Econ 57a, Environmental Economics, Fall 2020

Module 2: Efficiency

• Supply, demand, and equilibrium
• Efficiency and the equimarginal principle
• Benefits and costs for environmental services
• Benefit-cost Analysis

The King of Burgers

Robert Baratheon is a huge burger lover. One day he walks into a burger place, and finds the menu to be the following. Which burger should Robert choose?

Burgers	No. Sausages	Price	WTP
Veggie Burger	0	$4	$5
Cheeseburger	1	$6	$8.5
Double Cheeseburger	2	$8	$11
Triple Cheeseburger	3	$10	$12.5
The Ultimate Cheeseburger	4	$12	$13

Maximize net benefits

Burgers	Price	WTP	Net Benefit
Veggie Burger	$4	$5	$1
Cheeseburger	$6	$8.5	$2.5
Double Cheeseburger	$8	$11	$3
Triple Cheeseburger	$10	$12.5	$2.5
The Ultimate Cheeseburger	$12	$13	$1

Some Algebra

WTP: \(-0.5Q^2+4Q+5\)

The demand for beef sausage:

P = 4-Q

Price for beef sausage

P = 2

Net benefit is maximized when price equals marginal benefit

Q = 2

Consumer surplus

Consumer surplus is the value that consumers receive from an allocation minus what it costs them to obtain it. Consumer surplus is measured as the area under the demand curve minus the consumer’s cost.

Producer surplus

Producer surplus

• Producer surplus is the difference between the amount that a seller receives minus what the seller would be willing to accept for the good.
• Given price P*, the seller maximizes his or her own producer surplus by choosing to sell Qs units.
• The producer surplus is designated by area B, the area under the price line that lies over the marginal cost curve, bounded from the left by the vertical axis and the right by the quantity of the good.

Equilibrium

A market equilibrium is characterized by the equimarginal principle, i.e.,

• For the consumer, price equals marginal benefit
  
• For the producer, price equals marginal cost
  
• Thus a market equilibrium is characterized by:

Marginal Benefit = Marginal Cost

The First Welfare Theorem

a.k.a the Invisible Hand Theorem

A complete and competitive market leads to a Pareto efficient allocation of resources.
- Adam Smith

• Pareto efficiency: no other feasible allocation could benefit at least one person without any deleterious effects on some other person
• Equilibrium from a competitive market is (Pareto) efficient

Positive and Normative Economics

Positive inquiry: what is, what was, or what will be (factual judgment)
Normative inquiry: what ought to be (value judgment)

• Economic efficiency essentially means to maximize social welfare
• Entails a normative judgment, i.e., what the society should be doing
• What about the distribution of income? Environmental justice?

Question

What if you have waited in line for three hours for this amazing burger. Will your choice be different?

What if the restaurant has given you a free five-dollar coupon for your each visit?

What if on the way to the restaurant, you lost that five-dollar coupon?

What if the place is offering you a $11 coupon for your each visit?

What if in addition to the price the restaurant charges, the city collects a burger tax of $4 for each burger?

So, what happens when the good in question is environmental pollution?

Question: What is the optimal level of particulate matters (PM)?

We need to find:

• A demand curve
  • How much will we benefit from reducing pollution?
• A supply curve
  • How much will it cost to reduce pollution?
• An optimal level of pollution that equates supply and demand

Exposure to particulate matters will cause:

• Alzheimer’s (Science, 2017)
• Dementia (Bishop et al., 2017)
• Lower test scores (Ebenstein et al. 2016)
• Irrational stock trading behavior (Heyes et al. 2016)
• And much more

Marginal benefit of (reducing) environmental pollution

TQs from you

This is really just a thought, but it feels odd to say that an increase of 100 to 200 birds is more valuable than 1100 to 1200. I completely understand the logic behind it, but it doesn’t change the trivialization/pricing of lives in and of themselves.

1. Is an increase of 100 to 200 birds more valuable than 1,100 to 1,200? Why?
2. Does this trivialize the value of lives?

What about the costs

Ways to reduce particulate matters:

• Ban straw burning
  
• Switching from coal-fired to natural gas-fired power plants
  
• Stringent vehicle emission standards
  
• Switching to electric cars
  
• And…

The Beijing Olympics

Beijing is notorious for its poor air quality.

But during the 2008 Beijing Olympics, the air quality is surprisingly good. Why?

Factories in Beijing and the surrounding region were ordered to shut down weeks ahead of the opening ceremony.

Nineteen days before the Games were due to start, officials implemented restrictions on the use of private automobiles in the city.

Technicians practiced seeding clouds to bring cleansing rains.

-USC US-China Institute

An extreme example

• From mid March to mid June 2020, \(CO_2\) emission decreases by ~18% in the United States (Greestone 2020)
  • By the end of the year, ~6-12% reduction for the year 2020
  • RCP 2.0: 8% reduction every year until 2050
• \(PM_{2.5}\) levels decrease by 36% globally (Venter et al. 2020)
• \(NO_{2}\) levels decrease by 36%, also globally (Venter et al. 2020)

The US lost ~30% of its GDP in the second quarter * The best estimate for cost: $3,000-5,000 per tonne of CO_2

This is really using a missile to shot a cow - Michael Greenstone

Economic efficiency implies net benefit is maximized

Benefit-cost analysis implies net benefit is larger than zero * Every point inside the TC/TB eclipse can pass the BCA

Question: when will the MB = MC approach go wrong?

• Pollution abatement exhibits economies of scale
  • Hazardous waste sites / irrigation infrastructures
  • Cost function is not convex
• Marginal benefit from clean-up increases over scale
  • COVID-19 treatment
  • Benefit function is not concave

• MB > MC when everything is cleaned up
  • Leaded gasoline
  • Corner solutions
• MB < MC without cleaning up
  • Carbon emission from breathing

Marginal analysis vs. Benefit-Cost Analysis

• So far we have focused on the marginals
  • Is it worthwhile to clean-up/conserve/protect the last unit
  • In theory, it maximizes the net social benefit
• Real-world policies are (usually) not made in this way
  • Information on MB and MC is difficult to get
  • Political processes and voter preferences

Benefit-cost Analysis: Economists as Accountants

• There is a need to evaluate the efficacy/efficiency of public investments
• Benefit-cost Analysis (BCA) provides an economic framework
  • In every policy arena, from infrastructure to tax rates to dam constructions
• Straightforward, clear-cut rules

The Decision Rule

Let B be the total benefits from a proposed policy, and C be the total costs. The decision rule is:

If B>C, do it. Otherwise, don’t do it.

Alternatively,

If the benefit-cost ratio B/C>1, do it.

Benefit-cost Analysis

Benefit-cost analysis always considers the TOTAL benefits and TOTAL costs of the policy. For example, for benefits, we have:

• Direct benefits (Human health, species, flood risk reduction)
• Co-benefits (Mercury regulation decreases PM2.5)
• Future benefits (less climatic risk for future generations)
• Option and existence Value (even if we’re never going to see polar bears, knowing it’s there has economic value)

Benefit-cost Analysis

Benefit-cost analysis provides a normative criteria to evaluate public policy decisions

• Normative: entails a value judgment
  • That the societal welfare is measured by the TOTAL economic benefits and costs
• Public: Benefit-cost analysis only applies to decisions that involve a public project
  • Private companies will automatically evaluate decisions based on revenue and cost
  • Public projects do not face the scrutiny of economic(accounting) calculus
• Decision
  • Whether to do the project or not
  • Need a decision rule that is clear-cut

Class Reflections

You are evaluating whether to construct the Three Gorge Dam on the Yangtze River by applying the BCA framework.

1. (Choose one to answer) What are the benefits of the dam?
2. (Choose one to answer) What are the costs?
3. You find that B>C for the dam, and the government is ready to make a decision to build the dam, based solely on your BCA. What could go wrong?

Of course, benefit-cost analysis is NOT the only decision rule:

• Impact analysis
  • What are the environmental impacts of a proposed action?
  • If there is harm, then could it be mitigated?
  • Environmental Impact Analysis, Wetland Permit, Endangered Species Act
• Cost-effectiveness
  • Wish to achieve some normative societal outcome (social justice, universal healthcare)
  • What is the way that involves the least cost to achieve the policy target?

And there is this

Executive Order 13771 (1/30/2017): “(c) …any new incremental costs associated with new regulations shall, to the extent permitted by law, be offset by the elimination of existing costs associated with at least two prior regulations.”

• The Milton Friedman tradition: too much existing regulation are hurting businesses
• Total costs of the regulation should remain the same (or lower)
• But what about benefits?

And benefit-cost analysis does not guarantee economic efficiency

• BCA essentially evaluates whether the total benefit is larger than the total costs
  • Or, whether the net benefit is larger than zero
• That does not guarantee that the proposed policy MAXIMIZES societal welfare

What does benefit-cost analysis look like?