3.

Efficiency, property right, market failure and the Environment

3.1 Efficiency, discounting and intergenerational equity

1. Efficiency
 Efficiency: Maximization of Total Net Benefit
An allocation of resources is said to be efficient If the net benefit from the use of
resources is maximized by that allocation.
If it is not possible to reallocate resources to make one or more persons better off
without making at least one other person worse off →the allocation is at Pareto
optimality
Conversely, an allocation is inefficient if it is possible to reallocate resources that can
lead to improvement in someone's position without worsening the position of anyone
else → lack of Pareto optimality
A gain by one or more persons without anyone else loosing is known as a Pareto
improvement.

2. Static versus dynamic efficiency

I) Static efficiency

 Static allocation of resources:

→ Refers to allocations of resources in a single time period.
→ Time is not an important consideration in static allocation of resources.
→ The assumption is that the allocation in one period does not affect
allocations in the next period or the periods thereafter.
 Static efficiency:
→ The chief normative criterion for choosing among various allocations when time is
not an important consideration.
→ An allocation satisfies the static efficiency criterion if it maximizes the net
benefits from all possible uses of the resource.

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 Net benefit (NB) = Total benefit (TB) - Total cost (TC)

 How do we measure benefits and costs?

 Measuring benefits
Benefits can be derived from the (market) demand curve.
Demand curves measure the amount of a particular good people/consumers would be
willing to buy at various prices.

Demand curves are down sloping reflecting the inverse relationship between price and
quantity demand.
Consumers buy less of a commodity (or environmental service) the higher is its price.
That is, diminishing willingness-to-pay leads to a downward sloping

Marginal and total benefit

Marginal benefit

For each quantity purchased, the corresponding point on the demand curve represents
the price (P) or the marginal willingness to pay (MWTP) people/consumers are
willing to pay for the last unit of the good.
MWTP is the concept used to define marginal benefit (MB).

i.e. P = MWTP = MB

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 → The MB/MWTP for q1th units is the price of q1 units, P1.
→ The MB/MWTP for q2th units is the price of q2 units, P2.
→ The MB/MWTP for q3th units is the price of q3 units, P3.
Thus, the height of the demand curve measures marginal benefit (MB).

Total benefit

Total willingness to pay (TWTP) is equal to the area under the demand curve from the
origin to the allocation of interest.
TWTP is the concept used to define total benefits (TB), i.e., TWTP = TB
→ TWTP/TB for q1 units is the area under the demand curve between zero and q1
units.
→ TWTP/TB for q2 units is the area under the demand curve between zero and q2
units.
→ TWTP/TB for q3 units is the area under the demand curve between zero and q3
units.
Thus, the area under the demand curve measures total benefit (TB)
 Measuring costs
Measuring costs involves logic similar to measuring total benefits.
Costs can be derived from the (market) supply curve.
Supply curves measure the amount of a particular good people/producers would be
willing to supply at various prices.

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 In purely competitive markets, the supply curve is identical to the marginal
opportunity cost curve.
The marginal opportunity cost curve defines the additional cost of producing the last
unit.
The law of diminishing returns (increasing costs) leads to an upward supply curve.

Marginal and total cost

For each quantity supplied, the corresponding point on the supply curve represents the
marginal cost (MC) of the last unit of the good.
In purely competitive markets, price is equal to MC, i.e., P = MC.
→ The MC of q1th units is the price of q1 units, P3
→ The MC of q2th units is the price of q2 units, P2.
→ The MC of q3th units is the price of q3 units, P1.
Thus, the height of the supply curve measures marginal cost (MC).
Total cost (TC) is simply the sum of the marginal costs.
Geometrically, total costs are equal to the area under the supply curve from the origin
to the allocation of interest.
→ The TC of producing q1units of the good is the area under the supply curve
between zero and q1 units.
→ The TC of producing q2units of the good is the area under the supply curve
between zero and q2 units.
→ The TC of producing q3units of the good is the area under the supply curve
between zero and q3 units.
Thus, the area under the supply curve measures total cost (TC)
Geometrically, the total cost of producing q3units of the good is the area under the
marginal cost curve (supply curve) from zero to q3 units, i.e. the shaded area in the
figure.
 In a perfectly competitive market:

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 → All consumers face a common market price, and adjust their consumption until
their marginal utility (marginal benefit = MB) is equal to that price.
→ Each firm faces the same fixed market price, and adjusts its output so that its
marginal cost (MC) of production equals that price. So we have: P=MC=MB

In purely competitive markets, static efficiency is obtained at the point of equilibrium

(the intersection of D and S), i.e., point b in the figure.
❖ Equilibrium price = P* ; Equilibrium quantity = q*

Total benefit (TB):

 Total consumers' willingness to pay for q* units of the good

 The area below the demand curve between zero and q*units of the good
 Area 0abq*= A + B + C

Total cost (TC):

 The area below the supply curve between zero and q*units of the good
 Area 0cbq*= C
 Total benefit (TB) is greater than total cost (TC):
 Net benefit (NB) = TB – TC = 0abq*(A + B + C) - 0cbq*(C) = acb (A +
B)

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 The market equilibrium quantity or allocation (q*) is efficient, i.e., maximizes net
benefit.
Any position to the left or to the right of the equilibrium results in a lower net benefit.
That is, an allocation other than the equilibrium allocation is inefficient.
In other words, it is not possible to increase the net benefit by producing more or less
than q*units of the good.
 Thus, static efficiency is achieved (net benefits are maximized) when the marginal
benefits (MB) from an allocation equal the marginal costs (MC), i.e. MB =MC or P =
MC.
Note that P = MB = MWTP.

 Who gets the net benefit?

→ It is shared between consumers and producers
→ Consumers' share of the net benefit = consumers' surplus
→ Producers' share of the net benefit = producers' surplus
Consumer Surplus: Total benefit minus cost of purchasing the good, or the area
under the demand curve and above the price line.
→ Total benefit (TB) at q* level of output= Area 0abq*= A + B + C
→ Cost of purchasing q* level of output = Area 0P*bq*= B + C
→ Consumers surplus = 0abq*- 0P*bq*= P*ab, or = (A + B + C) - (B + C) = area A
Producer Surplus: Revenue minus Total Cost, or the area under the price line and
above the supply curve.
→ Revenue at q* level of output= Area 0P*bq*= B + C
→ Total cost of q* level of output = Area 0cbq*= C
→ Producers' surplus = 0P*bq*- 0cbq*= cP*b, or= (B + C) - (C) = area B
Thus, NB = Consumers' surplus + Producers' surplus
Efficient allocations are Pareto optimal.

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 An allocation is said to be Pareto optimal if no reallocation of resources could
benefit any person without lowering the net benefits for at least one other person.
Since net benefits are maximized by an efficient allocation, it is not possible to
increase the net benefit by rearranging the allocation.
In other words, reallocation of resources cannot lead to Pareto improvement, i.e., it
is not possible to make one or more persons better off without making at least one
other person worse off.

Dynamic (intertemporal) efficiency

Dynamic (intertemporal) allocation of resources: refers to allocations of resources

overtime
Static efficiency criterion (i.e. P = MC or MB = MC) is very useful for comparing
resource allocations when time is not an important factor.
However, in many cases resource allocation involves decision making over time.
Decisions made now have implications for the consumption and production
possibilities available in the future.
When time is involved and decisions are interdependent over time, the decisions
are dynamic in nature (and more complex). Example: a hypothetical demand
schedule for oil.

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Static solution:

Static efficiency criterion: Extract that quantity of oil for which P=MEC. (Note that
MC is replaced by MEC, the marginal extraction cost).
The efficient level of oil extraction would be 15 barrels.
If we heed to the static solution, 15 barrels should be extracted this period, leaving
only 5 barrels for the future. (There is no enough stock to allow extraction of 15
barrels each period.)
Is this a good allocation over time? Static models wouldn’t tell us. We need a
dynamic model to work this out.
 Now, assume that:
→ The 20 barrels of oil in stock can be used in two time periods: Period 0 (now) and
Period 1 (future).
→ The problem: allocating the fixed stock/supply of the oil between the two years.
→ In period 0, if 15 barrels were extracted, price would be $2 per barrel.
→ However, in period 1 the price would shoot to $6, because there are only 5 barrels
available.
→ Oil is scarcer in period 1. An allocation this period affects the net benefit
(profitability) in the next period.
→ An efficient/optimal allocation over time should, therefore, maximize the sum of
the net benefits (profits) in the two periods (more precisely the sum of the present
value of the profits in two periods), given a total stock of 20 barrels.
How can we make choices in a dynamic decision problem, where benefits and costs
occur at different points in time?
Time is an important factor in dynamic analysis. Incorporating time into the analysis
requires thinking not only about the magnitude of benefits and costs, but also about
timing.

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 In order to incorporate timing, the decision rule must provide a way to compare the
net benefit received in one period with the net benefit received in another. The
concept that allows this comparison is called present value.

Discounting

Discounting is finding present value. Present value explicitly incorporates the time
value of money.
Is a benefit of $100 received, this period the same as a benefit of $100 received a
year later? (Do you have any time preference?)
Birr 100 today invested at 10% interest yields Birr 110 a year from now (the Birr 100
principal plus Birr 10 interest).
The present value of Birr 110 received one year from now is, therefore, Birr [Link] =
110/(1+r) = 110/(1+0.10) = 110/(1.1) = 100. Because, given Birr 100 now, you can
turn it into Birr 110 a year from now by investing it at 10% interest.
 Given an annual interest rate of 10%, $110 received a year from now is only worth
$100 today. Therefore, we have to discount future receipts or expenditures to compare
them with current receipts or expenditures.

The discounting formula:

The present value of a one-time net benefit B received n years from now is:
𝑩𝒏
𝒑𝒗[𝑩𝒏 ] =
(𝟏+𝒓)𝒏

The present value of a stream of net benefits {B0, …,Bn}received over a period of n
𝑩
years is computed as 𝑷𝑽[𝑩𝟎 , , , , , , 𝑩𝒏 ] = ∑𝒏𝒊=𝟎 (𝟏+𝒓)
𝒊
𝒊

Where r is the appropriate interest rate and Bi is the amount of net benefits received i
years from now.
Note: B0 is the amount of net benefits received immediately. The process of
calculating the present value is called discounting, and the rate r is referred to as the
discount rate

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 Discounting is a central concept in natural resource economics. Itis a mechanism used
to compare streams of net benefits generated by alternative allocations of resources
over time.
✓ Example: Assuming the interest rate is 10%:
✓ What is the present value (PV) of Birr 100 received immediately
(now)?
PV0 = P0/(1+r)0 = 100/1 = 100
✓ What is the present value (PV) of Birr 100 received a year from now?
PV1 = P1/(1+r)1 = 100/(1.1)1=90.91
✓ The PV of Birr 100 received two years from now:
PV2 = P2/(1+r)2 = 100/(1.1)2= 82.64
✓ The PV of Birr 100 received three years from now:
PV3 = P3/(1+r)3 = 100/(1.1)3= 75.13
✓ PV of Birr 1000 received 5 years later at discount rate of 10%: r=10%,
n=5 years, FV=$1000.
PV = 1000/(1.1)5= 620.92

✓ The present value of B dollars delivered 10 years from now at rannual

rate of interest:
PV(B) = B/(1+r)10

Dynamic Efficiency

The criterion used to find an efficient allocation when time is involved is called
dynamic efficiency.
An allocation of resources across n time periods satisfies the dynamic efficiency
criterion if it maximizes the present value of net benefits that could be received from
all the possible ways of allocating those resources over the n periods.

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 Dynamic efficiency assumes that society’s objective is to balance the current and
subsequent uses of the resources by maximizing the present value of the net benefit
derived from the use of the resource
 Example: Consider a simple model to define an efficient allocation of a depletable
(nonrenewable) resource.

Assumptions:

The resource can be used in n time periods

The marginal cost of extracting the resource is constant: C per unit.
There is a fixed supply of the resource to allocate between the n periods: total supply
is Q units.
The demand for the resource is linear and constant over time: It is given by
Pt= a – bqt

How do we determine the dynamic efficient allocation?

 According to the dynamic efficiency criterion, the efficient allocation is the one that
maximizes the present value of the net benefit. The present value of the net benefit for
the n years is simply the sum of the present values in each of the n years.
 The inverse demand equation in year t: Pt= a – bqt
 The total cost of extracting any amount qt: TCt= Cqt
 Total supply of the resource: 𝑸 = ∑𝒏𝒕=𝟏 𝒒𝒕

Total Benefit:

Area below the demand curve from zero to the allocation of interest (qt)
Proceed by integration (the reverse of differentiation)

Where d is a constant term

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 𝒃
 Net Benefit= NBt=TBt -TC== 𝒂𝒒𝒕 − 𝒒𝒕 𝟐 + 𝒅 − 𝑪𝒒𝒕
𝟐
𝒃
𝒂𝒒𝒕 − 𝒒𝒕 𝟐 +𝒅−𝑪𝒒𝒕
 Present value of NBt: pv(NBt ) = 𝟐
(1+𝑟)𝑡

Efficient dynamic allocation is one that maximizes the present value of net benefits
over time. The sum of the present value of net benefits over time is given by:

𝑛 𝒃 𝟐
𝒂𝒒𝒕 − 𝒒 + 𝒅 − 𝑪𝒒𝒕
∑ 𝟐 𝒕
(1 + 𝑟)𝑡
𝑡=1

→ Maximize the sum of the present value of net benefits over time.
 Let Z = the sum of the present value of net benefits over time.

𝒃
𝒂𝒒𝒕 − 𝒒𝒕 𝟐 +𝒅−𝑪𝒒𝒕
MaxZ = ∑𝒏𝒕=𝟏 𝟐
(𝟏+𝒓)𝒕

 Subject to a constraint: Supply constraint: ∑𝑛𝑡=1 𝑞𝑡 = 𝑄

 Applying the Lagrange method:
𝒃
𝒂𝒒𝒕 − 𝒒𝒕 𝟐 +𝒅−𝑪𝒒𝒕
𝐿 = ∑𝒏𝒕=𝟏 𝟐
+ 𝝀(𝑸 − ∑𝑛𝑡=1 𝑞𝑡 )
(𝟏+𝒓)𝒕

First order conditions (FOCs):

The FOCs yield solutions for prices, quantities and λs for the n periods.

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 3.2 Property Rights
Property right refers to a bundle of entitlements defining the owner’s rights,
privileges, and limitations for use of the resource.
Property rights can be vested with individuals, a group or the state.

→ Efficient property right structure

An efficient (well-defined) property rights structure has four main characteristics:
– Universality / comprehensive
– Exclusivity,
– Transferability
– Enforceability

→ Universality / comprehensive
All resources are either privately or collectively owned and all entitlements are
defined, well known and enforced.
Ownership is an essential precondition to trade or exchange
→ Exclusivity
All benefits and costs from use of a resource accrue to the owner, and only to the
owner, either directly or indirectly by sale to others. This applies to both private and
common property resources. Others should not have competing rights to the same
resource.
→ Transferability
All property rights should be transferable from one owner to another in a voluntary
exchange
Transferable by way of lease, sale or bequest.
→ Enforceability
Property rights should be secure from involuntary seizure or encroachment by others.
There must be trust on the legal system to protect property rights
 An owner of a resource with a well-defined property right has a powerful incentive to
use that resource efficiently, since a decline in the value of the resource represents a
personal loss

Market failure

In a perfectly competitive market,

→ Market allocations and efficient allocations coincide so that net benefit is
maximized.

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 – i.e., Market equilibrium is efficient
A perfectly competitive market has the following properties:

i. Well-defined property rights

There are well-defined and enforceable property rights that define the ownership of
resources, goods, and services so that buyers and sellers can exchange these assets
freely.
ii. No externalities exist
The action of one agent (a producer or consumer) does not cause any external effect
(benefit or cost) on parties external to the transactions.
iii. All agents are price-takers.
There are many producers and consumers. Producers and consumers are small relative
to the market and thus cannot influence prices. Instead, they maximize profits or
utility taking market price as given.
IV. Information is symmetric between buyers and sellers.
Producers and consumers have full knowledge of the prices, quality, availability and
location of goods and services.
Transaction costs are zero
Transaction costs include:
✓ Information costs
✓ Contacting costs
✓ Enforcement costs

If these conditions were to exist, a market allocation of resources would be an

efficient allocation (i.e. Pareto optimal).
In practice, some of the conditions for perfectly competitive market are not satisfied.
▪ In such cases, the economy will be characterized by market failure and markets
will not allocate resources efficiently.
➢ Market failure- An inefficient allocation of resources produced by a market
economy when one or more of the conditions for a perfectly competitive market is
not met.

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 3.3 Externalities
❖ An externality exists whenever the welfare of some agent, either a
firm or a household, depends directly, not only on his or her
activities, but also on activities under the control of some other
agent as well.
❖ Externalities may be related to production or consumption
activities.
Production externalities occur when the production decision of
one agent affect the production possibilities of another agent.
Consumption externalities occur when the consumption
decision of one agent affect the utility of another agent.
➢ There are two types of externalities:
➢ Externalities (external effects) may be beneficial or adverse.
i) An external economy (external benefit, positive externality)
✓ Exists when the activities of one agent make another agent
better off.
✓ Example: - Vaccination against an infectious disease.
- Bee keeping and apple field (pollination of blossom)
ii) External diseconomies (external cost, negative externality)
✓ Exists when the activity of one agent makes another agent
worse off.
✓ Example: - Noise pollution from radio playing in a park
– A factory polluting river with a fishery downstream
Externalities:
 Occur in an unintended way.
 Violate the exclusivity characteristic of an efficient property
right structure.
 Are not transmitted accurately through a market
 Those who benefit from positive externalities do not pay for
them

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  The producers of negative externalities make no compensation
to the affected party.
The Consequence of Externalities
Economists make a distinction between private costs and external
costs.
Private costs are borne by someone involved in the transaction.
External costs are borne by someone not involved in the
transaction.
 The same distinction is made between private and external benefits.
→ Social costs = private costs + external costs
→ Social benefits = private benefits + external benefits
(i) External diseconomies
▪ Suppose a steel mill and a resort hotel are located by a river.
▪ The steel firm uses the river as a receptacle for its waste, while
the hotel uses it to attract customers seeking water recreation.
▪ The steel firm doesn't bear the cost of reduced business at the
hotel resulting from the waste it dumps into the river.
▪ Since the firm doesn't take into account the external cost in its
decision-making, it is expected to dump too much waste into the
river. Hence, an efficient allocation of the resource (the river)
would not be attained
Fig; Social and Private Equilibrium

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 • MPB – Marginal private benefit
• MPS – Marginal social benefit
• MPC – Marginal private costs
• MSC – Marginal social cost
• EC - External cost
• q – privately optimal level of activity (production)
• q’- socially optimal level of activity (production)
The demand for steel is shown by MPB=MSB.
The supply of the product (excluding the external cost) is given by
MPC
In the presence of negative externality:– MSC > MPC (the
difference is MEC - marginal external cost)
The privately optimal level of output exceeds the socially optimal
one (i.e. q > q’)
Conclusion:
The output (of the product that generates external benefit) is too
low
The price of the product that generates external benefit is too
high

Pecuniary externalities
arise when the external effect is transmitted through higher prices.
Suppose that a new firm moves into an area and drives up the rental
price of land.
That increase creates a negative effect on all those paying rent and,
therefore, is an external diseconomy.
This pecuniary diseconomy, however, does not cause a market failure
because the resulting higher rents are reflecting the scarcity of land.
The land market provides a feedback mechanism.

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 The pollution example is not a pecuniary externality because the
effect is not transmitted through prices.
That is, prices do not adjust to reflect the increasing waste load.
The scarcity of the water resource is not signaled to the steel firm.
An essential feedback mechanism that is present for pecuniary
externalities is not present for the pollution case
3.4 Public goods
A public good is a good or service whose consumption is non- rival
(indivisible) and non-excludable
→ Non-rivalry in consumption
Consumption is said to be non-rival (indivisible)when one person's
consumption does not diminish the amount available to others.
This characteristic of a public good implies joint consumption
possibilities, i.e. a public good can be consumed by several
individuals simultaneously without diminishing the value of
consumption to any one of the individuals.
→ Non-excludability in consumption
Consumption is said to be non-excludable when an individual
cannot be prevented/excluded from consuming the good or service
whether or not the individual pays for it.
This characteristic of a public good implies high exclusion costs,
i.e. it is very costly to prevent an individual from consuming a
public good even when the individual fails to pay for it.
Thus, once it is provided, a public good is accessible to all.
Examples of public good include:
– Fresh air
– A public park
– Charming landscape (a beautiful view)

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– National defense

Can the market provide the efficiently level of public goods?

No! The market provision of public goods tends to be inefficient.
Inefficiency results because each person is able to become a free
rider.
Due to the consumption indivisibility (non-rivalry) and non-
excludability properties of public good, individuals have the
incentive to free ride, or to not pay for the benefits they receive
from consuming the public good.
With a free-rider problem, private firms cannot earn sufficient
revenues from selling the public good to induce them to produce
the efficient (socially optimal) level of the public good.
Thus, markets often undersupply public goods.
Improperly Designed Property Rights Systems
Private property is not the only possible way of defining
entitlements to resource use. Other property rights regimes include:
– State-property regimes
– Common-property regimes
– Open access resources (Res nullius)
State-property regimes
State property is a regime in which the government owns and
controls the property.
It exists not only in former communist countries but also to
varying degrees in all countries of the world.

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 For example, parks and forests are frequently owned and managed
by the government in capitalist as well as socialist countries.
Efficiency and sustainability problems can arise in state-property
regimes since the incentives of bureaucrats who implement and/or
make the rules for resource use may diverge from collective
interests.
Common-property regimes
Common property refers to property owned in common rather than
privately.
Property right is held by a specified group of co-owners and excludes
those not in the group.
The group of owners jointly own and manage the property.
Thus, common property is a property rights regime in which the
rights of access, withdrawal, management and exclusion are held in
common by a group of owners.
Rights to use common – property resources may be formal, protected
by specific legal rules involving the use of the resource (e.g., specific
share agreements in certain fisheries).
Common property rights may also be informal, protected by tradition
and custom (e.g. in some agrarian communities’ customary
procedures govern the use and management of pasture lands).
Common- property resources may possibly be allocated efficiently
→ if the group of owners are small and can set up a system of
rules, and
→ if there is social sanctions against breaking rules by any
one of them.
On the other hand, common-property resources are allocated
inefficiently

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 → if there is no well-defined system of rules governing the
use of the resources or if the number of owners is large.
→ Even if the group of owners is small and can set up a
system of rules, every one of them has the incentive to
break the rules unless there are social sanctions against it.
Moreover, population pressure and the infusion of outsiders raise the
demand for common-property resources and undermine collective
decision making significantly that the rules became unenforceable,
producing overexploitation of the resource.
Open access resources (Res nullius)
Open access property is a property rights regime in which no entity
holds recognized access, withdrawal, management, exclusion, or
alienation rights to a resource.
Open access thus represents lack of property rights or ownership of
any kind.
Open access property resource can be exploited on a first-come,
first-served basis, because no individual or group has the legal
power to restrict access.
Rival but non-excludable resources are considered as open access or
common pool resources.
– Examples: unregulated fisheries or grazing lands
In the presence of open access, markets cannot by themselves
allocate resources efficiently.
In the presence of sufficient demand, open (unrestricted) access
causes resources to be overexploited.
Unlimited access destroys the incentive to conserve.

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 An individual exploiting an open-access resource would not have
any incentive to conserve because benefits derived from restraint
(conservation) would, to some extent, be exploited by others.
Open access to resources thus promotes an inefficient allocation.
Tragedy of the commons
Open access leads to the most serious problems in natural resource
use popularly known as the “tragedy of the commons”.
Hardin (1968) presented an argument that suggests that
overexploitation of a resource shared by many parties is inevitable.
This argument is termed 'the tragedy of the commons' and it states
that each individual with access to a commonly shared (open
access) resource will try to maximize his own gain from the
resource, and management of the resource to maximize long-term
yield will not be possible.
Every individual harvesting an open-access resource does not take
into account the cost he imposes (in terms of reduced productivity
of the resource) on others (the community) who are also harvesting
the resource.
The cost of individual behavior is borne by the whole community,
but the benefits accrue to individuals.
Every individual will thus try to take as much resource as
possible, and the resource will be exhausted (destroyed).
Such an outcome is referred to as the “tragedy of the commons”.
Example: Buffalo hunting
 Consider a buffalo harvesting (hunting) activity in a certain
park/village.
 The total revenue or benefit (TR/TB) and total cost (TC) of the
hunting activity are depicted in Figure 1(a).

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 The related average revenue (AR), marginal revenue (MR), average
cost (AC) and marginal cost (MC) of the hunting activity are also
shown in Figure 1(b).
 Two different levels of harvest effort (E1 and E2) are shown in the
Figure, where harvest effort refers to the time and effort expended by
hunters to harvest (hunt) buffalo.

 The efficient level of hunting activity (effort) is E1.

 E1is the level of effort where the marginal benefit (marginal
revenue) curve crosses the marginal cost curve.

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 At this level of harvest/hunting the marginal benefits would equal
the constant marginal cost implying that net benefits would be
maximized.
 Owner/owners with exclusive right would apply this level of
effort (E1) and earn scarcity rent (TR-TC) from the resource
 Under open access (with all hunters having unrestricted access to
the buffalo) the resulting allocation would not be efficient.
 Open-access hunters without exclusive rights would exploit the
resource until their total benefit equaled total cost, implying a
level of effort equal to E2.
 At this level of effort, over exploitation of the herd occurs and the
scarcity rent dissipates
 No individual hunter would have an incentive to protect scarcity
rent by restricting hunting effort.
 Since individual hunters cannot appropriate the scarcity rent, they
ignore it.
 Two characteristics of open-access allocation:
1. In the presence of sufficient demand, open/unrestricted
access will cause resources to be overexploited and
2. The scarcity rent is dissipated; no one appropriates the
rent, so it is lost

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