. Here two basic decisions are to be made, the utilization rate Qo and the recycling
ratio α.
Renewable Resources: A renewable resource is one that replenishes itself in some
fashion. For a forest, the amount of wood (cubic feet) in year 1 what existed at the
beginning minus that which was harvested during period 0 plus the biological growth
increment of the timber that was not harvested.
In this case, ∆𝑆 > 0, so the quantities available in period 1 are affected by the
replenishment period 0. Certain types of renewable resources are non-accumulating.
Consider a free-flowing river, for example each year a certain (no doubt fluctuating)
amount of water comes down the river; this is a meteorological and geographical fact
of life. But it flows by a given point and then is gone. Thus the annual replenishment
doesn’t add to any pre-existing quantity.
In this case, our basic relationships change to the following:
𝑆1 = ∆𝑠 𝑆0 − 𝑄0 = 0
The amount of the resource available in period 1 now does not depend on the rate of
use during period 0.
 Willingness to Pay

The value that a person puts on something is the amount they are willing to
sacrifice to obtain that something, which may be a good, or service or state.

The value a person places on a good or service is what they are willing to pay
to get that good or service.

Willingness to pay (WTP) refers to the maximum amount of money an

individual or group is willing to sacrifice or spend to acquire a good or service.
It represents the highest price a consumer is willing to pay to obtain a
particular product or service, reflecting the value they place on it.
 Determinants of willingness to pay

Determinants of willingness to pay:

1. Taste and preferences: Individual taste and preference are paramount.

Some people are willing to pay a lot to visit grand-canyon, others are
not. Some people are willing to pay a lot for white water recreation
opportunities others are not.

2. Person’s wealth: A person’s wealth affects the willingness to

sacrifice. The greater their wealth, the better a person can afford to pay
for various goods and services.
3. knowledge and experience: willingness to pay depends upon the state of
one’s knowledge and experience. For a person, who has never left the city, for
example, a backpacking experience may open up new opportunities and
essentially shift a person’s preference.
 Willingness To Pay

Consider an individual and some arbitrary good or service. We need a way of

representing graphically that person’s willingness to pay for the item in
questions. We will use simple numbers for illustrative purposes.
(WTP)$ Quantity (Unit)

38 1
26 2
17 3
12 4
8 5
7 6
Assume that the person has none of the good to begin with. We ask her,
or perhaps deduce from watching her spend her money, how much she
would be willing to pay for a single unit of a good rather than go
without.
Suppose this is some number, such as $38 depicted in the top of figure.
We then ask, assuming she would be willing to pay for the second unit.
According to figure, her answer is $26. In similar fashion, her
willingness to pay for each additional unit is depicted by the height of
the rectangle above the unit: $17 for unit 3, $12 for unit 4, and so on.
 Marginal Willingness to Pay

An individual’s demand/marginal willingness to pay curve for a good or

service is a way of summarizing his personal consumption attitudes and
capabilities for good.

Thus, we would normally expect those relationship to differ somewhat among

individuals because individual tastes and preferences vary.
 Marginal Willingness to Pay

The concept in use here is more exactly called marginal willingness to pay
(MWTP).Suppose a person is already consuming two units of this good;
according to figure, that person would be willing to pay $17 for a third unit.
This is the marginal willingness to pay-in this case, for the third unit.
"Marginal" thus describes the additional willingness to pay for one more unit.
So the height of the rectangles in the top of figure 3-1 and the height of the
curve in the bottom graph show the marginal willingness to pay for this good.
Marginal Willingness to Pay
Figure-3-2
 Marginal Willingness to Pay

Panel (a) shows two demand curves, one steeper than the other. The steeper
one shows a situation in which MWTP drops off fairly rapidly as the quantity
consumed increases; the other MWTP, although lower to begin with, goes
down less rapidly as quantity increases. These two demand curves could
represent the case of one consumer and two different goods or services, or
the case of two different consumers and the same good or service.
Panel (b) of Figure 3-2 also has two demand curves; they have the same general
shape, but one is situated well to the right of the other. The demand curve lying
above and to the right shows a good for which the MWTP is substantially higher
than it is for the same quantity of the other good. What could account for the
difference? They might represent the demand curves of two different people for the
same good. But there are other possibilities. How much a person is willing to pay
for something obviously depends on how much money she has; more than likely
the higher her income, the more she is willing to pay. So the two demand curves
in panel (b) could apply to the same individual and the same good, but at two
different points in time, the one to the right being her willingness to pay after
she has had a substantial increase in income.
 Aggregate Willingness to Pay/Demand for Private Goods

The aggregate marginal willingness to-pay curve is the summation of the

marginal willingness-to-pay curves of all the individuals in the group of
interest.

Figure 3-3 depicts the derivation of a simple aggregate marginal willing- ness-
to-pay curve, in this case by adding together (horizontally) the MWTP curves
of each of the three people in this group. A good like this which can be
consumed in separate and possibly different amounts by each of the
individuals in a group, depending on their preferences and wealth positions, is
called a private good.
The total amount consumed in this case is simply a sum of the individual
quantities consumed. Example, as are cars, fishing trips, and pencils. At a
marginal willingness to pay of $8, consumption is 10, 6, and 8 units,
respectively, for Anna, Bob, and Carlos. Thus total consumption at $8 is 24. At
a marginal willingness to pay of $15, aggregate consumption is 7 units (4 for
Anna, none for Bob, and 3 for Carlos).
 Aggregate willingness to pay demand for public goods

Many of the goods and services produced by natural resources are not private
goods, for which we add together the consumption levels of different people to
get total consumption. Rather, they are called public goods. A public good is
one that when it is made available to one person, automatically becomes
available to others as well.

A good example is a signal broadcast by a radio station. When the signal is

sent out, it is available to anybody within range who has a receiver.
The graph features three individual demand curves, each representing a
different person: Anna, Carlos, and Bob.

These curves depict how much each person is willing to pay for a public good
at varying levels of provision (ranging from Light to Medium to Extensive).

Anna’s Demand Curve: Anna’s curve slopes downward, indicating that her
willingness to pay decreases as the provision level increases. In other words,
she values the public good less as it becomes more abundant.
 Aggregate MWTP for restoring Bald Eagles

Extent of MWTP
restoration
Anna Bob Carlos Aggregate

Low 50 10 25 85

Moderate 30 5 10 45

extensive 10 0 5 15
Carlos’s Demand Curve: Carlos’s curve also slopes downward, but it starts
from a higher initial value compared to Anna. This suggests that Carlos places
a higher value on the public good initially, but his willingness to pay still
decreases as provision increases.

Bob’s Demand Curve: Bob’s curve is a straight horizontal line. This means
that his willingness to pay remains constant regardless of the level of
provision. Bob’s valuation of the public good doesn’t change as it becomes
more available.
The aggregate demand curve represents the societal willingness to pay for the public
good. It is obtained by summing up the individual willingness to pay at each level of
provision. The aggregate curve also shows a downward trend, reflecting that overall
societal willingness decreases as the provision level increases.

In summary, this graph provides insights into how different individuals and society as a
whole value a public good based on its provision level. Remember that this is a
simplified representation, but it helps us understand the concept of willingness to pay in
the context of public goods.
 Willingness to pay and benefit

Benefit is one of those ordinary words to which Economists have given a

technical meaning "benefits" clearly implies being made better off. The
benefits that people get from something are equal to the amount they are
willing to pay for it. It means we can use ordinary demand curves to determine
the benefits of making various things available.
 Willingness to pay and benefit
Fig: willingness to pay& benefits
 Willingness to pay and benefit

The fig shows two demand Curves and on the horizontal axis two quantity levels are indicated. Benefit
are measured by WTP, and the total WTP in measured by areas under the demand curve. The area under
the demand curves between quantity q1 and q2. So for the lower demand curve the benefits of each an
increase in availability are equal to an amount shown by area b whereas benefits in the case of the higher
demand curve are equal to the total areas.

The people with the higher demand curve must place a greater value on his item. Whatever it is they are
WTP more for it than the people whose demand curve is the lower function.

we have to remember that demand curves are critically affected by the ability to pay for something as
well as preferences. An individual demand for something in clearly affected by how much he knows
about it, limitation:

i. Very hard to measure benefit and demand.

ii. Lack knowledge.

 Willingness to pay over time

Willingness to Pay (WTP) over time refers to how much a consumer is willing to spend
on a particular product or service at different points in time. WTP can vary depending
on factors such as changes in consumer preferences, income levels, market conditions,
and the availability of substitutes.

problems in natural resource Economics are particularly complex because the time
factors play a major role in them. Decisions made today or this year will have in
consequences in future years. Trade- offs are necessary because present & future
willingness to pay and present and future costs are involved, the consumers can be
thought of as having a WTP not just for current consumption but also for a stream of
consumption quantities extending into the future.
Willingness to pay over time
 Willingness to pay over time

Thus consumers can be thought of as having a willingness to pay not just for
current consumption but also for a stream of consumption quantities extending
into the future as pictured in Figure.

The figure shows a sequence of willingness to pay for the current quantity q0
and for a sequence of future quantities q1, q2 q0 and so on.
 Discounting

Discounting involves applying a discount factor to future values in order to

convert them into present values. If a sum of money equal to $M is put in a
savings account at an interest rate of r, the value after one period of
compounding is given by the formula
$FV=$M(1+r)
The formula compounds the present value ($M) into future value (FV).

If M is left in the bank account for t periods, then the future value is
found by compounding the present value t times, thus,
FV(t) =M(1+r)t
Example: If, M= $1,000, r= 0.04, t=6,
The future value is,
FV6=$1.000(1+0.04)6
=$1,265
The reverse of compounding; applying a discount factor to future values to convert
them into present values. If I expect to receive to receive something of value in the
future, What is it worth today (PV)?

$𝐹𝑉
$PV=
1+𝑟 𝑛

Where, PV = present value, FV = Future value, r = Discount rate, n = Number

of periods into the future.
If we had numerous different future values occuring in the various future
years, we can convert their all to present values and aggregate them:

$100 $150 $150

$PV= $100 + + + +………….
1+𝑟 1 1+𝑟 2 1+𝑟 3

Aggregate the WTP amounts shown in figure-

(𝑐+𝑑) (𝑒+𝑓) (𝑔+𝑕)

PV (WTP) = (a + b) + + + +……….
1+𝑟 1 1+𝑟 2 1+𝑟 3
Examples: Suppose, Somebody gave you an IOU stating that they will
pay you $100 one year from now, and that the discount rate is 4
percent. The value of that IOU is the present value of that future $100,
and is found.
Here, $FV=$100 , r=0.04, n=1

$100
$PV = = $96.15
(1+0.04)

This means that $100 one year from now is the same as having $96.15
today, based upon a discount rate of 4 percent.
Examples: Suppose the IOU was for $100, but to be given to you 5 years from
now rather than after just one period. Then the present value of the IOU would
be:

FV= $100, n =5, r = 0.04

$100
$PV = = $85.48
1+0.04 5
Examples: Suppose the IOU given to you specifies the fallowing payment
schedule:

year

0 1 2 3 4 5

payment $100 $100 $150 $150 $50 $50

If the discount rate is 4 percent, the present value of this stream of payments is
found as follows:

$100 $150 $150 $50 $50

PV= $100 + + + + +
1+0.04 1 1+0.04 2 1+0.04 3 1+0.04 4 1+0.04 5

=$(100+96.15+138.68+133.3.34+42.74+41.09)

=545·18
 Opportunity Cost

Opportunity cost refers to the value of the next best alternative that must be forgone when a
decision is made to allocate scarce resources in a particular way. It represents the benefits that
could have been gained by choosing the next best alternative use of those resources.

Imagine a farmer who has a piece of land that can be used to grow either wheat or soybeans. If the
farmer chooses to plant wheat, the opportunity cost would be the potential revenue or benefits
from growing soybeans on that same land. Conversely, if the farmer decides to grow soybeans, the
opportunity cost would be the potential revenue from growing wheat instead.

In resource economics, decision-makers often face trade-offs between different uses of resources,
whether it's land, labor, capital, or other inputs. Understanding and considering opportunity costs
is essential for making efficient resource allocation decisions. By comparing the costs and benefits
of different choices, individuals, firms, and policymakers can determine the most effective way to
utilize scarce resources to achieve their objectives.
Opportunity Cost
 Marginal Cost curves

The cost curve shows the relation between the cost of a product &
quantity of that product.

Total cost = TFC + TVC

Marginal cost is defined as the change in total cost resulting from a

one-unit change in the quantity of output.

The total cost of producing a given quantity is the dollar amount equal
to the area under the marginal cost curve between the origin & the
quantity. Or, the sum of all the costs used in the production process.
Marginal Cost curves
 Social Cost

Social cost refers to the total cost incurred by society as a whole when
producing a good or service.

For example, when a factory pollutes the air and waterways, causing health
problems for nearby residents and damage to the ecosystem, these costs are not
borne by the factory alone but are also imposed on society as a whole. The
social cost of the factory's production includes both the private costs incurred
by the factory and the external costs imposed on others.
Marginal Private Cost (MPC): This refers to the additional cost incurred by
the company when producing one more unit of output.

Marginal External Cost (MEC): This represents the additional cost imposed
on society when one more unit of output is produced.

Marginal Social Cost (MSC): This is the sum of the marginal private cost and
the marginal external cost.

So, MSC = MPC + MEC.

 Present Value of Cost

In chapter 3 we apply the procedures of present value analysis to time streams

of benefits. The same procedure also is useful for evaluating future time
streams of costs. Resource development or protection programs normally
extend over long periods of time, with costs being incurred each year
throughout their life.
Costs in the current period (Co) are equal to the area under today's marginal
cost curve (MC) up to today's rate of output (qo). Likewise, the expected
marginal cost curves of future periods are shown, together with the expected
rates of output and total costs that will be incurred in each period. The formula
for determining the present value of this stream of costs is…
𝐶1 𝐶 𝐶3
Present value of costs = C0+ + 2 2 + + …….
1+𝑟 1+𝑟 1+𝑟 3

Where r is the rate of discount

 Efficiency

The notion of efficiency is used in positive economics to help explain how

people in fact behave in the real world. It is also a tool of normative
economics, as a criterion for judging outcomes, such as for evaluating in
specific instances whether the rate as which individuals are using a natural
resource is the best one from the standpoint of society as a whole.

We look at economic efficiency from two angels; Static efficiency and

Dynamic, or intertemporal, efficiency.
 Static Efficiency

A state of affairs that is efficient in the static sense is one that is efficient
strictly from the perspective of a single time period, in particular the present
one, e.g. in the spring of a farmer plants a crop, later harvesting it and shipping
it to market. A timber harvesting firm cuts down a number of trees this year
and also ships them to market. A public agency allows a certain number of
visitors into a park this year. These decisions will be efficient in the static
sense if they are undertaken in light of the consequences flowing from them
this year only.
The concept of marginal willingness to pay and marginal cost will clarify static
efficiency, and it is shown in figure below:

The horizontal axis = output of a good or service, and the vertical axis has a
value scale.

The MSC curve represents marginal cost & The MSB curve represents
marginal social benefits.
Figure 2.1 Static Social Efficiency
They represents the summed marginal willingness to pay and summed
marginal cost relationships of all the people and firms in our “society”. Since
nothing and nobody is left out, they are called “social”. The rate of output that
is socially efficient is the one that yields the maximum net benefits to society.

Thus the net social benefits of the output level q* is (a + b) – b = a. Net

benefits are equal to the difference between the area under the social marginal
willingness to pay curve and social marginal cost curve.
It is straightforward to show that q* is the rate of output that maximizes the net
social benefits associated with the production of this good or service. To do
this, take some other output level, such as q1 in figure 2.1.

The net benefits of this output are derived as follows:

Total benefits : a + b + d

Total costs : b + c + d

Benefits – Costs: (a + b + d) – (b + c + d) = a – c

So, at q1 level net benefits decreases as a > (a – c).

Again, to the left of q*, an additional unit of output would add more to social
benefits than to production costs (i.e. marginal willingness to pay exceeds
marginal cost). To see this, we turn out to figure 2.2.
Figure 2.2 Static Social Efficiency
At q2,
Total benefits : a + b
Total costs : b
Net benefits : (a + b) – b = a
Now, if we increase our production level to q*, what will happen?
At q*,
Total benefits : a + b + e + f
Total costs : b + f
Net benefits : (a + b + e + f) – (b + f) = (a + e)
We can conclude that net social benefits are definitely lowers at q1 and q2 than
at q*.

Of course the condition that identifies output level q* uniquely is that MSB =
MSC at that output. The reason this is called static efficiency is that it is based
on a balance between two contemporaneous or current period quantities.
 Dynamic or intertemporal efficiency

Dynamic or intertemporal efficiency makes a situation that is efficient when

account is taken not only of the present year but future years as well. If there
are no future consequences stemming from today’s decision, a static
perspective is sufficient also to achieve dynamic efficiency.
By dynamic or intertemporal efficiency, we also refer to a state of
affairs in which there is a maximum of net benefits; but now benefits
and cost categories are extended to include not only those of the present
period, but also the future consequences flowing from today’s decision.

Consider figure – 2.3. It shows a series of marginal benefit and

marginal cost curves, one set for each year starting with the current
year and stretching into the future Dynamic or intertemporal efficiency
now requires choosing a time series or output quantities, not just one.
Figure 2.3 Time profile of net benefits associated with
a series of outputs
Which particular time series of outputs will maximize the present value of the net
benefits stream depends on whether and how the different q’s are linked together.
Suppose they are not linked. Suppose for example, that figure 2.3 refers to the firm
case mentioned above. In this case, there is no connection between the time
periods. Intertemporal efficiency would be achieved by selecting the statistically
efficient output rate in each period shown in the figure as q0, q1, q2….
But suppose there is a connection. May be there are extraction rates for a small
mineral deposit, in which case we can’t change output in one year without having
to change it in some other year or years. Our intertemporally efficient time path of
outputs might now be something like q0ʹ, q1ʹ, q2ʹ….