1. Day, General background:
Chapter 1- 5
How much pollution: ?
How should the society choose among different projects that affect different people ?
Based on individual preferences;
Pareto criterion:
Individuals have preferences that are represented by their utility functions. Ui(e,x )
x represent the distribution of material good across individuals.
Let a, b, c represent different bundles of consumption.
If all individuals prefer one of theses alternatives, society too, should prefer that alternative.
Figure 1. Limited resources, pareto frontier.
Many allocations cannot be compared. ! Does not give enough guidance to choose among different projects. Stay with status quo.
Compensation principle
If transfers could be made to achieve unanimity on a particular choice, then the choice is desirable, even if transfers are not actually made. (Kaldor-Hicks compensation principle).
Figure 2.
Voting.
Social welfare function; Social indifference curves
Figure 3: Figure 1 with social indifference curves
There is no ideal way of making social choices based on individual preferences.
Arrow’s impossible theorem: There is no rule satisfying six basic requirements for a social choice mechanism. . page 40
What is special with the commodity “environmental good” or pollution ?
We know from economic theory that competitive markets for goods yield the “right” (efficient) amount of production.
Efficiency in consumption. Not possible to increase the utility for one person without a loss in utility for another person.
Efficiency in production.
Efficiency in the provision of goods.
Marginal social opportunity cost = marginal benefit (marginal willingness to pay).
Figure 4.
Note that efficiency is achieved only when the producers marginal cost equals the marginal social opportunity cost. (the value of the best alternative use of resources available to society, as valued by society.)
First Welfare theorem: In a competitive economy, a market equilibrium is Pareto optimal.
Characteristics of a competitive market:
Assumptions:
Price-taking producers and consumers, complete information, no transaction cost, complete property rights, ordinary private goods (no public goods) and no externalities.
Relaxing these assumptions leads to “market failure”, the failure of a market economy to achieve a Pareto optimum
Public goods:
Non-rival goods: A persons consumption does not reduce the amount available to others. Clean air, Recreational area (if large enough) , White snow
Bad - pollution
How much should be produced of a public good ?
Total marginal willingness to pay should equal marginal cost of provision. Sum up the willingness to pay from all agents for specific amounts of the non-rival good.
(This differ from the ordinary goods where we find the demand curve by horizontal summation of individual demands for a particular price)
Figure
Public good can be excludable or non-excludable. (note; the definition of public good vary). The difference is that excludability means that some can be denied access, and that implies that there is a possibility for charging a price for the good. (or deny access to get rid of the bad.)
Exampels:
Non-rival, excludable: Large park (large enough to avoid congestion) with a fence around. Pay- Tv
Non-rival, non-excludable: Lighthouse, military protection, clean air.
Private provision of a non-excludable public good:
Figure 6.
Produce too little, because consumers do not take into account that other consumers also benefit from their purchase of the good.
Pollute to much….
Private provision of an excludable public good:
Demand curve for the use of a park.
Maximizing utility implies zero price.
Figure 7
The competitive market does not provide the efficient amount of a public good.
EXTERNALITIES:
An externality exist when the consumption or production choices of one agent enters the utility or production function of another agent without that agent’s permission or compensation.
There is no price on the externality, the externality is nonexcludable!
We cannot demand a price from the producer for being exposed to pollution.
When there are externalities in production, the private cost do not correspond to the social cost of production.
Fig 8.
(Internalize the cost of the externality by constructing market for pollution)