1. Foundations
1.1. Welfare: efficiency and optimally
1.1.1. Economic efficiency
An allocation of resources is Pareto efficient if it is not possible to make one or more persons better
off without making at least one person worse off.
Efficiency in allocation (= economic efficiency) requires that three efficiency conditions are fulfilled:
o Efficiency in consumption: Marginal rates of substitution are equal across consumers
o Efficiency In production: Marginal rates of technical substitution is the same in the
production of all commodities
o Product-mix efficiency: Marginal rate of substitution of consumption between sector (for
any given person) is equal to marginal rate of transformation of production between sectors
(for any given input)
An efficient allocation of resources is not unique
The criterion of economic efficiency does not provide any basis for making interpersonal
comparisons
The utility possibility frontier (UPF) show the combinations that correspond to efficiency in
allocation
1.1.2. Social welfare function
A SWF can be used to rank alternative allocations
When social welfare is maximised: SWF is tangential to UPF
Problems with SWF and the Pareto improvement criterion
o The relative weights to be assigned to the utilities of different individuals in SWF are an
ethical and political matter
o Pareto optima are not unique
o Practical policy suggestions are very seldom Pareto improvements.
o If re-allocations involves winners and losers, it is outside of the terms of the Pareto
improvement criterion
1.1.3. Hicks-Kaldor Criteria
Economists seek to separate efficiency from ethical question of distribution, so:
o Kaldor’s test: could the gainers compensate the losers after the project is implemented, and
still be better off
o Hick’s test: the losers could not compensate the winners for the project not occurring, and
still be as well off as they would have been if it had taken place
o Scitovsky’s test: the project is desirable if both the Kaldor and Hicks tests are satisfied
o Moving from a Pareto inefficient allocation, to a Pareto efficient one, will always satisfy both
the Kaldor and the Hicks tests.
Compensation tests and fairness
o Compensation tests do not align with maximising social welfare
Compensation tests give equal weight to winner’s gains and losers’ losses
irrespective of income and wealth levels
o These issues are generally ignored in practice for small projects
‘Assume all will come out in the wash’
o For large projects we cannot assume all will come out in the wash via re-distributive
taxation
1
,1.2. Market failure, public policy and the environment
First welfare theorem: the competitive equilibrium is efficient. (If markets are perfect -> they
aren’t)
1.2.1. Externalities and public goods
Externalities: when the actions of one economic agent affect another other than through the price
mechanism/market transaction we say that there is an externality, they can be positive or negative.
Important examples are: Public goods, Common goods, Pollution and positive spillovers from R&D.
o Public goods: an externality which is non-rival and non-excludable.
Samuelson condition: Society’s willingness to pay for the public good, which is the
sum of the individual willingnesses to pay is equal to the marginal cost of the public
good. This is the jointly optimal way, but not the individual optimum -> free riding
will occur and this condition will not be satisfied without government intervention.
1.2.2. Externalities such as pollution
Marginal external cost (MEC): Is the change in the cost to parties other than the producer or buyer
of a good or service due to the production of an additional unit of the good or service. Typically
increases with quantity of pollution.
Social-welfare-maximising solution: If q is the pollutant, the optimal q, q* is such that MB(q*) =
MEC(q*), with MB the marginal benefits of producing one more polluting good q -> Efficient
quantities of pollution -> also pareto optimal.
Income effects: there could be many different Pareto efficient quantities of pollution because MEC
and MB are both measured relative to marginal utility of money.
Externalities resolved with property rights: Hand out rights to pollute, the owner can block
pollution or allow it, now our MB = MEC picture is very like a supply and demand figure.
1.2.3. Coase theorem
When trade in an externality is possible and there are no transaction costs, bargaining will lead to a
Pareto efficient outcome regardless of the initial allocation of property rights. Moreover, if the
profit/utility functions are quasilinear then the quantity of the externality is independent of the
initial allocation of property rights
o This suggests the role for government is to define and enforce property rights, and minimise
transaction costs.
o When quasilinearity is absent (income effects), there will be many efficient quantities of the
externality, and the initial allocation of property rights will influence which is reached by the
bargaining
o Private information is an issue -> creates transaction costs -> possible that polluting project
is inefficient, but takes place
1.2.4. Externalities & Role for government
Externalities acting on public goods
o We do not expect voluntary offsets to solve the climate problem, even with clearly assigned
property rights, because the environment is a public good -> incentive is to free ride -> clear
role for the government to step in
2
, Quantity control:
o Government unlikely to have enough information to work out the right quantity for each
polluting source
o However, it can decide on the total quantity allowed, if the right total quantity is chosen we
can eliminate the DWL and reach an efficient pollution level. Government can do this
through cap and trade or through running an auction for the right to pollute
Price instruments:
o Pigouvian taxation: impose a per-unit-tax on pollution of t per unit where
t = MEC(q*) = MB(q*) -> polluter sets MB = MC = t and so constraints to q*
1.2.5. Common goods
Rival, but non-excludable
o We had an externality affecting a public good. An alternative way to look at this is that the
good is no longer non-rival
Tragedy of the commons:
o Complete optimization: marginal benefit of commons equals marginal cost
o Individual optimization: average benefit of commons equals average cost
o So we end up with too many commons
o We can address this with: property rights, taxes or quantity constraints
o If all potential users of a common can form a deal to use it sustainably, and that deal can
stick, the commons need not be a tragedy. (game theory)
1.3. Economics within the environment
Economy and environment interdependence
Economy is located within the environment, which provides four functions:
o Natural resources
Flow resources (solar radiation, wave and wind power)
Stock resources (level of current use does affect future availability)
Renewable resources
Non-renewable resources
o Energy resources
o Mineral resources
o Source of amenity services
o Receptacle for wastes
o Provides life support services
Environmental impact of economic activity: I (IPAT identity states that I = P * A * T)
o P = population, A = per-capita affluence, T= technology of production
The environmental Kuznets curve (e = y or e = 0y - 1y2)
o e = per capita emissions, y = per capita income
2. Valuation
2.1. Introduction
Categories of environmental benefits:
o Use & non-use values: users interact directly, while non-users never physically interact, but
still derive value
Use values: Consumption uses & Non-consumption uses (revealed preference
methods)
Non-use values: Altruistic, Existence, Bequest (stated preference methods)
3
1.1. Welfare: efficiency and optimally
1.1.1. Economic efficiency
An allocation of resources is Pareto efficient if it is not possible to make one or more persons better
off without making at least one person worse off.
Efficiency in allocation (= economic efficiency) requires that three efficiency conditions are fulfilled:
o Efficiency in consumption: Marginal rates of substitution are equal across consumers
o Efficiency In production: Marginal rates of technical substitution is the same in the
production of all commodities
o Product-mix efficiency: Marginal rate of substitution of consumption between sector (for
any given person) is equal to marginal rate of transformation of production between sectors
(for any given input)
An efficient allocation of resources is not unique
The criterion of economic efficiency does not provide any basis for making interpersonal
comparisons
The utility possibility frontier (UPF) show the combinations that correspond to efficiency in
allocation
1.1.2. Social welfare function
A SWF can be used to rank alternative allocations
When social welfare is maximised: SWF is tangential to UPF
Problems with SWF and the Pareto improvement criterion
o The relative weights to be assigned to the utilities of different individuals in SWF are an
ethical and political matter
o Pareto optima are not unique
o Practical policy suggestions are very seldom Pareto improvements.
o If re-allocations involves winners and losers, it is outside of the terms of the Pareto
improvement criterion
1.1.3. Hicks-Kaldor Criteria
Economists seek to separate efficiency from ethical question of distribution, so:
o Kaldor’s test: could the gainers compensate the losers after the project is implemented, and
still be better off
o Hick’s test: the losers could not compensate the winners for the project not occurring, and
still be as well off as they would have been if it had taken place
o Scitovsky’s test: the project is desirable if both the Kaldor and Hicks tests are satisfied
o Moving from a Pareto inefficient allocation, to a Pareto efficient one, will always satisfy both
the Kaldor and the Hicks tests.
Compensation tests and fairness
o Compensation tests do not align with maximising social welfare
Compensation tests give equal weight to winner’s gains and losers’ losses
irrespective of income and wealth levels
o These issues are generally ignored in practice for small projects
‘Assume all will come out in the wash’
o For large projects we cannot assume all will come out in the wash via re-distributive
taxation
1
,1.2. Market failure, public policy and the environment
First welfare theorem: the competitive equilibrium is efficient. (If markets are perfect -> they
aren’t)
1.2.1. Externalities and public goods
Externalities: when the actions of one economic agent affect another other than through the price
mechanism/market transaction we say that there is an externality, they can be positive or negative.
Important examples are: Public goods, Common goods, Pollution and positive spillovers from R&D.
o Public goods: an externality which is non-rival and non-excludable.
Samuelson condition: Society’s willingness to pay for the public good, which is the
sum of the individual willingnesses to pay is equal to the marginal cost of the public
good. This is the jointly optimal way, but not the individual optimum -> free riding
will occur and this condition will not be satisfied without government intervention.
1.2.2. Externalities such as pollution
Marginal external cost (MEC): Is the change in the cost to parties other than the producer or buyer
of a good or service due to the production of an additional unit of the good or service. Typically
increases with quantity of pollution.
Social-welfare-maximising solution: If q is the pollutant, the optimal q, q* is such that MB(q*) =
MEC(q*), with MB the marginal benefits of producing one more polluting good q -> Efficient
quantities of pollution -> also pareto optimal.
Income effects: there could be many different Pareto efficient quantities of pollution because MEC
and MB are both measured relative to marginal utility of money.
Externalities resolved with property rights: Hand out rights to pollute, the owner can block
pollution or allow it, now our MB = MEC picture is very like a supply and demand figure.
1.2.3. Coase theorem
When trade in an externality is possible and there are no transaction costs, bargaining will lead to a
Pareto efficient outcome regardless of the initial allocation of property rights. Moreover, if the
profit/utility functions are quasilinear then the quantity of the externality is independent of the
initial allocation of property rights
o This suggests the role for government is to define and enforce property rights, and minimise
transaction costs.
o When quasilinearity is absent (income effects), there will be many efficient quantities of the
externality, and the initial allocation of property rights will influence which is reached by the
bargaining
o Private information is an issue -> creates transaction costs -> possible that polluting project
is inefficient, but takes place
1.2.4. Externalities & Role for government
Externalities acting on public goods
o We do not expect voluntary offsets to solve the climate problem, even with clearly assigned
property rights, because the environment is a public good -> incentive is to free ride -> clear
role for the government to step in
2
, Quantity control:
o Government unlikely to have enough information to work out the right quantity for each
polluting source
o However, it can decide on the total quantity allowed, if the right total quantity is chosen we
can eliminate the DWL and reach an efficient pollution level. Government can do this
through cap and trade or through running an auction for the right to pollute
Price instruments:
o Pigouvian taxation: impose a per-unit-tax on pollution of t per unit where
t = MEC(q*) = MB(q*) -> polluter sets MB = MC = t and so constraints to q*
1.2.5. Common goods
Rival, but non-excludable
o We had an externality affecting a public good. An alternative way to look at this is that the
good is no longer non-rival
Tragedy of the commons:
o Complete optimization: marginal benefit of commons equals marginal cost
o Individual optimization: average benefit of commons equals average cost
o So we end up with too many commons
o We can address this with: property rights, taxes or quantity constraints
o If all potential users of a common can form a deal to use it sustainably, and that deal can
stick, the commons need not be a tragedy. (game theory)
1.3. Economics within the environment
Economy and environment interdependence
Economy is located within the environment, which provides four functions:
o Natural resources
Flow resources (solar radiation, wave and wind power)
Stock resources (level of current use does affect future availability)
Renewable resources
Non-renewable resources
o Energy resources
o Mineral resources
o Source of amenity services
o Receptacle for wastes
o Provides life support services
Environmental impact of economic activity: I (IPAT identity states that I = P * A * T)
o P = population, A = per-capita affluence, T= technology of production
The environmental Kuznets curve (e = y or e = 0y - 1y2)
o e = per capita emissions, y = per capita income
2. Valuation
2.1. Introduction
Categories of environmental benefits:
o Use & non-use values: users interact directly, while non-users never physically interact, but
still derive value
Use values: Consumption uses & Non-consumption uses (revealed preference
methods)
Non-use values: Altruistic, Existence, Bequest (stated preference methods)
3
