Economic Efficiencey and

Environmental Protection

Lifeboat of the English yacht Mignonette (1884)

Engraving by J. Nash after sketches by Mr. Stephens, the mate of

the Mignonette.(Rischgitz/Getty Images)

Social Choice

Question 1: How should society decide on which outcomes (i.e. “allocations”) are “good”?

Question 2: If the criteria is efficiency, how do we identify the ideal choice or action?

Social Choice

Question 1: How should society decide on which outcomes (i.e. “allocations”) are “good”?

• By what criteria or value system(s) should we rank a set of options?

•One criteria favored by economists is the welfare-oriented notion of efficiency – maximizing net benefits (Kaldor-Hicks efficiency)– Caveat: other criteria recognized as important (e.g. equity)

• Immanuel Kant– Major work on ethics: Groundwork of the Metaphysics of Morals, (1785, p. 96):

– Imperative: a proposition declaring a certain action to be necessary; a motivation for an action

– A hypothetical imperative “presents the practical necessity of a possible action as a means of achieving something else which one desires…”

• `means to an end’

– “The categorical imperative would be one which presented an action as of itself objectively necessary, without regard to any other end.”

• ‘an end unto itself’

Reference: Hackett, 2006

Prussian philosopher Immanuel Kant

(1724-1804)Source: wikimedia commons

Ethics: the systematic study of morality (code of conduct establishing what is right vs wrong)

Value/ethical systems• deontological ethics

– An action is judged by its intrinsic rightness based on a moral obligation or duty (not by the degree to which it serves instrumental goals or aspirations)

– Leads to “categorical imperatives” that prescribe choice. Examples:

• Kant: “Act only according to the maxim by which you can at the same time will that it should become a universal law.”

• John Rawls: a system of justice should be determined under a “veil of ignorance” in which one is not yet aware of one’s status or position.

• Leopold: humans have no right to reduce biodiversity except to meet vital needs (land ethic)

• Biocentrism: All species have inherent value irrespective of use to humans.

– Challenge: in a diverse society how do we aggregate over the moral positions of large numbers of people?

Reference: Hackett, 2006

Value systems, cont’d

• teleological ethics (consequentialism)– The worth of an action is determined by the

degree to which it has instrumental value in meeting a desirable goal.

– advocates: Aristotle, Jeremy Bentham (utility), John Stuart Mill (happiness)

– Examples: prescribes following a social rule if…• Egalitarian ethics: equity is enhanced• Utilitarian ethics: the net change in utility is positive

Reference: Hackett, 2006

Intrinsic morality v. consequentialism

• Nativeness: not necessarily positive (e.g. native North American mountain pine beetle.)

introduced species (left to right) tamarisks, pheasants, honeysuckle and zebra musselsK. MOLONEY/THE NEW YORK TIMES/REDUX/EYEVINE; T. & P. LEESON/ARDEA.COM; P. DEL TREDICI; J. WEST/PHOTOLIBRARY

(deontological v. teleological ethics)

Value systems:Utilitarian ethics

•Jeremy Bentham (1748-1832): founded doctrine of utilitarianism.

– English moral philosopher, legal reformer

– Pain and pleasure can be distilled to a single (+/-) number for each individual

– Net social utility can be determined by adding up individual utility.

•Objections: – individual rights – validity of common currency

References: Hackett (2006; 2011), Sandel (2010)

photo: Reeve

Value systems:Utilitarian ethics

•John Stuart Mill (1806-1873): – Maximize utility in the long run.

Upholding individual liberty will promote long-run welfare

– “there needs protection” against the “tyranny of the majority”

References: Hackett (2006; 2011), Sandel (2010)

Photograph: London Stereoscopic Company/Getty Images

Value systems, cont’d

• fundamental elements of utilitarianism (Sen, 1987): – Consequentialism: “(T)he ethical policy is the one that generates

policy outcomes (“end”) that lead to the largest net social utility.”– Sum ranking: “The utility information regarding any proposed

rule is assessed by looking only at the sum total of all the individual utilities associated with the rule.”

– Welfarism: “(T)he goodness of a proposed rule is determined by the utility or disutility that it creates among members of society.

• Motivates a focus on “efficiency”

• W. H. Auden (1962): “Pleasure is by no means an infallible critical guide but it is the least fallible.”

References: Hackett, 2006; Amartya Sen (1987). On Ethics and Economics. New York: Basil Blackwell.

Efficiency

• Kaldor-Hicks efficiency: an allocation in which the aggregate net benefits are maximized – in which there may be winners and losers, relative to the status

quo (or other comparison point), but where winners could, in theory, compensate losers for their losses such that no one worse off than the comparison point.

• Pareto efficiency: an allocation in which no one can be made better off without making some else worse off.

Pareto frontier

• Allocations on the frontier are ‘Pareto efficient’• ‘Pareto improvement’: from an initial allocation X, an alternative allocation Y is a Pareto

improvement if at least one person is better off no one is worse off.• Exercises:

1. Allocation ______ is a Pareto improvement relative to ______

2. F and D __[are, aren’t]__ Pareto improvements relative to E

3. The Pareto criteria ____[does | doesn’t]____ provide guidance for choice between D and F

4. How tractable is strict application of the Pareto criterion for real world policy questions (e.g. climate policy, biodiversity conservation, etc)?

Mike’s utility

Matt’sutility

A

B

C

DE

F

feasible allocations

Example: K-H vs Pareto improvements

PolicyNet benefits to Mike

Net benefits to Matt

K-H improvement?

Pareto improvement?

Status quo 100 100 . .

Alternative A 75 75 No No

Alternative B 75 200 Yes No

Alternative C 100 200 Yes Yes

Alternative D 150 150 Yes Yes

h/t Richard Woodward, AMU

Efficiency• A policy is (K-H) efficient if it achieves the greatest possible net benefits.

o Net benefits = total benefits – total costso NB = TB – TC

• Efficient choice means maximizing the size of the pie (net benefits)….

is preferred to

>

Note that the K-H efficiency criteria doesn’t say anything about how the pie is sliced up

(distribution).

Key problem: How do we quantify the pie/net benefits?

…with a model…

On models in general

• “Essentially, all models are wrong, but some are useful” (George E. P. Box)

• "Theories should be as simple as possible, but no simpler.” (Albert Einstein paraphrased)

• Models are as good as the underlying assumptions (garbage in, garbage out)

• Know the purpose and limitations of the model.

A typical model for characterizing benefits• A model of the benefits to a group or

individual of some good.

• Characteristics typically assumed

(but which are NOT universal)– Diminishing marginal benefits– Smooth curves

• Terminology:

– “Demand”– “Marginal Willingness to Pay”

(MWTP) – “Marginal Benefit” (MB)

• Semantic point: when price falls does demand fall? Not exactly. The ‘quantity demanded’ falls.

Demand

Quantity demanded

Getting a feel for marginal benefits vs. total benefits

Definitions• MB, Marginal benefits (or MWTP): the

(maximum) willingness to pay for a one unit increase in quantity of a good – the rate of change (slope) of the total benefit

curve: dTB(x)/dx

• TB, Total benefits (or total WTP): the total (maximum) willingness to pay for some quantity of a good. – Typically the area under the MB curve up to a

given quantity demanded.

WTP approach to characterizing value: Advantages & Drawbacks

• Advantages: – renders value observable -- we’re all used to

thinking about currency, we know what a dollar means

– treats individuals as the legitimate source of judgment as to the value of things.

• Drawbacks: – difficulty of measurement – doesn’t account for differences in wealth between

individuals (WTP is also limited by ability to pay). – cannot work well if consumers do not know

potential outcomes with reasonable accuracy

A typical model of costs• Characteristics typically assumed

(but which are not universal)– INCREASING marginal costs– Smooth curves

• terminology

– “Supply” – “Marginal willingness to accept”

(MWTA)

Costs of “supplying” the California Condor

From the USFW Recovery Plan summarized in Keohane and Olmstead, Markets and the Environment, 2007.

Expected condors saved per year

Definitions

• MC, Marginal cost: the change in total cost when the quantity is increased or decreased by a unit – the rate of change (slope) of total cost curve:

dTC(x)/dx

• TC, Total costs: the total cost of supplying some number of units of a good.• Typically the area under the MC curve up to a given quantity

demanded.

Definitions: “net”

• Marginal net benefits: MNB = MB - MC

• Total net benefits: NB = TB – TC

• Closely related concept: “surplus”– Surplus: the total net benefits of producing

and consuming X number of units of a good.

Social Choice

Question 2: If the criteria is efficiency, how do we identify the ideal choice or action?

• E.g. how much environmental protection should society choose?

• Need: analytical tools to predict the impacts of policies on “welfare” (net benefits).

Putting it all together: identifying the efficient choice

One example of the “equimarginal rule” for identifying the efficient allocation.

Equating values at “the margin”•In this case, MB=MC.

(Note: In other cases the equimarginal rule might imply a choice where MBA

=MBB or MCA =MCB. )

max{X} NB(X)

max{X} TB(X) – TC(X)

Note: TB’(X) = MB(X) TC’(X) = MC(X)

(calculus) first order condition for max: MB(X*) – MC(X*) = 0 suppressing X: MB = MC

NB(X)

Keohane and Olmstead, Fig 2.6

Putting it all together: identifying the efficient choice

Class exercise:•Using both

1. definitions in this lecture (MB, TB, MC, TC, surplus), and

2. plain language

verbally explain why:

• The point XL is not efficient

• The point XH is not efficient

Social choice from individual values

• The value that an individual places on goods (e.g. environmental

protection) can be captured (imperfectly) by her demand or MWTP.

• To assess policies from an economic perspective we will aggregate the value that society places on goods (or bads).

• Social welfare: “aggregate” NB (net benefits) – Several ways to aggregate individual values (e.g. the minimum of

individuals’ NB; weighting NB by income before summing).– For simplicity in this course we’ll stick with equal weighting

Finding aggregate MWTP for a private good

• Aggregate MWTP for a private good:– Heuristic: “sum demand curves HORIZONTALLY for a private good”– for any given dollar value (p) sum up the quantity demanded (q) across all

individuals: qAgg(p) = qA(p) + qB(p) + qC(p)

qAgg(15) = qA(15) + qB(15) + qC(15) = 4+0+3 = 7

Classroom exercise: Calculate aggregate quantity demanded at p = 8.

?

The need for careful marginal thinking“The value of the world's ecosystem services and natural capital”Costanza et al., Nature, May 1997, pp. 253-260.

• “We have estimated the current economic value of 17 ecosystem services for 16 biomes, based on published studies and a few original calculations.” (abstract)

• Ecosystem services (a couple examples) SERVICE FUNCTION EXAMPLE– Pollination: Movement of floral gametes Prov. of pollinators for plant

reproduction

– Water regulation: Regulation of hydrological flows Prov. of water for agric., industry & travel

• “For the entire biosphere, the value (most of which is outside the market) is estimated to be in the range of US$16-54 trillion (1012) per year, with an average of US$33 trillion per year.” (abstract)

– Global GNP ~$18 trillion/yr

Careful marginal thinking…

• Valuation: what is the value of pollination services? – Method used:

(1) Find the value of pollination for the last marginal hectare pollinated.

(2) Multiply this figure by the total area of land under pollination.

– What does this approach assume about the marginal value of the particular service as the level declines from current to zero? Is this reasonable?

• “Because of the nature of the uncertainties, this ($16-54 trillion) must be considered a minimum estimate.” (abstract)

Further references

Efficiency“Generally refers to the condition of producing something of value with a minimum of waste. •Efficient resource allocation is realized under market exchange with all the available gains from trade are realized, while …•efficient production occurs when goods or services are produced at minimum cost. •A proposed social policy is Pareto-efficient when it makes some people better off and nobody worse off in comparison to the status quo or some other policy option. •In contrast, a proposed social policy is potentially Pareto-efficient (or Kaldor-Hicks-efficient) when it generates an increase in total net social benefits compared to the status quo and other policy options, and thus the potential exists for those made better off to compensate those made worse off.” (Hackett, 2006, p. 490)