CHAPTER ONE

INTRODUCTION TO NATURAL
RESOURSE AND
ENVIRONMENTAL ECONOMICS

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 Introduction
❖ Economics
✓ Science of allocating scare resources among competing uses. It
studies how to make trade-offs( science of choice or decision
making)
✓ If resources are not scares we don’t need economics.

❖ Natural resources economics

✓ Study how society allocate natural resources over time under
different market setting
✓ It is about problems natural resources management
- inter temporal in nature
- deal with different types of resource
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 Environmental economics

❖ Environmental economics
✓ Deal with economic analysis of environmental problems
(pollution, global warming etc…)

 It undertakes theoretical or empirical studies of the economic

effects of national or international environmental policies around
the world.

 study alternative environmental policies to deal with pollution,

water quality, toxic substances, solid waste, and global warming

 study about environmental problems & policy

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 Ecological economics
 Study about the physical, biological and social structural and
functional relations b/n economies and natural ecosystem

 the interdependence and coevolution of human economies and

natural ecosystems over time and space

 Treat the economy as a subsystem of the ecosystem and

emphasis preserving natural capital

 It uses principles from the natural sciences (particularly

thermodynamics and ecology) to study the joint economy-
environment system

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Ecological economics

Physical and Natural

Environment

Social System

Economic
System

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 Basic issue in natural resource
&environmental economics
 Three important themes of natural resources economics :
efficiency, optimality and sustainability
 Efficiency
◦ Missed opportunities; wasteful use of resources
◦ Eliminating waste/inefficiency => increase net benefits
◦ Technical or physical inefficiency vs Allocative
inefficiency
◦ Efficiency allocation which maximizes society's
benefit

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 Optimality
 Related to efficiency but conceptually distinct
 Optimality needs:
(1) a relevant group of people/society and
(2) an overall objective of this society.

 This enables us to measure the extent of desirability of resource

use decision from that society’s point of view
 A choice of a given resource use is socially optimal if it maximizes
the objective, given the relevant constraints
 – related to inter-temporal
sustainability
distributional equity.

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 Economy-Environment Interdependence
• Economic activity depends upon and affects the natural
environment
• Services that the environment provides

– Resource base (energy resources- oil, mineral resources-

iron ore)

– Amenity service base

– Waste sink (byproducts of production & consumption)

– Life-support system ( ecosyatem services)

▪ pollunation of crops and vegetables

▪ maintain air and water quality, soil quality

▪ Ozone layer protect living organism from strong rays

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 Materials Balance Model
 show links between economic activity and the natural
environment via two sets of flows
 Flow of resources from the environment to the economy
- The focus of Natural Resource Economics

 Flow of residuals from the economy to the environment

- The focus of Environmental Economics

 Residuals are pollution remaining in the environment after

some process has occurred
 Residuals can be delayed, but not prevented, through
recovery, recycling, and reuse

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Materials Balance Model

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1.1 The Emergence of Natural Resource
and Environmental Economics
1. classical thought
 A central interest of the classical
economists was what determines
standards of living and economic growth.
 Natural resources were seen as important
determinants of national wealth and its
growth.
 Land (sometimes used to refer to natural
resources in general) was viewed as limited
11 in its availability
 classical thought (cont’d)
 This limited Input to production exhibited
diminishing returns.
 For the classical economists, the origin of
the pessimism about long-run economic
prospects was acceptance of the law of
diminishing returns in agricultural
production.

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.

Diminishing return to output

 The additional amount produced for each
successive increment of the variable input
(labor) must eventually decline.
output

labor
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 John Stuart Mill (1806-:-1873)
 Among the classical economists John Stuart
Mill's work also utilizes the idea of diminishing
returns, but recognizes the countervailing
influence of the growth of knowledge and
technical progress in agriculture and in
production more generally.
 Mill placed less emphasis on diminishing returns,
reflecting the relaxation of the constraints of
the extensive margin as colonial exploitation
opened up new tranches of land, as fossil fuels
were increasingly exploited, and as innovation
rapidly increased agricultural productivity.
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 John Stuart Mill (cont’d)
 In addition to agricultural and extractive
uses of land, Mill saw it as a source of
amenity values (such as the intrinsic
beauty of countryside) that would become
of increasing relative importance as
material conditions improved.

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 2 Neoclassical Economics: Marginal
theory and Value
 In case of classical, value arise from the labor power
embodied (directly and indirectly) in output.
 Neoclassical economists explained value as being
determined in exchange, so reflecting preferences and
costs of production.
 The concepts of price and value ceased to be distinct.
 Jevons (1835-1882) and Menger (1840-1921) formalized
the theory of consumer preferences in terms of utility
and demand theory.

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 Neoclassical Economics (con’d)
 Leon Walras (1834-1910) developed
neoclassical General Equilibrium Theory, and
in so doing provided a rigorous foundation for
the concepts of efficiency and optimality.
 The introduction of natural resources into
neo-classical models of economic growth
occurred in the 1970s, when some neoclassical
economists first systematically investigated
the efficient and optimal depletion of
resources. This led to emergence of Natural
resource Economics.
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 1.2 The inter linkage between the Economy and the
Environment
The economy:
✓all economic agents
✓their institutions
✓the inter linkages between the institutions and the agents
The environment:
✓ The biosphere
✓The geo sphere
✓The atmosphere and
✓All flora and fauna
 The biosphere: the thin skin on the earth’s surface on which life
exists
 The atmosphere: the stratosphere (high atmosphere) and
troposphere (low atmosphere)
18  The geosphere: that part of the earth lying below the biosphere
 Thus, environment includes life forms, energy and material
resources, the stratosphere (high atmosphere) and troposphere
(low atmosphere)

19 E4: Global Life Support Services

 The economy: two sectors (production and
consumption). Exchange takes place in these
sectors.
The environment is shown in two different
ways:
–one of them having three different linkages
with production and consumption (E1, E2, and
E3)
–and one with a general element (E4).
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 E1: Here the role of the environment is supplying
resources;
 production extracts energy and materials from the
environment, transforms them into outputs (useful goods
traded with consumers and harmful-emissions such as
CO2).
 some recycling in production and consumption (loops R1
and R2)
E2: Here the environment serves as a sink/receptor
 Limited assimilative capacity for waste
 But we mostly have increasing damage and the rate of
increase may exhibit abrupt changes due to ‘threshold’
effects
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 E3: The environment acts as a supplier of amenity, educational and
spiritual values to society.
 Non natives may derive pleasure from the existence of wilderness
areas or rainforests.
 Natives may attach spiritual and cultural values to them, and the flora
and fauna therein.
E4: Represents the global life-support services provided by the
environment. These include
 maintenance of an atmospheric composition suitable for life; a
composition whose limits of variability are small from the point of view
of continued existence;
 maintenance of temperature and climate:
changes in composition of the upper atmosphere change climate
 recycling of water and nutrients.
22 Examples are the hydrological, carbon and oxygen cycles.
 With respect to the role of environment as a sink/receptor
(E2), the effects of waste on the environment depend on the
type/nature of the pollutant.
A note on classification of pollutants:
1. ‘Cumulative’/’’conservative’/non-biodegradable
pollutants:
✓ With no natural processes to transform some inputs to
the environment into harmless/less harmful, substances;
e.g. Lead, cadmium, and man made substances
such as PCBs (polychlorinated biphenyls) and DDT
(dichloro-diphenyl-trichloro-ethane).
✓ Unbroken by chemical or biological processes,
and build up by ‘bioaccumulation’.
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 2. Assimilative/degradable pollutants: The stock in
any time period is current flows less the amount
removed by biodegradation/chemical reactions.

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 Environmental goods and scarcity
 Economists ‘count’ the values of environmental goods and
services.
 Economic value is dependent on social well-being, measured in a
particular way.
 Social well-being is seen as depending on the (possibly weighted) sum
of individuals levels of well-being.
 Individual well-being is measured by utility, thus social welfare is the
sum of individual utilities.

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 Environmental goods and scarcity(CTD)
E.g. X1 is consumption of services of a car, but the
use of car decreases air quality, Q1.
An increase in the consumption of ‘car services’
increases utility but this increase in car use
decreases air quality this fall in air quality reduces
utility.
Net effect-ambiguous: depends on the relative
strength of these positive and negative changes.

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 Environmental goods and scarcity(CTD)
 Thus, using the environment for one purpose can
reduce its ability to supply us with other services.
The reason for E1, E2 and E3 to be shown as
overlapping: there are conflicts in resource use.

 Thus, the environment is a scarce resource,

has conflicting demand placed on it. Scarcity in
this cases is called relative scarcity. In principle
a correct set of (shadow) prices could solve it.

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 Environmental goods and scarcity(CTD)
 This differs from absolute scarcity, whereby all
demand on environmental services are together
increasing.
 The major cause of absolute scarcity is economic
growth: this implies an
 ↑in demand for materials and energy,
 ↑ in waste outputs, and
 ↑ in demand for environmental quality.

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 Environmental goods and scarcity(CTD)
Examples of conflicts in resource use include:
➢Using an area for minerals means it reduced
amenity value;
➢ Using a river as a waste-disposal means its reduced
amenity value; reduced fish production from it;
➢Felling a forest for timber reduces electricity-
generating capacity of a dam, owing to soil erosion,
amenity values since the forest’s inhabitants are
displaced; preserving a wetland for its aesthetic qualities
forgoes use of the drained land for agriculture.

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Environmental goods and scarcity(CTD)
 Yet if the amounts of environmental resources are fixed then
absolute scarcity will increase as world economic growth
occurs.
 Therefore, economics has a role to play since it is
concerned with allocating scarce resources to
conflicting demands.
 But it is also clear that the economic system, primarily
the market system, works very poorly in allocating
environmental resources mainly because of:
 imperfect specification of property rights
 individual benefits of preservation understate the collective
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benefits
 Substitution for Environmental Services
Clearly, economic activity operates within the environment.
1. Recycling (two ways of substitution possible); it substitutes for
environmental functions in two ways: it reduces demands made on
waste sink functions and it reduces demands made on resource base
function, in so far as recycled materials are substituted for extractions
from the environment;
2. Reproducible capital substituting natural capital services: e.g.,
discharge of sewage into a river estuary; according to levels of treatment
of sewage prior to discharge into the river, the demand made on the
assimilative capacity of the estuary is reduced for a given level of sewage.
This way capital in the form of a sewage treatment plant substitutes for
the natural environmental function of waste sink to an extent dependent
on the level of treatment the plant provides.

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 Substitution for Environmental Services(CTD)

3. Energy conservation: e.g., through use of energy saving

equipment substituting for resource base functions

4. Amenity services: e.g., use of manufactured swimming

pool and services of the entertainment industry from which
people derive pleasure from the natural environment (could
be better with advances in IT) as close substitutes

5. Substitution possibilities with life support services

considered by many scientists as most limited (from a purely
technical point of view this may not be the case, e.g.,
possibilities of life outside the biosphere though the quality of
life supported and the quantity of service is limited)

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 Economic
Activity

Emission Flows in to
environmental media

Absorption of some proportion Non-absorbed emission

of flow in to harmless forms flows

Accumulation of
pollutant stock

Degradation of stock in Stock pollution Flow pollution damage

to harmless forms damage

Pollution
damage

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 1.3. Materials Balance Principle
 The most implications of the materials balance
principle is that economic activity essentially involves
transforming matters extracted from the
environment.
 Economic activity cannot in a material sense, create
any thing.
 It does of course involve transforming material
extracted from the environment so that it is more
valuable to humans i.e energy and matter are neither
created nor destroyed rather change from one form
to other form.
 But another implication is that all of the material
extracted from the environment must, eventually, be
returned to it albeit in a transformed state (entropy
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laws) but not 100% efficient.
 1.3. Materials Balance Principle

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Materials Balance Principle (con’d)
 Materials Balance and Economic Growth
 Materials balance model suggests that
economic growth will give rise to larger
amounts of resource extraction and that,
in turn, these resources will reappear as
waste disposed to the environment.
➢Hence economic growth 'causes'
environmental degradation.

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 1.4. Analytical Tools in Environmental
Economics
1 Positive and Normative Economics
 Positive economics attempts to describe what is,
what was, or what will be while normative
economics deals with what ought to be.
 Normative disagreements, however, involve value
judgments. For example, to evaluate the
desirability of either a proposed new pollution
control regulation or a proposal to preserve an
area currently scheduled for development.
 Here the relevant question is: should we do it or
shouldn’t we?
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 Analytical Tools in Environmental
Economics (con’d)
2 Normative Criteria for decision-making
i. Cost benefit Analysis
➢ Is investment appraisal looked at from social point of
view
➢ It is for public sector decision-makers, and for
decisions to be taken by government about whether
private projects should be permitted.
➢ In principle, it should take into account all effects (+
or -) on all members of society at all points in time.
➢ These effects should be measured in some common
unit.
➢ So, the aim is maximizing social welfare (well-being)
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 Analytical Tools in Environmental
Economics (con’d)
❑Steps
o Specify objective and decide boundaries of
project
o Identify and list all relevant benefits and
costs
o Evaluate all benefits and costs
o Discount benefits and costs
o Calculate Social NPV

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 Analytical Tools in Environmental
Economics (con’d)
 Where B-Social benefit, C- Social cost, r-
social discount rate

(B0 − C 0 ) (B1 − C1 ) (Bn − C n )

NPV = + + ... +
(1 + r )0
(1 + r )1
(1 + r )n

(B t − C t )
t =n
=
t =0 (1 + r )t

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 Analytical Tools in Environmental
Economics (con’d)
 Project Appraisal -we have a project to
consider.
 Do we do it?
 Perspectives: private versus social
 Does the project have a positive net
present value (NPV)?
 What categories of costs and benefits are
included in the NPV calculations?

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Analytical Tools in Environmental
Economics (con’d)
 Now, it is necessary to understand first
the idea of present value.
 The incremental value of a project is known
as its net present value.
 The net present value criterion of
investment appraisal states that a project
should be undertaken if its net present
value (NPV) is positive.
 We shall use the following notation:
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 Analytical Tools in Environmental
Economics (con’d)
 Vt is the net cash flow (inflows less
outflows) that results from the project in
year t
 r is the annual interest rate
 t = 0 defines the start of the present time
period (one period is taken to be one year)
 t = n defines the project horizon; n is the
number of years after which no cash flow
will accrue from the project
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 Analytical Tools in Environmental
Economics (con’d)
  Indicates that a sum is being taken of a
sequence of terms.
 This sequence consists of the expression
following, evaluated first at t = 0, then at
t = 1, and so on up to t = n.
 The net present value of a project is given
by
t=n
Vt
NPV = 
t =0 (1 + r ) t

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 Analytical Tools in Environmental
Economics (con’d)
 If a project has a NPV > 0, that
project should be undertaken
 If a project has a NPV < 0, that
project should not be undertaken
 Shortly, the NPV and interest rate has
inverse relation ship.
 There fore, lower NPV indicated that non-
renewable resources are exhausted at
short period of time
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 Analytical Tools in Environmental
Economics (con’d)
 Definition: Discount Rate is the social
opportunity cost of capital.
 Traditionally long term interest rates on long
term government bonds as a measure of the
cost of capital, adjusted by a risk premium of
which would depend on the riskiness of the
project is taken as a discount rate.
 A higher discount rate lowers the present
value of future resource extraction, which
accelerates depletion of exhaustible
resources.
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 Analytical Tools in Environmental
Economics (con’d)
ii. Efficiency
a. Static Efficiency
 Static efficiency analyzes resource
allocations when decisions are independent
across periods in cost-benefit analysis.
 The level of activity that will maximize net
benefits will be determined using the First
equimarginal principle.
 There are three types of static efficiency,
such as consumption efficiency, production
efficiency and Product mix efficiency
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 Analytical Tools in Environmental
Economics (con’d)
 Consumption efficiency: - the allocations of resources
are efficient in consumption when the marginal rates of
substitution among the goods to be consumed are equal
for all individuals.
 Suppose, in a perfectly competitive market, the society
produce and consume only two goods, say good X and
good Y.
 Moreover, the superscript numbers indicates the
individuals in the society.
 The above efficiency rule can be written as;
MRS1x, y = MRS2x, y = …= MRSnx, y
➢ this equation satisfy at Pareto efficiency point.
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 Analytical Tools in Environmental
Economics (con’d)
 Production efficiency: - the utilization of
resources (inputs) is efficient if the marginal
rate of technical substitution among these
inputs is equal across all production types.
 Suppose, in a perfectly competitive market,
the economy has only two inputs, say labor L
and capital K, and two products to be
produced, say good X and good Y.
 The above efficiency rule can be written as;
MRTSxL,K = MRTSyL,K
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 Analytical Tools in Environmental
Economics (con’d)
 Product mix/overall-economic efficiency: - Efficiency in
the economy is attained when the marginal rate of
substitution between goods equal to the marginal rate of
transformation between produced goods. i.e
MRS x,y = MRT X,Y this implies that the production
and consumption of goods is at the production possibility
frontier and the indifference curve of an ideal consumer,
which is representing the society, will be tangent to the
product possibility frontier(PPF).
 Moreover, at the tangential point the Slope of a line
indicating the price ratio of the products will also be
equal to the MRSx,y and MRTx,y which indicates the
equilibrium point.
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 Analytical Tools in Environmental
Economics (con’d)
b. Dynamic Efficiency
 An allocation of resources across time periods
satisfies the dynamic efficiency criterion if it
maximizes the present value of net benefits that
could be received from all the possible ways of
allocating those resources over that periods.
 In this case, satisfaction of the dynamic
efficiency criterion requires present-value
calculation and the selection of a discount rate.
 There is no need to discount money received in
the present or current period.
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 1.5 Visions of the Future
1 The Self-Extinction Premise
 This premise says that societies germinate
the seeds of their own destruction.
 Malthus (early 19th c) foresaw a time when
the urge to reproduce would create a
situation in which population growth would
outstrip the growth of food supply,
resulting in starvation and death.
 The focus is no longer on individual
societies but on the survival of the planet.
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 Visions of the Future (con’d)
 In addition to this human activity has an
increased carbon dioxide level to the point
where the global climate is being affected.
 The protective ozone shield is being
depleted.
 Dead lakes and other natural resources
are common across countries (Example
Haromaya, eastern Oromia).

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 Visions of the Future (con’d)
2. The Basic Pessimists Model
 The Limits to Growth model (pessimistic
model), presented in 1972, and addressed
the issue of physical limits to economic
growth.
 The study employed a model which
attempted to capture interrelationships
between population, agricultural output,
economic growth, resource use, and
pollution.
 the main conclusions of the pessimist
model:
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 Visions of the Future (con’d)
➢ Within a time span of less than 100 years with
no major change in the physical, economic or
social relationships that have traditionally
governed world development, society will run
out of the non renewable resources on which
the industrial base depends
➢ Piecemeal approaches to solving the industrial
problems will not be successful.
➢ if the depletable resource and pollution
problems were somehow jointly solved,
population would grow unchecked and the
availability of food would become the binding
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constraint.
Visions of the Future (con’d)
➢ Overshoot and collapse can be avoided only by an
immediate limit on population and pollution, as
well as a cessation of economic growth.
➢ There are only 2 possible outcomes.
➢ The termination of growth by self restraint and
conscious policy, an approach that avoids the
collapse or the termination of growth by a
collision with the natural limits, resulting in social
collapse.
➢ Several resource are held in fixed supply by
pessimistic model (including availability of land
and stock of depletable resource)
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 Visions of the Future (con’d)
3. The Basic Optimist Model
 Conclusions of the Optimist vision of the future
concludes that the standard of living has arisen along
with the size of the world's population since the
beginning of recorded time.
 Moreover, with increases in income and population have
come less severe shortages, lower costs, and an increased
availability of resources, including a clearer environment
and greater access to natural recreation areas.
 Therefore, there is no convincing reason why these
trends toward a better life, and toward lower prices for
raw materials (including food and energy), should not
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continue indefinitely
 Visions of the Future (con’d)
 To bolster his argument, Simon offer
several observations such as:
➢The first observation is-the amount of
land being committed to agriculture is still
increasing.
➢Even where it is decreasing agricultural
production has increased.
➢Food production is therefore not likely to
be a limit.

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 Visions of the Future (con’d)
➢ Pollution levels have declined as population and
income increased.
➢ Pollution is not the inevitable consequence of
economic activity, but rather results from
societal choices about how resources should
be invested.
Summary
▪ Everywhere we look, we encounter
environmental problems:
▪ Scientists believe that the mean temperature
of the planet is increasing over time and is
likely to exceed the highest levels ever
experienced by humans.
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 Visions of the Future (con’d)
▪ The diversity of species is being reduced at an
unprecedented rate.
▪ Rates of population growth continue at levels
which are likely to exceed rates of growth in the
production of food for many countries of the
world.
▪ Modern agriculture in some areas has become
dependent on irrigation that is drawing down
groundwater supplies and pesticides that are
contaminating the quality of remaining water.
▪ The field of environmental and natural
resource economics has become an important
source of ideas for coping with these
60 problems.