The Basic Models of Environmental Economics

1. Finn R. Førsund Department of Economics, University of Oslo The Basic Models ofEnvironmental Economics THE FOURTH INTERNATIONALCONFERENCE ON ECONOMIC CYBERNETIC ANALYSIS: GLOBAL CRISIS EFFECTS ON DEVELOPING ECONOMIES, Bucharest, May, 22-23 2009 The Basic Models

2. The Basic Models Background What is environmental economics? Building blocs: Production and consumption of man-made goods and generation of pollutants Production of environmental services Interaction economic activity and the environment Evaluation of man-made and environmental goods

3. The Basic Models Tools for dealing with the building blocks Production and generation of pollutants Multi-output production theory Production of environmental services and interaction pollutants – the environment Knowledge about natural environments and effects of deposition of pollutants Evaluation of environmental goods Externalities Public-good theory

4. The Basic Models The basic social-choice model Social choice: how much environmental protection, trade-off marketed goods – environmental services Benefit to the production sector from pollution and damage of pollution to consumers B = benefit, e = pollution, D = damage

5. The Basic Models The basic social-choice model, cont. The social optimisation problem Necessary first-order condition Second-order sufficient condition

6. The Basic Models Illustration of the social solution b’,d’ b’ d’ b’* = d’* e e*

7. The Basic Models The fundamental pedagogical marginal rule Optimal pollution where marginal benefit from pollution equals marginal damage of pollution Towards policy instruments: What is behind benefit of pollution? What is behind damage of pollution? Must disaggregate to formulate prescriptions for policy instruments.

8. The Basic Models The materials balance Pollution is generically a problem with joint outputs in economic activities of production and consumption The first law of thermodynamics tells us that matter cannot disappear A production/consumption activity using physical inputs must generate residuals General feature of residuals that they arise from use of inputs in a wide sense

9. The Basic Models Explaining the benefit function and the purification function of the basic model Factorially determined multi-output production (Frisch, 1965) in the production sector, with purification Marketed output: y Pollutants: e Production inputs: xy (K,L,E,M,S) Purification inputs end-of-pipe: xa (K,L,E,M,S)

10. The Basic Models Options for reducing pollutants Reduced activity level and use of all inputs Substitution among inputs Modification; end-of-pipe purification Change of production technologies of production, pollution generation and modification f*(xy) > f(xy), h*(xy) < h(xy), a*(xa) > a(xa) Changing type of product, types of inputs Recirculation of residuals, residuals as goods Relocalisation of activities

11. The Basic Models Factorially determined multi-output production Profit maximisation with environmental constraint Output price: p Input prices: qy, qa Pollution constraint: eR

12. The Basic Models Profit maximisation, cont. The Lagrangian First-order conditions Endogenous variables as function of exogenous variables

13. The Basic Models The benefit function Environmental restriction is so lax that the constraint is not binding e* < eR No purification resources are used. xa = 0 The profit function with binding environmental constraint

14. The Basic Models The relationship between the benefit- and the abatement cost function Minimising production and purification costs Comparing with the profit maximising case, solving for endogenous variables as functions of exogenous variables we have

15. The Basic Models Illustration of cost function c’ Marginal costs c’(e;yo) c’(e,y) Emissions eπ emin

16. The Basic Models The damage function, 1 Utility of environmental services as public goods Man-made goods: yi Environmental services: M = m(e), m’ < 0 Demand for the environmental services, vertical summation

17. The Basic Models The damage function, 2 Using the relationship between the environmental service M and the emissions e The coefficient, v, converting “utils” to money may be a function of preferences, income, income distribution and emissions

18. The Basic Models Damage functions and standards Methods of estimating d(e) Direct methods; contingent evaluation, asking about willingness to pay Indirect methods; hedonic prices, property values, travel cost method Standards

19. The Basic Models Illustration of standards c’ Marginal costs c’(e;yo) eS c’(e,y) Emissions eπ emin