Assist. Prof. Dr.

Billur ENGİN BALIN ECON3014 Environmental Economics

INTRODUCTION AND OVERVIEW

WHAT IS THE ECONOMICS?

The most popular definition says, “Economics is a social science which studies human behavior as a
relationship between ends and scarce means which have alternative uses.” 1

• Note that the theories of economics can be applied to any scarce resource, not just traditional
commodities.
• Economics is not simply about profits or money. It applies anywhere constraints are faced so
that choices must be made.
• Economists study how incentives affect people’s behavior.

WHAT IS ENVIRONMENTAL ECONOMICS?

Environmental economics is the application of economic principles to the study of how environmental
and natural resources are developed and managed. There is a mutual relationship between the
environment and economics: natural resources serve as inputs to the economic system, and
environmental resources are affected by the system (e.g., pollution).

WHY DO WE STUDY ENVIRONMENTAL ECONOMICS?

• In general, prices reflect the relative scarcity of goods. However, in environmental economics,
markets, and thus prices, often do not exist.
• What aspects of environmental and natural resource economics make it unique?
1. Market failures (If the allocation of goods and services by a free market is not efficient2, this is
called a market failure.)
2. The decision to consume a good today typically does not affect the ability to consume it
tomorrow. However, the decision to use natural resources today does affect what will be
available tomorrow.
3. Irreversibility (Damage to natural resources has long-term effects. For example, if Cappadocia
were flooded, future generations would be unable to enjoy its beauty. This is not as large a
problem for normal consumer goods.)
4. Linkages between the economic and ecological system (An interdisciplinary understanding of
the environment, political science, etc., necessary to be a good environmental economist.)

1
Lionel Robbins, (1935), An Essay on the Nature and Significance of Economic Science, London:
Macmillan
2
We mean “Pareto Efficiency” here. An economic situation is Pareto efficient if there is no way to
make any person better off without hurting anybody else. An allocation is Pareto inefficient if there is
some way to make someone better off without anybody worse off. In this case, we say that Pareto
improvement is possible.

1
Assist. Prof. Dr. Billur ENGİN BALIN ECON3014 Environmental Economics

MARKET FAILURE & EXTERNALITIES

Hal R. Varian, Intermediate Microeconomics, 5th ed., Chapter 32
http://www.policonomics.com/

WHAT ARE THE SOURCES OF MARKET FAILURE?

• Externalities
• Imperfect Competition [Imperfect competition or imperfectly competitive markets is one in which
some of the rules of perfect competition are not followed. Virtually all real-world markets follow
this model, as in practice, all markets have some form of imperfection. When dealing with
imperfect competition, the equilibrium price can be influenced by the actions of agents. In
imperfect competition, the price of goods can increase above their marginal cost and thus have
customers decrease their level of purchase and so reach inefficient levels of production.
Governments try to avoid these situations and take measures to stop imperfect competition. The
most common forms of imperfect competition include monopolies, oligopolies, duopolies,
monopolistic competition and monopsony.]
• Public Goods [Public goods are those that are non-rival and non-excludable in consumption. Being
non-rival implies that even if someone consumes, it does not prevent someone else from doing it
as well. Being non-excludable implies that no one will be prevented from consuming the good due
to impossibility or because of a high price.]
• Asymmetric Information [Asymmetric information refers to transactions in which one of the
parties has better information than the other one. Adverse selection and moral hazard can result
from the worst cases of asymmetric information in transactions between economic agents. A key
article on this subject is “The Market for Lemons: Quality Uncertainty and the Market Mechanism”,
1970, in which George Akerlof develops a classic example of a second-hand car market in which
the seller is the only one that truly has complete information about the quality of the car, to simply
explain the risk of asymmetric information.]

DEFINITION OF EXTERNALITY

Externalities are the benefits or costs that arise when the decision to consume or to produce generates
some positive or negative impact on the environment, affecting the welfare of others in a way that is
not transmitted through prices or market mechanisms. When the market price does not truly reflect
the real price in which the externality should be considered, there is a loss of efficiency. As previously
stated, it is important to keep in mind that externalities can be linked both to an improvement of the
utility for individuals and also to its damage. The former is known as positive externalities. An example
of one would be the vaccination of an individual that would prevent having a disease and, at the same
time, avoid the spread of the disease to others. On the other hand, negative externalities are those
that reduce utility, and a common example is the air pollution produced by many factories.

• An externally imposed benefit is a positive externality.

o A well-maintained property next door that raises the market value of your property.
o A pleasant cologne or scent is worn by the person seated next to you.
o Improved driving habits that reduce accident risks.
o A scientific advance.
• An externally imposed cost is a negative externality.
o Air pollution.

2
Assist. Prof. Dr. Billur ENGİN BALIN ECON3014 Environmental Economics

o Water pollution.
o Loud parties next door.
o Traffic congestion.
o Second-hand cigarette smoke.

Crucially, an externality impacts a third party, i.e. somebody who is not a participant in the activity that
produces the external cost or benefit.

Externalities cause Pareto inefficiency; typically,

• too much scarce resource is allocated to an activity, which causes a negative externality.
• too little resource is allocated to an activity which causes a positive externality.

For consumption externalities For production externalities;

MSB = MPB + MEB MSC = MPC + MEC

MSB: Marginal Social Benefit MSC: Marginal Social Cost

MPB: Marginal Private Benefit MPC: Marginal Private Cost
MEB: Marginal External Benefit MEC: Marginal External Cost

3
Assist. Prof. Dr. Billur ENGİN BALIN ECON3014 Environmental Economics

INEFFICIENCY & NEGATIVE EXTERNALITIES

• Consider two roommates, Aylin and Can, and two commodities, money and smoke.
• Both smoke and money are good for Can.
• Money is good, and smoke is bad for Aylin.
• Can is endowed with TL 100
• Aylin is endowed with TL 100
• Smoke intensity is measured on a scale from 0 (no smoke) to 1 (maximum concentration, 100%).

• Suppose Aylin is the owner of the room. Because of this ownership Aylin has a legal right to clean
air.
• Then the initial endowment is labelled E, Can has (TL100, 0 smoke), Aylin has (TL100, 0 smoke) or
(TL100, 100% clean air)
• Is this allocation efficient?

4
Assist. Prof. Dr. Billur ENGİN BALIN ECON3014 Environmental Economics

EXTERNALITIES AND PROPERTY RIGHTS

• The initial endowment is not Pareto Efficient. But Aylin can sell “rights to smoke”.
• Having a property right to clean air means having the right to trade some of it away for other
desirable goods – in this case, money.
• Aylin would prefer to trade some of his right to clean air for some more money. Point labelled X is
an example of such a case.
• Both agents gain from trade (their utilities have increased), and there is a positive amount of
smoking.
• Establishing a market for trading rights to smoke causes an efficient allocation to be achieved.
• Suppose instead that Can is assigned the ownership of the air in the room. Now, Can has a legal
right to smoke.
• Then the initial endowment is labeled E’, Can has (TL100, 100% smoke), Aylin has (TL100, 100%
smoke) or (TL100, 0 clean air)
• E’ allocation is not also Pareto efficient. For efficiency, Aylin can now pay Can to reduce the smoke
intensity.

• Both agents gain from trade (their utilities have increased), and there is a reduced amount of
smoking.
• Establishing a market for trading rights to reduce smoke causes an efficient allocation to be
achieved.
• Notice that the
o agent given the property right (asset) is better off than at her own most preferred
allocation in the absence of the property right.
o amount of smoking that occurs in equilibrium depends upon which agent is assigned the
property right.
• As long as we have well-defined property rights in the good involving the externality -no matter
who holds the property rights- the agents can trade their initial endowment to Pareto efficient
allocation.

5
Assist. Prof. Dr. Billur ENGİN BALIN ECON3014 Environmental Economics

• The only problem arises if the property rights are not well-defined. If Can believes that he has the
right to smoke and Aylin believes that he has the right to clean air, we have difficulties. THE
PRACTICAL PROBLEM WITH EXTERNALITIES GENERALLY ARISES BECAUSE OF POORLY DEFINED
PROPERTY RIGHTS.