Economics in the Biophysical World

Nicolas Kosoy

Outline

• Closed world/open world• Circular flow of commodities• Value and welfare• Externalities• Environmental Policy• Conclusions

• Illimitable cylinder– Reinforces the idea of frontiers– Beyond known limits

Earth as Planet

• Expanding Universe• Closed system- materials and some energy• Open system –energy (Sun)• Evolutionary perspective• Embedded self

What about the current economic system?

•Systems may be open or closed in respect to a number of classes of inputs and outputs•World Economy is an open system:• Matter• Energy• Information

Value and Welfare

• Value: subject-object; subject is human.• Demand: interpretation as marginal benefits,

marginal willingness-to-pay (Derived from utility function - downward sloping=diminishing returns).

• Supply: marginal costs (derived from production function).

• Consumer and producer surplus: marginal versus total benefits/costs (or welfare effect).

Value- total and marginal WTP

Partial equilibrium

Consumer and producer surplus

OBE = sum of producer and consumer surplus

Measure of net social value

The invisible hand

• Adam Smith 1776: maximisation of individual welfare contributes to maximisation of social welfare.

• Market takes care of an efficient allocation of scarce means: sum of consumer and producer surplus maximal.

• This only holds if social costs = private costs.

Market failures

• No socially efficient/optimal allocation of scarce means through markets if:

– There are not markets for all goods and services. – There is imperfect competition on some markets.– Economic activities generate externalities– Public goods exist. Property rights are incompletely assigned– Transactions do not occur under perfect information. – Not all firms maximise their profit– Not all individuals maximise their utility (bounded rationality)– There are transaction costs (search, contract, negotiation, policy).

Negative externalities

• Also known as ‘negative external effects’ or ‘external costs’.

• Social costs = private costs + external costs. => external costs, unlike private (production) costs do not end up in market prices.

• No social welfare optimum: economic activity too large scale, or based on undesirable input mix, or on undesirable production technique.

Externality

“An externality is present whenever some individual's (say A's) utility or production relationships include real (i.e. non-monetary) variables, whose values are chosen by others without particular attention to the effects on A's welfare.”

Baumol/Oates (1974/1988)

Externality (cont)

• Unintended effect (originator unconscious): pestering and charity do not generate externalities.

• Externality is technological or physical: direct, physical interaction between humans, not humans and environment - environment implicit.

• Different from monetary (pecuniary) externality: change in demand (taste, fashion) or supply (technology, discovery of resource) affects prices (of products and production factors) and in turn welfare/profit of buyers, suppliers, workers, etc.

Different externalities

Technological externalities

• Positive/negative (Marshall/Pigou). • Caused by / effect on: production (profits) or

consumption (utility/welfare).• Symmetrical/asymmetrical (polluter, victim):

congestion vs. river up-/downstream pollution.• Static/dynamic: future, delayed effects;

flow/stock (climate change).• Private/public good (‘bad’)

Private and Public goods (cont)

Economic differences

• Private good: marginal willingness-to-pay (WTP, or price) equal for all individuals (single price); different amounts consumed.

• Public good: equal consumption; different WTP (unpaid ‘prices’); total price is sum of individual prices (willingness to pay).

• ‘Free rider’ problem: real WTP cannot be elicited or with uncertainty (purpose monetary valuation methods).

Optimality vs elimination of externality

• Externalities are no exception or rarity: thermodynamics, scarce space.

• From a welfare perspective the level of external costs should be optimal: derived from the notion of optimal social welfare.

• Thus in general external effects do not need to be reduced to zero: for this would in most cases imply elimination of economic activity (and even human existence).

Optimality approach

NB(E)=B(E)-D(E)NB: net benefits of pollution;E: flow pollution (emission of a substance);B: benefits of pollution; D: damage costs of pollution.

maximise NB(E): dNB/dE = 0 => dB/dE = dD/dEInterpretation: marginal benefits of pollution should be equal to marginal damage costs.

Graphical solution

Environmental policy?• Internalisation (literally !)

– Integration of polluter and pollutee/ victim (merger or take-over) => external costs become private costs.

• Negotation (not same as market !)– Coase(1960): negotations between polluter and victim.

• Regulation (government intervention/policy – Include smarket based instruments – Pigou(1938): regulating with optimal levy.

• Note: Libertarians emphasize social cost of governance itself. Their suggestion of ‘minimal governance’ seems based on perception of local communities, local problems and evolving, self-organised solutions (i.e. lack of global commons and concentrated power). Coase theorem (property rights + negotiation) fits in this line of thinking.

Coase Theorem

• Conflict solution based on negotiations between polluter and victim.

• Required: enforceable property or user right.• Results:– Allocation satisfies socially optimal level of external

costs => no env. regulation needed.– Efficiency independent of allocation of right: but

there is a distribution effect.– Government has to garantuee rights: legislation,

accessible administration of justice.

An example

What is the solution?

1. Right with saxophone player => Ψ3: benefits minus costs = (a+b+d)-(b+c+d) = a- c.2. Right with neighbour => Ψ1: benefits minus costs = 0.3. After negotiations, irrespective of whether one starts from situation 1 or 2, Ψ2 will be the equilibrium outcome3 is optimal: marginal costs= marg. benefits.

Limitations

• Not realistic in case of many agents: transaction costs high.

• If public good/bad: risk of ‘free rider’ behaviour.• Free entry: influenced by compensation victim(s).• Does not work in case of effect far ahead in the future:

e.g., climate change.• Property rights may influence valuation of costs and

benefits: endowment/status quo effect.• Conclusion: many reasons for government

intervention => Environmental policy theory

Conclusions• Negative externality central concept in welfare (environmental)

economics.• Many types :static/dynamic, public/private goods

– relevant distinctions for regulation.• In general optimal, not zero level of externality.• Optimality in economics: marginal costs = marginal benefits

– in market, negotiation or regulatory contexts.• Social costs = private + external costs.• Social welfare optimum: marginal social costs = marginal social

benefits.• Coase theorem: surprising insight, but not wide applicability.