Chapter 2

Economics of
Environmental Quality
I. Market efficiency

 Market: a system in which the major

economic decisions about how much to
produce are made by the more or less
unhindered interaction of buyers
and sellers
 Demand curve shows the quantity of a
good or service that the individual in
question would demand (i.e., purchase
and consume) at any particular price
 An aggregate demand curve is the
summation of a number of individual
demand curves
I. Market efficiency

 The supply curve shows the quantity of

the good the firm would supply at different
prices
 The aggregate supply curve of a group of
firms is the sum of the individual supply
curves of all the firms in the group
 I. Market efficiency
 Market equilibrium: E(P*,Q*)

P
C S (MC)

E
P*

D (MB)
Q
0 Q*
I. Market efficiency

An allocation of resources is said to

satisfy the static efficiency criterion if
the economic surplus derived from
those resources is maximized by that
allocation.
 I. Market efficiency
 The market equilibrium is also the
efficient point which marginal benefits
equal marginal production costs

P
C S (MC)

E
P*

D (MB)
Q
0 Q*
I. Market efficiency
 Total social benefit at E:

 Total social cost at E

 Net social benefit at E:

I. Market efficiency

 Consumer surplus is the difference

between total willingness to pay for
the good and the actual cost of the
good. (What they are willing to pay
and what they actually pay)
 Consumers’ surplus at E:
I. Market efficiency
 Consumer surplus is measured as the area
under the demand curve that lies above the
price line, bounded from the left by the
vertical axis and the right by the quantity of
the good
I. Market efficiency

 Producer surplus is the difference

between the amount that a seller
receives minus what the seller would be
willing to accept for the good
 Producers’ surplus at E:
I. Market efficiency
The producer surplus is designated by area B,
the area under the price line that lies over the
supply curve, bounded from the left by the
vertical axis and the right by the quantity of
the good
II. The environment as a commodity

1. The environment as an asset

 In economics, the environment is
viewed as a composite asset that
provides a variety of services
• The environment asset is limited → a
scarce resource
II. The environment as a commodity
2. Public goods

 Public goods: those that exhibit both

consumption non-rivalry and
non-excludability

II. The environment as a commodity
2. Public goods
II. The environment as a commodity
2. Public goods

An impure public good

 A non-excludable good but it can
become congested
 A non-rivalrous good but exclusion
may be possible
II. The environment as a commodity
2. Public goods
 Free rider problem → the private market
undersupplies public goods
 In the real world, enough people may
contribute to paying for a public good
 III. Externalities
 If an agent making a decision
does not bear all of the
consequences (costs and
benefits) of that decision, then
this results in what is know as
externality.
 Externalities = third party effects
 III. Externalities
Types of Externalities
 Negative externality: When a firm’s
production/an individual’s consumption
reduces the well-being of others who
are not compensated by the firm/the
individual
E.g.: Water pollution from a plant;
someone’s smoking; global warming
due to emissions from fossil fuels
 III. Externalities
Types of Externalities
 Positive externality: When a firm’s
production/ an individual’s consumption
increases the well-being of others but
the firm is not compensated by the
firm/individual
E. g.: Scenic area, vaccines etc.
 III. Externalities

Market failure due to externality:

- The output of the commodity is too
large or too small
- The price of product responsible for
externality is too low
- Externality creates deadweight loss to
the society
 III. Externalities

a. Negative externalities
Steel production:
 Market supply curve represents MC
 Market demand curve represents MB
→ Private market competitive equilibrium:
MB = MC
→ A(Pm, Qm)
III. Externalities

P
MC

A
Pm

MB
Q
0 Qm
 III. Externalities
a. Negative externalities
Sludge from the steel plant causes
water pollution → external on
fishermen
External cost is represented by the
MEC curve (marginal external cost)
Total external cost:
III. Externalities

P
MC

A
Pm
MEC

MB
Q
0 Qm
 III. Externalities
a. Negative externalities
Social efficiency:
MSB = MSC
or MB = MC + MEC
→ E (Ps, Qs)
Thus:
Qm > Qs or too much steel is produced
Pm < Ps or the price of steel is too low
III. Externalities
At A, there is deadweight loss which
equals the area of EAB

P MSC=MC+MEC

MC
C B

E
Ps
Pm A MEC

MB
Q
0 Qs Qm
 III. Externalities
Public-Sector Remedies
Corrective taxation: Pigouvian taxation
t* = MEC(Qs) → MC’ intersects MB at E
→ The tax effectively internalizes the
externality and leads to the socially
optimal outcome
Total tax collected: T = t* x Qs
III. Externalities

MSC=MC+MEC
P

C B
MC
E
Ps
Pm A MEC

MB
t*
Q
0 Qs Qm
 III. Externalities
b. Positive externalities
Forestry:
 Market supply curve represents MC
 Market demand curve represents MB
→ Private market competitive equilibrium:
MB = MC
→ A(Pm, Qm)
III. Externalities

P
MC

A
Pm

MB
Q
0 Qm
 III. Externalities
b. Positive externalities
Benefits from the forest include
regulation of climate, conservation of
biodiversity, carbon storage, erosion
control and other non-wood values
→ External benefits to the society
Total external benefit:
III. Externalities

P
MC

A
Pm
MEB
MB
Q
0 Qm
 III. Externalities
a. Positive externalities
Social efficiency:
MSB = MSC
or MB + MEB = MC
→ E (Ps, Qs)
Thus:
Qm < Qs or too little forest is planted/
protected
Pm < Ps or the price of forest product is
too low
III. Externalities
At A, there is deadweight loss which equals the
area of EAB

P
C MSB=MB+MEB
MC
MB
B
E
Ps
Pm A

Q
MEB
0 Qm Qs
 III. Externalities
Public-Sector Remedies:
Subsidy
At s* = MEB(Qs) → MB’ intersects MC at E
→ The subsidy effectively internalizes the
externality and leads to the socially
optimal outcome
Total subsidy: S = s* x Qs
III. Externalities

P
C MSB=MB+MEB
MC
MB
B
E
Ps
Pm A

s* MEB
Q
0 Qm Qs
IV. Pollution Control—A General
Model

The socially efficient level of

emission: the level emission at
which net social costs are
minimized
→ The socially efficient level of
emission IS NOT EQUAL to zero
IV. Pollution Control—A General
Model

 Social costs
◦ Damage cost (DC): all the negative
impacts that users of the environment
experience as a result of the
degradation of that environment
◦ A Marginal Damage Cost (MDC)
function shows the change in
damages stemming from a unit
change in emissions or ambient
concentration
Representative MDC Functions
IV. Pollution Control—A General
Model
Total damage cost at emission level of W1
W1
DC
TDC =  MDCdW = OAW1
0
MDC
A

w
0 W1
 IV. Pollution Control—A General
Model
 Social cost
◦ Abatement cost
➢ Abatement cost (AC): describes the costs
of abating, or reducing, the quantity of
wastes put in the environment: production
technology, input switching, residuals
recycling, treatment, abandonment of a
site
➢ A Marginal Abatement Cost (MAC) function
show the added costs of achieving a one-
unit decrease in emission level, or
alternatively the costs saved if emissions
are increased by a unit
Representative MAC Functions
 IV. Pollution Control—A General
Model
 Total abatement cost from Wmax to W1
W max
AC TAC =  MACdW = Wmax AW1
W1

MAC
Wmax
w
0 W1
IV. Pollution Control—A General
Model

 The overall marginal abatement cost

curve is the horizontal sum of the
individual abatement cost curves
 The socially efficient level of emission:
at which TSC = TDC + TAC → min
IV. Pollution Control—A General
Model
The level of emission W* at which
MAC = MDC
DC,
AC MDC

E
a c g
e

d f h MAC
b
Wmax
w
0 W1 W* W2
V. Environmental Policies

1. Standards
2. Emission fees
3. Transferable emission permits
4. Deposit – refund system
5. Environmental remediation deposits
6. Eco-label
 1. Standards

 Emission standards are never-exceed

levels applied directly to the quantities
of emissions coming from pollution
sources
 Normally expressed in terms of quantity
of waste per some unit of time
1. Standards
 The economics of standards: setting
the standard at the efficient level of
emissions: S = W*
DC, S
AC MDC

MAC
Wmax
w
0 W*
 1. Standards

 Uniform standard: applying the

same standards to all sources
S = W*/n
(n: number of sources of emission)
→ makes their regulatory lives much
simpler and it gives the impression
of being fair to everyone
 1. Standards

 Behaviours of the enterprises: To

abate from Wmax to the standard
→ Total enforcement cost

W max
TEC = TAC =  MACdW
S
 Standard is a command-and-
control (CAC) instrument
 2. Emission fees

 A fee collected by the

government, levied on each unit
of pollutant emitted into the
environment
 Total payment = fee x amount of
pollution emitted
 2. Emission fees
 Economics of emission fees: The
fees/charges should be set so that the
emission would be W*
DC,
AC MDC

MAC
Wmax
w
0 W*
 2. Emission fees

 Behaviour of the enterprises: To

emit at the level at which the total
enforcement cost is minimized:
 The enterprises would emit at Wo
where MAC = f
 Thus the fee should be set at
f = MAC = MDC
 Emission fee is an incentive-based
instrument
2. Emission fees

AC

a
c f
e
g
b d
f h MAC
Wmax
w
0 W1 W0 W2
There are two polluters with the same pollutant. Their MAC
functions are defined as:
MAC1 = 100 – 2W1
MAC2 = 180 – 3W2
W: level of emission, measured in tons. MAC is measured in $
a. What are their levels of emission if there is no intervention?
b. The government wants to decrease the total level of emission
to 60 tons. Compute the uniform standard that the government
should impose on each polluters and total enforcement cost for
each one.
c. If the government wants to use emission fee to reach the total
level of emission of 60 tons, how much should they impose on
each ton of emission? Compute each polluter’s level of emission
and total enforcement cost.
d. Which instrument would the polluter prefer, uniform standard
or emission fee? How about the preference of the government?
e. Use graph to illustrate your result
 Instrument choice under
uncertainty
 The government wants to decrease the total
level of emission to a certain level
→ The government can use standards or
emission fees → which one should they
choose?
Two scenarios:
 The government has precise information on
the MAC and MDC
 The government has imprecise information
on MAC and MDC
→ The government will choose the instrument
with less total social cost
 Scenario 1: Precise information
 Uniform standard
→ S = W*/n MDC,
MAC
→ The total MAC1
abatement cost
of polluter i is:
MAC2
𝑊𝑚𝑖
𝑇𝐴𝐶𝑆𝑖 = න 𝑀𝐴𝐶𝑖 𝑑𝑊
𝑆
0 S Wm2 Wm1 W

→ With standard: MAC1 ≠ MAC2 ≠ … ≠ MACn

 Scenario 1: Precise information

 Emission fee
MDC,
→ Each polluter choose MAC
the level of emission MAC1
at which MAC = f
→ MAC1 = MAC2 = …
MAC2
= MACn = f f

→ The total abatement

cost of polluter i is:
0 W2 S W1 Wm2 Wm1 W

𝑊𝑚𝑖
𝑇𝐴𝐶𝑓𝑖 = න 𝑀𝐴𝐶𝑖 𝑑𝑊
𝑊𝑖
 Scenario 1: Precise information

→ Both standard and

MDC,
emission fee leads MAC
to the same level MAC1
of emission
→ The government MAC2
f
should choose the
one with less total
abatement cost:
0 W2 S W1 Wm2 Wm1 W
𝑛 𝑛

෍ 𝑇𝐴𝐶𝑆𝑖 vs. ෍ 𝑇𝐴𝐶𝑓𝑖

𝑖=1 𝑖=1
→ The government should choose emission fee
 Scenario 2: Imprecise information

Assumption: The MDC,

government know MAC
MDC
precisely about
MDC but only
knows the slope
of MAC
Which instrument MACt
should be used? MACes w
Wmax
0 W*
 Scenario 2: Imprecise information

The socially efficient

level of emission is MDC,
MAC
W* where MAC = MDC
MDC E
The total social cost
at W*:
TSC* = OGEWmax G
MACt
MACes w
Wmax
0 W*
 Scenario 2: Imprecise information

Setting the standard:

The government sets S
MDC,
standard at the level of MAC
MDC
emission where MDC = A
MACes E

The total social cost at

Ws is: B
TSCs = OGEWmax + G
MACt
EAB MACes w
Wmax
0 Ws
W*
 Scenario 2: Imprecise information

Setting the emission S

fees: The government MDC,
MAC
sets the fees so that f A MDC
= MDC = MACes C
E
The total social cost D
at Wf is: f
B
TSCf = OGEWmax + MACt
G
ECD MACes w
Wmax
0 Ws Wf
W*
 Scenario 2: Imprecise information
S S C
MDC, MDC
MDC,
MAC A C MDC MAC A E
E
D
D f
f B
B MACt
G MACt MACes
MACes G
w w
Wmax
0 Ws W* Wf Ws W* Wf Wmax
0

If MAC is steeper than MDC If MDC is steeper than MAC

→ Area of ECD < Area of EAB → Are of EAB < Area of ECD
→ The government should use → The government should
emission fee use standard
 3. Tradable emission permit

 Decentralized market interactions in

which polluters may buy and sell
emission permits, and pollution is
controlled by linking emissions with the
number of permits held
3. Tradable emission permit

Steps:
 The government decides the
aggregate quantity of emissions to
be allowed
 Permits are then written in
accordance with this quantity and
distributed among the sources
responsible for the emissions
3. Tradable emission permit
TEP market:
• Supply: the number of TEP issued by
the government
• Demand:
✓ Individual demand: the individual
MAC
✓ Aggregate demand: the aggregate
MAC
3. Tradable emission permit
 The market price of TEP: P* at the
equilibrium
P
S

E
P*

MAC
Q
0 W*
3. Tradable emission permit
Behaviour of the polluters:
 Buyers of permits: the ones with
MAC > permit price P*
 Sellers of permits: the ones with
MAC < permit price P*
 There are gains from trade to be had
by the sources in effect rearranging the
number of TEP among the polluters
4. Deposit-refund system

 A deposit-refund system is
essentially the combination of a
tax and a subsidy
◦ The tax is a deposit
◦ The subsidy is a refund
 To provide the incentive for
people to refrain from disposing
of these items in environmentally
damaging ways
4. Deposit-refund system

Deposit-refund systems are used

when:
 A product is widely dispersed
when purchased and used
 Disposal is difficult or impossible
for authorities to monitor
E.g.: lubricants, batteries, cars…
4. Deposit-refund system

Advantages:
◦ Financially sustainable
◦ Fair
◦ Creating incentives to change
behavior
◦ Cost-effective
Disadvantages:
◦ High operating costs
 5. Environmental remediation
deposits
 Those cause negative impacts on the
environment have to pay environmental
remediation deposits to a fund as
provided in the law
 To guarantee that the polluters will
execute environmental restoration and
remediation works following their
activities
 5. Environmental remediation
deposits
 The deposit amount must be equal to or
greater than the environmental
remediation cost
 Deposits shall be returned when the
polluters finish the environmental
remediation
 5. Environmental remediation
deposits
 Decree 40/2019/NĐ-CP and Decree No.
19/2015/NĐ-CP: Environmental
remediation deposits for mining
activities
 Environmental remediation deposits for
scrap importing:
[Link]
hw5TJtjKs
6. Ecolabel

 Ecolabels are a specific type of

product labeling that certifies the
environmental performance of a
specific product or service
 6. Ecolabel
 The label is certified by
the state and issued to
the company's products
 Self-declaration label is
based on self-
assessment results or
third-party reviews
 Voluntary label according
to the voluntary program
proposed by economic
sectors/economic
organizations
6. Ecolabel

Ecolabel “Blue sail” for tourist

boats in Quang Ninh:
[Link]
v=6myx675YBAI
 VI. Decentralized policy

1. Property rights
In economics, property
right refers to a bundle
of entitlements
defining the owner’s
rights, privileges, and
limitations for use of
the resource
1. Property rights
A well-defined property rights:
 Exclusivity: All benefits and costs accrued as
a result of owning and using the resources
should accrue to the owner, and only to the
owner
 Transferability: All property rights should be
transferable from one owner to another in a
voluntary exchange.
 Enforceability: Property rights should be
secure from involuntary seizure or
encroachment by others.
2. Coase Theorem

If property rights over the

environmental asset are well
defined, enforceable, and
transferable, and bargaining
among owners and prospective
users is allowed, the efficient level
of effluent will result irrespective
of who was initially given the
property right
2. Coase Theorem
The model:
Consider a lake and two entities
Firm A polluting the lake → MAC
Fisherman B → MDC
DC,
AC MDC

E
a c e g

d f
b h MAC
Wmax
w
0 W1 W* W2
2. Coase Theorem
 Fisherman B owns the lake
→ Level of emission is zero
Firm A’s total abatement cost is
maximized → Firm A would have
to buy permission from B to place its
wastes in the lake
 The first ton: any amount agreed on
between 0 and $c would make both
parties better off
2. Coase Theorem
 A & B could continue to bargain
 B would be better off for any payment
in excess of its MDC
 Any payment less than MAC would
make Firm A better off
 The bargain stops at W* where MAC =
MDC → the socially efficient level of
emission
2. Coase Theorem
 Firm A owns the lake
→ Level of emission is Wmax
B’s total damage cost is maximized →
B offers A some amount of money to
reduce its effluent stream
 The first ton: any amount agreed on
between 0 and $r would make both
parties better off
2. Coase Theorem
 A & B could continue to bargain
 B would be better off for any payment
less than its MDC
 Any payment excesses MAC would
make Firm A better off
 The bargain stops at W* where MAC =
MDC → the socially efficient level of
emission
2. Coase Theorem

Disadvantages
 It’s difficult to have a well defined,
enforceable, and transferable property
right for environmental assets
 High transaction cost
 Strategic behaviours in bargaining