Lecture Note, Natural Resource and Environmental Economics Chapter Three

CHAPTER III
EFFICIENCY, MARKET FAILURES AND THE ENVIRONMENT
WELFARE ECONOMICS AND THE ENVIRONMENT

3.1 Efficiency
3.1.1 Definition
The Definition of Efficiency in welfare economics owes much to the economist-Vilifiredo Pareto.
Therefore, an efficient local State is often known as Pareto Optimality.
Definition of Pareto optimality:
“A situation is efficient or Pareto optimal if it is impossible to make one person better-off except
by making some one else worse-off”.
Stated differently, Pareto efficiency is a situation in which it is impossible for an individual to gain
with out another individual incurring a loss. But if an economy is inefficient, it is possible to make
at least one person better off at no cost to any one else. Such a change is called Pareto
Improvement or a Pareto Superior Move.
Two important facts make efficiency a point of concern in Natural resource and environmental
economics
i. The natural environment is a complex system of resource stock, which provides a variety of
valuable service flows to society.
ii. Environmental resources are available in limited quantity.

Economic efficiency is classified in to two:

a. Static efficiency: concerned with allocation of resource in specific point of time (ignores
time factor).
b. Dynamic efficiency: concerned with allocation of resource over a period of time.

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3.1.2 Necessary Conditions in Static Efficiency

In a two person, two good and two input economy, the following three conditions have to be
fulfilled for static efficiency: efficiency in consumption, efficiency in production and product mix
efficiency.
9 Tow person: (A,B) UA = (XA, YA); X=(KX,LX)
9 Two goods: (X,Y) UB = (XB, YB); X=(KY,LY)
9 Two input: (L,K)

1) Efficiency in consumption
The efficient consumption requires that all individuals place the same relative value on all products
(value being assessed at the marginal).
A B
⎛Ux ⎞ ⎛ ⎞
⎜ ⎟ = ⎜Ux ⎟ Where Ux = Marginal Utility from commodity X.
⎜U ⎟ ⎜U ⎟
⎝ y ⎠ ⎝ y⎠
A
MRS XY = MRS XY
B

D If they are not in equilibrium, there is a condition for exchange.

Graphically:
Exchange efficiency is described by the tangency between two indifference curves in Edgeworth–
Bawley Box
X
O2
Contract Curve

D
4 Y
Y C
B
IV
3
2
III
A II
1

I z
O2
X

Note: - Exchange efficiency occurs on the contract curve.

- Movement from Z to A or Z to B is Pareto improvement. But mort from A to B(or B to C or
C to D)is not improvement.

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Lecture Note, Natural Resource and Environmental Economics Chapter Three

2) Efficiency in production
Efficient production requires that the marginal rate of substitution between factors be the same in all
industries.
X Y
⎛ MPL ⎞ ⎛ MPL ⎞
⎜⎜ ⎟⎟ = ⎜⎜ ⎟⎟
⎝ MPK ⎠ ⎝ MPK ⎠
X
MRTS LK = MRTS LK
y

Graphically, production efficiency is described by the tangency between two isoquants (in the
Edgeworth-Bawley Box)
L
OY
Efficiency Locus

D
4 K
K C
B
IV
3 Note that production efficiency occurs on
2 the efficiency locus like at points
III A,B,C,&D
A
1 II

OX
L

3) Product-mix efficiency
Product-mix efficiency requires that the subjective value of X in terms of Y should be equal to its
marginal cost.
UX MPKY
= MRSYX = MRTYX
Uy MPKX

Y
Note that exchange and production
efficiency occurs where MRSYX=MRTYX
like at points B&D
MRS

D
MRT

B
A

X
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 Lecture Note, Natural Resource and Environmental Economics Chapter Three

To Fervent Students
Some Concepts on the Social Welfare Function and Optimality
There are numerable efficient configurations of the economy, depending among others, in the initial
distribution of resources. However, efficiency does not constitute asocial optimum. To obtain social
optimum, we need a utility frontier of the economy known as grand utility frontier (GUF), and the
social welfare function (SWF).
• To obtain GUF, we take each feasible output mix from the transformation curve, and construct
its utility frontier. This gives a family of utility frontier. The overall utility frontier is then the
outer envelop of all these frontiers

Grand Utility frontier of

Utility frontier
for (X0,Y0) Pareto Optimality

UB

Utility frontier
for (X1,Y1)
Utility frontier
for (X2,Y2)

•
UA
• The social welfare function is given as:
W= (UA, UB)
This is the function, which relates the welfare of the society to utility level of individuals in the
society. It gives rise to what is sometimes called the isowelfare curve.
UB

W= (UA, UB) with a slope of

∂w
∂U A = wU A
∂w wU B
W2(UA, UB) ∂U B

W1(UA, UB)

W0(UA, UB)

UA

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• To obtain the Social Optimum (or constrained “Bliss Point”), we use the social welfare
function to pick the preferred utility mix. At the optimum, the slope of the isowelfare curve is
equal to the slope of the grand utility frontier.
U XB wU A
i.e. =
U XA wU B

UB
Isowelfare function

Constrained Bliss-Point

SICIII
SICII Grand Utility frontier
SICI

UA

This is the fourth optimality condition. It is the condition for social justice (It is an optimality
condition, but not Pareto optimality condition. The Pareto optimality conditions are the former
three).

Intertemporal (Dynamic) Economic efficiency and optimality

In static efficiency, we do not talk about time. Here time is considered

UG1 Inter temporal Utility Possibility

Frontier (IUPF)

SICIII

SICII

SICI

UG2
G1 G2
Inter temporal social welfare function = W = W (U , U )

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Rawlins and utilitarian social welfare function

♣ Rawlins Social Welfare function
Rawls argued that if one wants to maximize welfare function of a society, it must maximize this
function W= min (UG1, UG2). They argued that SWF depends on the minimum of UG1 and UG2
Example, consider the following function: W= min (10, 15); the value of this fun is 10 because it is
the minimum. It doesn’t matter what happens to 15 as long as 15 doesn’t go down below 10. We
should care for the least well of in society. It focuses more on the issue of equity.

In this case, the decision is made by the current generation, but they took future generation in to
account. In order to arrive at fair decision, you need to put every body behind a veil of ignorance.
Here they do not know to which generation they belong and hence less likely to bias to their
generation.

♣ Utilitarian Social Welfare function (USWF)

W= φ1UG1 + φ2UG2
To determine inter temporal welfare you have to add the weighted current generation utility and
weighted (discounted) future generation utility.
1
Where, r is a discount rate, φ1=1 and φ2 =
1+ r

3.1.3 Efficiency in a market economy

Does the market system results in efficiency? Yes, but under several assumptions.
Conditions required for a market system to efficiently allocate resources.
1. market exist for all goods and services exchanged,
2. all markets are perfectly competitive,
3. all transactions (agents) have perfect information,
4. property rights are fully assigned,
5. no externalities exist,
6. all goods and services are private; i.e. there is no public goods or no common property
right,
7. long run average costs are non decreasing; i.e. there is no natural monopoly,

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8. all firms are profit maximizers and all individuals are utility maximizers,
9. transaction costs are zero,
10. all relevant functions satisfy convexity conditions.
In reality, however, we find
1. missing future market
2. imperfect competitions
3. information asymmetry among transactrs
4. property rights are not fully assigned
5. externalities exist especially in the use of environmental goods
6. public goods and common property rights exist
7. long run average costs are decreasing over the relevant range of output; there is natural
monopolies in some cases such as in the supply of water, electricity etc
8. not all individuals are profit maximizers; altaism (self sacrificing) may exist; e.g. mother
Tressa, some NGOs
9. there are private transaction costs
10. not all relevant functions satisfy convexity condition.

3.1.4 Static and dynamic efficiencies as net benefit maximization.

a) Static Efficiency:
The chief normative economic criterion for choosing among various allocations occurring at the
same point in a time is called static efficiency or merely efficiency.
Definition: An allocation of resource is said to satisfy the static efficiency criterion if net benefit
from the use of those resources is maximized by that allocation. i.e., B>C or B/C >1 for both B&C
positive.

Net Benefit = total benefit – total cost

NB = TB - TC
Efficiency = Max NB
dNB dTB dTC
= − = 0 , because at maximum of NB, the derivative is zero.
dQ dQ dQ
MB-MC=0
MB=MC

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 Lecture Note, Natural Resource and Environmental Economics Chapter Three

So far so good, but how do we measure benefits and cost?

In economics the system of measurement is anthropocentric, which simply manse human centered.
All benefits and costs are valued interims of their effects on humanity.

9 Benefits can be derived from the demand curve (of the good or service provided by the action).
Demand curves measure the amount of a particular good people would be willing to purchase at
various prices.
For each quantity purchased, the corresponding point on the market demand curve represents the
amount of money some person is willing to pay for the last unit of the good. The total willingness
to pay for some quantity of this good-say, 3 units-is the sum of the willingness to pay for each of
the three units. Hence, the total willingness to pay is the area under the continuous market demand
curve to the left of the allocation in question.

Total willingness Sum of WTP for the The area of the

E.g. = 1st, 2nd, & 3rd unit =
to pay for 3 units shaded region below

Note that total willingness to pay is the concept we shall use to define total benefits. Thus, total
benefits are equal to the area under the market demand curve from the origin to the allocation of
interest.
9 Measuring total costs on the same set of axes involves logic similar to measuring total benefits. It
is important to stress that environmental services have costs even though they are produced without
any human inputs

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Note that all costs should be measured as opportunity costs. For environmental services, their
opportunity cost is the net benefit forgone because the resources providing the service can no longer
be used in the next most beneficial use. Resources are not free if they can be put in alternative
resources.

In graphing costs, we shall use the marginal opportunity cost curve to correspond to the marginal
willingness–to–pay function used previously to graph benefits. The marginal opportunity cost
curve defines the additional cost of producing the last unit. In purely competitive markets, the
marginal opportunity cost curve is identical to the supply curve.
Total cost is simply the sum of the marginal cost. The total cost of producing 3 units is equal to the
cost of producing the first unit plus the cost of producing the second units plus the cost of producing
the third unit. As with total willingness to pay, the geometric representation of the sum of the
individual elements of a continuous marginal cost curve is the area under the marginal cost curve.

Since net benefit is defined as the excess of benefits over costs, it follows that net benefit is equal to
that portion of the area under the demand curve which lies above the supply curve.

Having defined the measurements of costs & benefits, we can now make an inference as to whether
a certain allocation is efficient or not. An allocation is said to be efficient if it maximizes the net
benefit. One implication of the above analysis is what we shall call the first equimarginal principle.
First Equimarginal Principle (the “Efficiency Equimarginal Principle”): Net benefits are
maximized when the marginal benefit from an allocation equal the marginal costs.
This criterion helps to minimize wasted resources, but is it fair? The ethical basis for this criterion
is derived from a concept called Praetor optimality,….

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b) Dynamic efficiency:
The static efficiency criterion is very useful for comparing resource allocations when time is not an
important factor. Yet many of the decisions made now have consequences, which persist well in to
the future time. Examples:
9 Exhaustible energy resources, once used, are gone;
9 Biological renewable resources (such as fisheries or forests) can be over harvested, leaving
smaller and possibly weaker populations for future generations;
9 Persistent pollutants can accumulate over time.
Since many of the decision made now affect the value of assets for the future generation, we should
take the future generation in to account while taking some actions. How can we make choices when
the benefits and costs may occur at different points in time?

Incorporating time in to the analysis requires an extension of the concepts we have already
developed. i.e. we have to extend the static efficiency concept. This extension provides a way for
thinking not only about the magnitude of benefits and costs, but also about timing. 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 period. The concept that allows this comparison is
called present value.
Recall that the net present value of a one - time net benefit received n years from now is
Bn
NPV [Bn] =
(1 + r ) n
And, the net present value of a stream of net benefits {NBo, NB1, …, NBn} received over a period of
n years is computed as
n
NBi
NPV [NBo, ---, NBn] = ∑ (1 + r )
i =0
i

Where r is the appropriate interest rate and NBo 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.

This traditional criterion used to find an optimal allocation when time is involved is called dynamic
efficiency,

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Lecture Note, Natural Resource and Environmental Economics Chapter Three

Definition: Dynamic efficiency can simply be defined as the maximization of net benefit over time.
This is a generalization of the static efficiency concept already developed. In this generalization,
the present value criterion provides a way for comparing the net benefits received in one period
with the net benefits received in another.

An allocation of resources across n time period satisfies the dynamic efficiency criterion if it
maximizes the present value of net benefits that could be received from all the possible ways
allocating those resources over n – periods.
When optimizing over time, we introduce discounting because there is a time value of money.
NB1 NB2 NBt
NB0 + + + ,,,, + where NB0 is maximum NB of current period.
(1 + r ) 1
(1 + r ) 2
(1 + r ) t
Note that the issue of discounting and intergenerational equity will come up with the discussion of
dynamic efficiency.

The simple mathematics of Dynamic Efficiency

Assume that the demand curve for a depletable resource is linear and stable over time. Thus the
inverse demand curve in year t can be written as
pt = a − bqt ---------------------------------------------------------------1

The total benefits from extracting an amount qt in year t are then the integral of this function (the
area under the inverse demand curve).

qt

(Total Benefits)t = ∫ (a − bq)dq ------------------------------------------------------- 2

o

b 2
= aq t − q t ------------------------------------------------------- 3
2
Further assume that the marginal cost of extracting the resource is a constant c and therefore the
total cost of extracting any amount qt in year t can be given by
(Total Cost)t = cqt --------------------------------------------------- 4
If the total available amount of this resource is Q, then the dynamic allocation of a resource over n
years is the one which satisfies the maximization problem:

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b
aqi − qi2 − cqi
n
⎡ n
⎤
Max
q
∑
i =1
2
(1 + r ) i −1
+ λ ⎢
⎣
Q − ∑
i =1
qi ⎥ --------------------------------5
⎦

Assuming that Q is less than would normally be demanded, the dynamic efficient allocation must
satisfy
a − bqi − c
− λ = 0 ---------------------------------------------------------- 6
(1 + r ) i −1
n
Q − ∑ qi = 0 ---------------------------------------------------------------- 7
i =1

An implication is that (P – MC) increases over time at rate r.

Illustration:
Let the inverse demand function for the depletable resource is P = 8-0.4q and the marginal cost of
supplying it is $2.
a) If 20 units are to be allocated between two periods, in a dynamic efficient allocation how much
would be allocated to the first period and how much to the second period when the discount rate
is 0.10?
Solution: Using equation 6, we obtain the following
8 − 0.4q1 − 2 − λ = 0 ------------------------------------------------------------------ 8
8 − 0.4q 2 − 2
− λ = 0 ----------------------------------------------------------------- 9
1.1
q1 + q 2 = 20 -------------------------------------------------------------------------- 10
From equation 8, 9, and 10, we obtain
Q1 = 10.238
Q2 = 9.762
λ = $1.905
Note that equation (8) implies in a dynamic efficient allocation the PV of the marginal net
benefit in period 1 (8-0.4q1 -2) has to equal λ. Similarly, Equation (9) implies the PV of the
marginal net benefit in period 2 should also equal λ. Therefore, they must equal each other.

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b) Check that PV-MNB1 = PV-MNB2

6 − 0.4q 2
6 − 0.4q1 =
1+ r
6 − 0.4(9.762)
6 − 0.4(10.238) =
1 .1
1.905 = 1.905 = λ

c) What does λ measure?

The value of λ obtained from equations 8 & 9 is the present value of marginal user cost. That
value is λ=1.905. MUC = PVMNB =λ.
What does the marginal user cost measures? Marginal user cost measure the opportunity cost of
producing an extra unit of the resource against the future generation. i.e. every unit of the
resource produced and used in one period is a loss to the other period and this loss is referred to
as the marginal user cost. Hence the marginal cost is not only the extraction cost but also the
opportunity cost (MUC).
Traditionally, at optimum levels,
MC = MB
MC = total MC ⇒ the total socially accepted MC
Social accepted MC includes, Private MC + MUC
Private MC = MEC
MCT=MEC + MUC
Thus, at equilibrium,
MB = MCT
MB = MEC + MUC
d) What would the efficient price be in the two periods?
P= 8 – 0.4q
P1= 8 – 0.4q1 and P2= 8 – 0.4q2
P1= 8 – 0.4(10.238) and P2= 8 – 0.4(9.762)
P1 = 3.9 and P2 = 4.1
e) What would the marginal user cost be in each period?
Note that equation (8) states that price in the first period (8-0.4q1) should be equal to the sum of
marginal extraction cost ($2) and marginal user cost ($1.905). Multiplying (9) by (1+r), it

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Lecture Note, Natural Resource and Environmental Economics Chapter Three

become clear that price in the second period (8-0.4q2) is equal to the marginal extraction cost
($2) plus the higher marginal user cost [λ (1+ r) =(1.905) (1.10)= $2.0955] in period 2.
f) Check that MCT = MB
Recall that we obtain P1=3.905 and P2= 4.095 (from question b).
Furthermore, we know that P1= MB1 and P2=MP2
Hence, MEC + MUC = MB
Period I: MEC1 + MUC1 = MB1 Period II: MEC2 + MUC2 = MB2
2+1.905 = 3.905 2+2.095 = 4.095
3.905 = 3.905. 4.095 = 4.095.
Efficiency is achieved!!
Therefore, the price here is not only the private price but also social price; that is why it is above the
(private) MC.

MCT
P
P, C

MUC

MEC

Q Time
As resource gets scarce, P increases
As time goes, the unavailability of resource increases
=>P increases
Note: the gap between p & MC is the MUC which
involves the value of depletion of resources to the next
generation.
MUC = P - MEC

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Lecture Note, Natural Resource and Environmental Economics Chapter Three

3.2 Environmental Externalities

The assumption of the perfect competitive market is that all benefits form sale of product and cost
of production is fully reflected in its demand and supply of the product. When all benefits and cost
are considered the intersection of MSB&MSC leads to maximum benefits.
An externality exists whenever the welfare of some agent, either a firm or a house hold, depends not
only on his or her activities but also on activities under the control of some other agent.
In other words it occurs whenever the activity (or consumption & production decisions) of one
agent affect the utility of another agent in unintended way, and when no compensation is made by
the producer of the external effect to the affected party (i.e. when the effect of the causer is not
reflected in the market transaction).
E.g. Consider the case of steal factory &the resort hotel (both using the same river).

In analyzing externality, we have to distinguish between social & private values.

Distinction between private and social values

Private costs: cost that are borne to under take an activity by the economic agent undertaking the
activity
Social costs: cost that are borne to undertake an activity by the economic agent undertaking the
activity plus costs imposed on all other economic agents.
Social costs = private costs + external cost
Social costs ≥ private costs
Private benefit: benefit obtained form the realization of an activity by the economic agent
undertaking the activity.
Social benefits: benefits obtained form the realization of an activity by the economic agent
undertaking the activity plus benefits obtained by all other economic agents.
Social benefits = Private benefits +External benefits
Social benefits ≥ private benefits

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3.2.1 Types of Externalities

1. Negative Externality [External diseconomy]
9 It is cost of resources not reflected in the price of the product.
9 It causes additional cost to the other members of society that consumers and producers
of the good will not take into account.
9 It leads to an excess of social cost [SC] over private cost [PC]. A steel manufacturing
firm for instance produces both the steel & pollution. Here, the society consider both the
cost of pollution & the cost of producing the steel
⇒ Private cost = cost of producing the steel
Social cost = cost of producing the steel & cost of pollution
SC = PC + EC
Hence, social marginal cost function (MCs) includes both of these cost as well.
Eg -emission of smoke form factory
-a noise of air plane, etc
2. Positive Externality (external economies)
• It is a benefit not reflected in prices
• It causes additional benefit to other member of the society that consumer or producer of
the good & service will not take into account.
• It results in excess of social benefit over private benefit.
i.e MSB > MPB by MEB
e.g. – Vaccination - plainest certain infections disuse
- Education - Directly benefit the individual
- Spillover effects to society
- Discovery of HIV /Aids vaccine
- Bees keeper benefit fruits producers & vice-versa .
3. Pecuniary Externality [Pseudo externality]
• It occurs when one individuals activity level affects the financial circumstance of other,
but which need not produce a misallocation of resources in a world of pure competitions
E.g. suppose that a new firm moves in to 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.

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• This pecuniary diseconomy, however, doesn’t cause a market failure because the
resulting higher rent is reflecting the scarcity of land.
E.g. increase shoe demand→increase price of leather→affect the welfare of leather
4. Unidirectional Externality
• occur when externalities are in one directional, or uni-directional. A→B
5. Reciprocal Externalities
• Occur when externalities are reciprocal, bi-lateral or bi-directional
A↔B
i.e., in the case of negative externalities, each of the agents damages all the other agents
through its actions. E.g. Acid rain in Europe !

3.2.2 Externalities and Economic Efficiency

Here, we are going to analyze the impact of externality on the market system and demonstrate the
condition for efficacy. Recall that, in the presence of externalities social cost are different form
private costs and /or social benefit are different form private benefit
=> MSC≠MPC and /or MSB≠M$B
Hence, in the existence of externalities the traditional condition of MC=MB has to be revised so as
to incorporate the external costs & benefit.
9 When there are external benefits
In this case an unregulated market system would under produce (desired) quantity of a given good.
⇒ Qs>Qm, where Qs = social optimum
Qm = Private (market) optimum
P

MSC (=MPC)

Ps
Pm

MSB (=D2)
MPB (=D1)

Qm Qs Education

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MPB= marginal private benefit

MSB = marginal social benefit
MEB = marginal external benefit
Qm = out put produced by the market system
Qs = socially optimum out put level
Social optimum occurs when MSB= MSC
Private optimum occurs when MPB = MPC

Alternative method of depicting positive externality

a = social inefficiency or dead

weight loss due to the
externality.

Concussion: when there are positive externalities not enough of the activity is undertaken by the
market system

9 when there are external casts:

In this case an unregulated market system would over produce the [undesired ] quantity of a give
good.
⇒Qs < Qm

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Alternative method of depicting a negative externality

MPC = marginal private cost

MSC = marginal social cost
MEC = marginal external cost

Summery of the impact of externalities on the market system.

Negative externality Positive externality

Quantity produced Too much Too little

Cost / Benefits Costs greater than socially Benefits lees than socially optimal
optimal
Stimulus to innovation Little incentive to reduce social Little incentive to expend social
costs benefits

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3.3 Public Goods

3.3.1 Definition
Public goods are goods that either will not be supplied by the market or if supplied, will not be
supplied in sufficient quantity. E.g. clean air, clean water, biological diversity, national defense,
police , public clock, street light, etc

3.3.2 Major characteristics of pure public good

Public goods are largely characterized by the following two points:
1. Non rival in consumption (=> indivisibility )
2. Non exclusive in consumption (=> non excludability )
™ Consumption is said to be indivisible when one person’s consumption of a good does not
diminish the amount available for other (or does not reduce the supply available for others)
This implies that it costs noting for additional individual to enjoy the benefits of the public
good. => the marginal cost of producing public good to additional consumer is zero. Hence,
according to the efficiency rule p should be zero. Thus it is inefficient to put positive price on
public goods.
E.g. let’s take defense:
70 million people = costs x br
60 million +1 person =?
=> cost x !!
=> Admitting one user does not increase the of defense because MC=0

™ Non excludability: refers to circumstance where ,once the resource is provide , even those who
fail to pay for it cannot be excluded form enjoying the benefit it confers.
It is not possible or at least very costly to exclude or to protect non payers from getting benefit
from these type of goods.
⇒ Can we rely on the private sector to produce the efficient amount of public goods such as
biological diversity ? Unfortunately the answer is no! Why? Consider the following case.

In the following figure, individual demand curves for preserving biodiversity have been
presented for two consumers A&B. The market demand curve is represented by the vertical

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summation of two individual – demand curves. A vertical summation is necessary because

every one can simultaneously consume the same amount of biological diversity. We are
therefore able to determine the market demand by finding the sum of the amounts of money
they would be willing to pay for that level of diversity.
What is the efficient level of diversity? => The amount that maximize net benefit (= area under
the market demand cure that lies above MC)

Cost of
Diversity

Person A Q* is the allocation that maximizes net

A
benefit because it is the allocation were
O
the demand curve crosses the Marginal
cost cure.
Note: Both consumers consume this
B Person B
amount. At this level of availability, the
marginal net benefit to person B is OB, to
O person A is OA, and the sum of this
(OA+OB) is society marginal cost curve.

MC
OB

OA

Q*

⇒ Would a private market supply this amount? No! The efficient market equilibrium for a public
good requires different price for each consumer. In this case, if A is charged Pa (=OA) and B
is charged Pb (=OB), than both consumer will be satisfied with the efficient allocation.
⇒ Further more, the revenue collected will be sufficient to finance the supply of the public good
(because PbQ* + PaQ* = MC.Q* ). Thus although an efficient pricing system exists, it is very
difficult to implement.
The efficient pricing system requires charging a different price to each consumer font in the absence
of excludability; consumer may not choose to reveal the strength of their preface for this

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commodity. Therefore, the producer could not possibly know what price to charge. Inefficiency
results because each person is able to become a free rider on the other’s contribution.
⇒ A free rider is someone who drives a benefits form a commodity without contributing to its
supply.
Because of the consumption indivisibility and a non excludability property of public good,
consumer receive the benefits of any diversity purchased by other people. When this happens, it
tends to diminish incentive to contribute, and the contribution are not sufficiently large to finance
the efficient amount of the public good; it would be under supplied.
Summery: the fundamental problem associated with public good are
1. Free rider problem: individual want to consume freely
2. Pricing problem: efficiency in public good requires different pricing for different
individual which is difficult to implement.
3. Information problem: the problem of revealing the demand for public goods.

Distinguish b/n common pool resources and public goods.

Common pool resources are characterized by non exclusivity and divisibility.
E.g. A large lake like Lake Tana with unlimited no of fishermen who have access to it.

3.4 Property Right

3.4.1 Definition
Property right refers to a bundle of entitlements defining the owner’s right, privileges and
limitations for use of the resource. This property right can be vested either with individuals as in
capitalist economy or with the state as in centrally planned socialist economy
Note that the manner in which producers and consumers use environmental resource depends on the
property right governing those resources.
Four main characteristics of an efficient property rights structure in a well functioning market
economy include
1. Universality: all resources are privately owned and all entitlement are completely specified
2. Exclusivity: all benefits and costs accrued as a result of owning and using the resource should
accrue to the owner and only to the owner, either directly or indirectly by
sale to other

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3. Transferability: all property right should be transferable form one owner to another in a
voluntary exchange
4. Enforceability: Property rights should be secure form involuntary seizure or encroachment by
other
An owner of a resource with a well defined property right has a powerful incentive to use that
resource efficiently because a decline in the value of that resources represents a personal loss.
Transferability (exchangeability) of property rights facilitates efficiency. The price level which
producers & consumers face will adjust until supply equals demand. Given that price, consumers
and producers maximize their surplus and market clears.
Is this allocation efficient? According to our definition of static efficiency it is clear that the answer
is yes! The net benefit is maximized by the market allocation and it is equal to the sum of the
consumer and producer surplus.

3.4.2 Property Rights Regimes

Private property is not the only possible way of defining entitlements to resource use other
possibilities include
a. State property regimes: where the government owns &controls the property. With varying
degrees state property regimes exist in virtually all countries of the world e.g. parks &forests.
Here the efficiency & sustainability problem can also arise when the incentives of bureaucrats
who implement and /or make the rules for resource use diverge form collective interests.
b. Common property regimes: are those resources jointly owned and managed by a specified
group of co-owners rather than private. Entitlement to use such resources may be formal
(protected by specific legal rule) or informal (protected by tradition or custom). Efficiency &
sustainability of use depends on these rules (unsuccessful experience is more common).
e.g. Grazing land in rural area
c. Res nullius Regimes: are those resources in which no one owns or exercises control over the
resource. The main focus of this section can be exploited on a ‘first-come-first-served’ basis,
because no individual or group has the legal power to restrict its access.
Every body’s property is no body property.
Get it while the getting is good.
Note that open access resource have given rise to what has became known as the “tragedy of
the commons”

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3.5 Market Failures

3.5.1 Definition
Market failure is a situation that occurs when market prices fail to reflect the true social cost and
benefits of resource use. Stated differently, market failure is a situation in which unregulated
competitive market is inefficient because prices fail to provide proper signals to consumers and
producers.

Competitive market fail for four basic reasons: market power, incomplete information, externality
and public goods.
Market power: ability of a seller or a buyer to affect the price of good. Monopoly (market with only
one seller) and monopsony (market with only one buyer) are the two forms of market power.
Incomplete information: consumers and producers may have incomplete information and may there
after err in their consumption and production decision.
Externality: is when a consumption/production activity has an indirect effect on the other
consumption/production activity that is not reflected directly in market prices.
Public goods: non exclusive or non rival good that can be made available cheaply but which once
available is difficult to prevent others from consuming.

Here it is necessary to distinguish market failure from policy failures and institutional failures.
Policy failures occur when government intervention in the market system lead to economic
inefficiency. Examples are subsidies taxes tariffs quotas etc
These types of issues are dealt under SAP (structural adjustment program) and PAM (policy
analysis matrices)
Institutional failures occur when government does not establish and enforce property rights even
when it is technically possible to do so. Examples in natural resource management are inefficient
taxation of economic rent from natural resources, low or zero stumpage fees etc.

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3.5.2 Correcting Market Failure

The major problem in environmental economics are public good & externalities But is there any
solution to these problems. Basically two solutions are proposed.
a. Redefining Property Right : One reason for inefficiency is improper definition of property
right. Hence, we need to assign exclusive property right to the individuals. The individual will
get a fee for the use of resource. The fee should be equal to the MC (= SMC) of using the
resource. However, it should be noted that most common property resources are vast (or large)
and single ownership may not be practical. Therefore, government regulation or ownership may
be needed.
When assigning property right is not possible a government or community can invest on
resource maintenance or it can restrict harvesting. e.g. by giving quotas, issuing license or
imposing taxes.
b. Internalizing Externalities:When there is an externality, for firm which causes the externality,
the profit maximization conditions are not the same as the Pareto efficiency conditions.
Therefore, the society must find a way of inducing their firm to accounting for the externality.
Internalizing externalities may be defined as the process by which an externality is absorbed by
the market system. This can be done by:
¾ private transaction
¾ government instruments

i. Conditions required for internalizing externalities by private transactions

¾ there must be technically feasible gains form internalizing externalities
¾ there must be net gains form internalizing the externalities
⇒ transactions cost must be less than gains form internalizing externalities
¾ there must be well defined property right
⇒ there should be no institutional barriers in internalizing
But the conditions are hardly achieved!

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ii. Government instrument

There are two main types of government instruments for internalizing externalities, namely
a. Regulatory instruments
E.g. air and water quality standards, permits and licenses, land water controls.
They are also called command-and-control measures.
b. Economic instruments
E.g. Pigovian subsidies and taxes, tradable pollution rights, etc.
They are also called the market based instruments
What other policies generate efficiency? One clever method is known as Merging.
The computation of the effectiveness of the method is obtained by merging the two firms and
maximizing the joint profit πj, where πj=π1+π2.

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