Wolaita Sodo University,Dawuro-Tarcha Campus Department of Economics

CHAPTER ONE
INTRODUCTION
1.1. Definitions and Concepts of basic terms
 Economics is the study of the allocation of scarce resources.

 It is a social science, which studies how societies allocate scarce resources in

the production and distributes of goods and services so as to attain the
maximum fulfillment of society’s material wants.

traditional commodities. It also includes natural and environmental resources.

faced, so that choices must be made.

choices should be made.

 Natural resources Vs environmental resources
Natural resources are taken to be those components of land units that are of direct
economic use for human population groups living in the area, or expected to move in
to the area: near-surface climatic conditions; soil and terrain conditions; fresh water
conditions; and vegetation and animal conditions in so far as they provide produce.

These can be divided into increasingly smaller units and allocated at the margin.
Environmental resources are taken to be those components of the land that have an
intrinsic value of their own, or are of value for the longer-term sustainability of the use
of the land by human population.

protective value of vegetation in relation to soil and water resources; the functions of
the vegetation as a regulator of climate and of the composition of the atmosphere; water
and soil conditions as regulators of nutrient cycles (C, N. P. K, S), as influencing
human health and as a long-term buffer against extreme weather events; occurrence of
vectors of human or animal diseases (mosquitoes, tsetse flies, etc.).

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Environmental resources are to a large degree "non-tangible" in strictly economic

terms.

are affected by the system (e.g. pollution).

Natural Resources Economics: the study of how society allocates scarce natural
resources such as stocks of fish, stands of trees, fresh water, oil, and other naturally
occurring resources.

It is about problems of managing common-pool natural resources, determining optimal

rates of extraction, & understanding resource markets.
-pool natural resources: difficult to exclude access, but once extracted is no
longer available to others (groundwater, rivers, fisheries, public forests)
Environmental Economics: It is concerned with the way wastes are disposed of and
the resulting quality of air, water, and soil serving as waste receptors.

In addition, environmental economics is concerned with the conservation of natural

environments and biodiversity.

 It is economic basis for pollution problems & policy alternatives.

Environmental and natural resource economics is the application of the principles

of economics to the study of how environmental and natural resources are developed
and managed.
Why Study Environmental and Natural Resource Economics?

is not sufficient to completely analyze problems because these sciences do not include
human behavior.
hat are not
typical of many economic problems:
1. Optimal allocation of environmental resources has implications for future
choice (Dynamism).

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2.
consume it tomorrow. However, the decision to use natural resources today
does affect what will be available tomorrow.
3. Many decisions regarding environmental resources are irreversible.
4. Market failure is an important characteristic of many environmental issues.
vernment intervention may be appropriate.
5. Optimal allocation requires understanding the whole ecological system and how
it responds to changes in both ecological and economic systems.
1.2. The emergence of resource and environmental economics
We now briefly examine the development of resource and environmental economics
from the time of the industrial revolution in Europe.
1.2.1 Classical economics: the contributions of Smith, Malthus, Ricardo and Mill to
the development of natural resource economics
While the emergence of natural resource and environmental economics as a distinct
sub-discipline has been a relatively recent event, concern with the substance of natural
resource and environmental issues has much earlier antecedents.

Natural and environmental issues are central to the work of Adam Smith (1723–1790).
Smith was the first writer to systematize the argument for the importance of markets in
allocating resources, although his emphasis was placed on what we would now call the
dynamic effects of markets.

A central interest of the classical economists was the question of what determined
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 in its availability. When to this
were added the assumptions that land was a necessary input to production and that it
exhibited diminishing returns, the early classical economists came to the conclusion
that economic progress would be a transient feature of history. They saw the
inevitability of an eventual stationary state, in which the prospects for the living
standard of the majority of people were miserable. This thesis is most strongly
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associated with Thomas Malthus (1766–1834). For Malthus, a fixed land quantity, an
assumed tendency for continual positive population growth, and diminishing returns in
agriculture implied a tendency for output per capita to fall over time. There was,
according to Malthus, a long-run tendency for the living standards of the mass of
people to be driven down to a subsistence level. This notion of a steady state was
formalized and extended by David Ricardo (1772–1823), particularly in his Principles
of Political Economy and Taxation (1817). Malthus’s assumption of a fixed stock of
land was replaced by a conception in which land was available in parcels of varying
quality. Agricultural output could be expanded by increasing the intensive margin
(exploiting a given parcel of land more intensively) or by increasing the extensive
margin (bringing previously uncultivated land into productive use).

1.2.2 Neoclassical economics: marginal theory and value

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. Moreover, previous notions of absolute scarcity and value were replaced
by a concept of relative scarcity, with relative values (prices) determined by the forces
of supply and demand.
The evolution of neoclassical economic analysis led to an emphasis on the structure of
economic activity, and its allocative efficiency, rather than on the aggregate level of
economic activity. Keynes was concerned to explain, and provide remedies for, the
problem of persistent high levels of unemployment, or recession.

The introduction of natural resources into neoclassical models of economic growth

occurred in the 1970s, when some neoclassical economists first systematically
investigated the efficient and optimal depletion of resources. This body of work, and
the developments that have followed from it, is natural resource economics. The
models of efficient and optimal exploitation of natural resources are based on the
writings of those neoclassical authors.

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1.2.3 Welfare economics

Welfare economics attempts to provide a framework in which normative judgments can

be made about alternative configurations of economic activity. In particular, it attempts
to identify circumstances under which it can be claimed that one allocation of resources
is better (in some sense) than another.
The notion of economic efficiency, also known as allocative efficiency or Pareto
optimality (because it was developed by Vilfredo Pareto (1897)). Where the conditions
do not hold, markets do not attain efficiency in allocation, and a state of ‘market
failure’ is said to exist. One manifestation of market failure is the phenomenon of
‘externalities’. These are situations where, because of the structure of property rights,
relationships between economic agents are not all mediated through markets.
Environmental economics is also concerned with the natural environment as a source of
recreational and amenity services, which role for the environment can be analyzed
using concepts and methods similar to those used in looking at pollution problems.
The modern sub-disciplines of natural resource economics and environmental
economics have largely distinct roots in the core of modern mainstream economics.
The former emerged mainly out of neoclassical growth economics, the latter out of
welfare economics and the study of market failure. Both can be said to effectively date
from the early 1970s, though identified.
1.2.4 Ecological economics
Ecological economics is a relatively new, interdisciplinary, field. In the 1980s a
number of economists and natural scientists came to the conclusion that if progress was
to be made in understanding and addressing environmental problems it was necessary
to study them in an interdisciplinary way. Economics and ecology were seen as the two
disciplines most directly concerned with what was seen as the central problem –
sustainability.

Kenneth Boulding is widely regarded as one of the ‘founding fathers’ of ecological

economics. To date, the impact of ecological economics on the approach to the natural

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environment that emerged from mainstream economics has been somewhat limited,
and his book will largely reflect that.

1.3.3 The time dimension of economic decisions

 Classification of natural resources

Natural resource stocks can be classified in various ways. A useful first cut is to
distinguish between ‘stock’ and ‘flow’ resources. Whereas stock resources, plant and
animal populations and mineral deposits, have the characteristic that today’s use has
implications for tomorrow’s availability, this is not the case with flow resources.
Examples of flow resource are solar radiation, and the power of the wind, of tides and
of flowing water. Using more solar radiation today does not itself have any
implications for the availability of solar radiation tomorrow. In the case of stock
resources, the level of use today does have implications for availability tomorrow.
Within the stock resources category there is an important distinction between
‘renewable’ and ‘nonrenewable’ resources. Renewable resources are biotic, plant and
animal populations, and have the capacity to grow in size over time, through biological

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reproduction. Non-renewable resources are abiotic, stocks of minerals, and do not have
that capacity to grow over time. What are here called non-renewable resources are
sometimes referred to as ‘exhaustible’, or ‘depletable’, resources. Renewable resources
are exhaustible if harvested for too long at a rate exceeding their regeneration
capacities. From an economic perspective, stock resources are assets yielding flows of
environmental services over time.

1.3.4 Substitutability and irreversibility

Substitutability and irreversibility are important, and related, issues in thinking about
policy in relation to the natural environment. If the depletion of a resource stock is
irreversible, and there is no close substitute for the services that it provides, then clearly
the rate at which the resource is depleted has major implications for sustainability. To
the extent that depletion is not irreversible and close substitutes exist, there is less cause
for concern about the rate at which the resource is used.
There are two main dimensions to substitutability issues. First, there is the question of
the extent to which one natural resource can be replaced by another. Can, for example,
solar power substitute for the fossil fuels on a large scale? This is, as we shall see, an
especially important question given that the combustion of fossil fuels not only
involves the depletion of non-renewable resources, but also is a source of some major
environmental pollution problems, such as the so-called greenhouse effect which
entails the prospect of global climate change.
Second, there is the question of the degree to which an environmental resource can be
replaced by other inputs, especially the human-made capital resulting from saving and
investment. This question is of particular significance when we address questions
concerning long-run economy–environment interactions, and the problem of
sustainability.
Some pollution problems may involve irreversible effects, and the extinction of a
species of plant or animal is certainly irreversible. Some assemblages of environmental
resources are of interest for the amenity services, recreation and aesthetic enjoyment
that they provide, as well as for their potential use as inputs to production. A wilderness
area, for example, could be conserved as a national park or developed for mining.
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Some would also argue that there are no close substitutes for the services of wilderness.
A decision to develop such an area would be effectively irreversible, whereas a
decision to conserve would be reversible.

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CHAPTER TWO
II. Some issues on the environment and development
Objectives:
At the end of this chapter you will be able to:

 Define sustainable development,

 Explain the objectives of sustainable development,
 Describe various concepts of sustainability,
 Explain different types of capital and conventional measures of
national account,
2.1 Introduction

The general notion of sustainability that we explore in this chapter

concerns the potential for some acceptable state of human well-being to
be maintained over an indefinite period of time. We shall present some
more precise definitions shortly but this one will suffice as a starting
point. The principal purpose of this chapter is to show how economists
think about sustainability. In particular, we explain how economists
establish models that can be used to examine the conditions required
for sustainability, to assess whether patterns of economic activity are
likely to satisfy sustainability objectives, and to provide a solid
foundation for policy recommendations. We also consider the way in
which ecologists think about sustainability.
There is no universally accepted definition of the concepts of
sustainability. But, it can be seen as the general notion of
sustainability that the potential for some acceptable state of human
well being to maintain over an indefinite period of time. Some times
many writers deduced that sustainability follows from a moral
obligation to those generations that will come after it, that means we do
not act in ways that jeopardize the chance of future generation having

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equal opportunity to those that are currently enjoyed. Some says, it

means all individuals living now and in the future have a right to at
least a decent minimum standard of life. Sustainable development is a
way of organizing behavior so that this objective is achieved. According
to WCED, 1987 sustainable development is “a development that meets
the needs of the present with out compromising the ability of the future
generation to meet their own needs”. It can also be defined knowing the
capacity of the environment and using it to its maximum. It is the
maximum development that can be achieved with out running down
the capital assets of a nation which are its resource base. The base is
interpreted widely to encompass man made capital, natural capital,
human capital, moral or ethical capital, and cultural capital.

2.2 Population and Environment

2.2.1 Population Growth and Demand for Natural Resources
Human population growth, in conjunction with pressure for higher
standards of living, increases the demand for agricultural land, energy
and water resources, and intensifies the problems of managing and
disposing of waste products. These are associated with a number of
serious environmental changes including forest depletion, declining soil
fertility, loss of top soil etc. The inter linkages between population
growth and the environment are complicated. Some are directly
operate, while others are in indirectly. The following are particular inter
linkages between each other.
 High level of population growth place greater demands on non
renewable material resources and greater strain on renewable
stocks, including world food resources.
 High level of population growth tend to be associated with greater
volumes of material and energy through put, increasing the likely

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hood that caring capacities of the environmental sink will be

exceeded.
 High level of population growth will tend to increase ecological
pressure generally and promotes changes in agricultural
practices in particular that will reduce biological diversity.
 Higher rate of population growth may contribute to low and
possibly falling rates of real per capita income, which can
exacerbate environmental pressures.

2.2.2 Population Growth and Environmental Degradation

Thomas Malthus came out with a view that population growth would
out strip the growth of food supply, resulting in starvation and death.
Ecologists suggest that the environment poses a carrying capacity to
support humans (biological life), exceed that capacity, ecological
disruption (disaster) would occur. Today:
 World has lost one fifth of top soils from its crop land or arable
land as a result of increasing population. It would require an
increasing demand for food which intern increasing for the need
of arable lands which finally creates land degradation.
 World has lost one fifth of its tropical forests due to wild fire in
finding additional cultivated land as a result of population
pressure.
 Human activities increased carbon dioxide level as a result of
increasing physical waste material which leads to environmental
degradation.
The economic perspectives of the consequences of population growth
are rapid population growth puts more pressure on both Depleted stock
and renewable resources. Negative environmental effects of population
density coupled with poverty.

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2.2.3 The Effects of Economic Growth on the Environment

There is no clearly defined direction about the link between economic
growth and the environment. Some times economic growth will have a
positive impact on the environment while others say it will have a
negative impact on the environment. The World Bank report, 1992 said
„The view that the greater economic activity inevitably hurts the
environment is based on static assumptions about technology, testes
and environmental investment‟.
Growth and new investment stimulates technological change, this
produce new market opportunities which is part of the growth
processes. The size of modern industrial output, rapid technological
development, and continued pressure for more material growth have
increased the rate of environmental change. For example: the use of
fertilizer and pesticides, and the cultivation of marginal lands have
affected landscape quality and reduced the diversity of flora and fauna.
1. Environmental problems increases with economic growth it
includes emissions of carbon dioxide and nitrogen dioxide in to the
atmosphere.

Environmental
Problem

PCI

The cost of bearing and controlling these problems is huge. These

problems are not static or inevitable but they depend on country
environmental policy may improve or worsen this stated relationship.
2. Environmental problems decline as the economy is growing. It
includes sanitation problems, safe water, and urban congestion.
3.

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Environmental
Problems

PCI

4. Some problems initially worsened and then improved as income

rises. It includes air pollution, and water pollution.

Environmental
Problems

PCI

2.3 The Environmental Kuznet Curve (EKC)

The EKC hypothesise that instead of being a threat to the environment,
economic growth is the means to environmental improvement. As
countries develop economically, moving from lower to higher levels of
per capita income, over all level of environmental degradation will
eventually fall. Although economic growth is usually leads to
environmental degradation in the early stages of the process, in the end
the best and probably the only way to attain a decent environment in
most countries is to became rich.
Implications of EKC: given likely levels of income per capita, the
global environment impact concerned would decline in the medium
term future. The general proposition that economic growth is good for
the environment has been justified by the claim that „there exists an
empirical relationship between per capital income and some measures
of environmental quality‟. Even if an EKC relationship between income
and environmental impact is generally applicable, given exponential
income growth, it is only in very special circumstances that there will
not, in the long run, be positive relationship between income and
environmental impact. EKC implies that the magnitude of
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environmental impacts of economic activity will fall as income rises

above some threshold level, when both these variables are measured in
per capita terms.
Env’tal
Impact

b
a
q* q PCI

Case A- environmental impacts per unit of income eventually fall to

zero as the level of income rises. Suppose that world consists of two
countries developing and developed which are growing at the same rate
constant „g‟. However, the growth process began an earlier time in DCs
and so at any point in time its per capital income is higher than LDCs.
so that in long run they are optimist about the environmental quality
as PCI increases. As time path of environmental impacts one could
observe similar to that shows down ward sloping of EKC. In the initial
stage of economic growth, with rapid industrialization, pollution will
result but after some growth the need for decreasing pollution arises
because of the strong power of the government and the need for
recreational site.
Case B- with increasing PCI a country will shift from manufacturing to
industrialization, consequently the DCs will stop in producing dirty
products but import from LDCs and they will produce clean products.
What is the rationale for EKC increasing in early stage?
Until Q* both have positive relationship because at low level of
development people have more income elasticity to necessary items
(food, cloth, & shelter) than environmental quality. In addition
 Literacy rate is insignificant
 State of technology maters

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 Less awareness about the environment and more

deforestation
 Stage of agricultural transformation
 Excess use of fertilizer and pesticides etc...

To the right of Q* both have negative relationships because people have

high income elasticity to environmental quality. In addition
 Information intensive technology
 Increased environmental awareness
 Enforcement of environmental regulation
 Better technology and higher environmental expenditure
2.4 Objectives of Sustainable Development
Sustainable development has three objectives that are economic, social,
and ecological (environmental). An economic objective includes
promoting growth and efficiency. Environmental objectives constitute
maintain and improved long term validity of the ecosystem. On the
other hand social objective embraces in fulfilling peoples cultural,
national and spiritual needs. Sustainable development requires not
only the partial integration of its objectives but also the full integration
of them. The three objectives of sustainable development are strongly
linked, so it can be expressed in the form of triangle.

Figure 2.1: Objectives of Sustainable Development

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The basic rational for sustainable development is increasing per capital

of the poor and decreasing uncompensated future cost. As a result it
has a role in balancing role between human needs and limited
resources, a role in between the poor and the rich, and a balancing
between the present and future generations.
Sustainability is seen as a constraint, it is also use full to distinguish
between a numbers of distinct types of constraint. One classification
has been proposed by Pezzey (1997), who distinguishes between
sustainable developments, sustained development, and survivable
development.

If Ut= the utility at time t.

Ut’= the rate of change of utility at any time t.
Usurv= the minimum utility level consistent with survival of a given
population.
Utmax= the maximum utility which can be held constant for ever from
time t on wards , given production opportunities available at t.
 Development is sustainable if Ut ≤ Utmax always.
 Development is sustained if Ut. ≥ 0 always.
 Development is survivable if Ut > Usurv always.
2.3 Various Concepts of Sustainability
1. A sustainable state is one in which utility / consumption/ is
none declining.
2. A sustainable state is one in which resources are managed so
as to maintain production opportunities for the future.
3. A sustainable state is one in which the natural capital stoke is
none declining.
4. A sustainable state is a one in which resources are managed so
as to maintain a sustainable yield of the resource services.

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5. A sustainable state is a one in which satisfies minimum

condition of ecosystem stability and resilience through time.
6. Sustainable development as capacity and consensus building.
Before discussing these six concepts things which are being stressed
here are:
Not all of them are purely economic conceptualizations. It is
difficult to claim that satisfying ecosystem stability and
resilience is an economic objective per se.
The concepts are not necessary mutually exclusive. The first
may imply the third. For example the first requires the fifth
because production and consumption can not be maintained
over time in the face of economic system collapse.
Some of these concepts view sustainability as a constraint on
economic behavior. For example the case for the first and
third concepts.
None explicitly specifies the duration of time over which
sustainability is to operate.
1. A sustainable state is one in which utility / consumption/
is none declining.
It has two variants the first one is utility that is required to not
declining through time and other is consumption to be none declining.
“Sustainability is defined as non declining utility of a representative
member of the society for millennia in to the future”, John Pezzey
(1992). This concept is one of the class in which sustainability is
viewed as a constraint on economic behavior with the constraint being
couched in terms of the human wellbeing. It relates to sustained rather
than sustainable development.

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John Hartwick (1977) advocates this concept in contrast to Pezzey.

He chooses to interpret sustainability in terms of non declining
consumption. He works with models where there is only one
consumption good, non declining utility and consumption are
equivalent. If the rents ( the surplus of revenues over marginal
extraction costs) derived from non renewable resources extraction are
saved and then invested entirely in reproducible ( physical) capital then
under certain condition the levels of out put and consumption will
remain constant over time. Robert Solow a sustainable state is one in
which satisfies some relevant criterion of intergenerational equity. He
uses sustain undiscounted utility of the per capital consumption and
asserts the over infinite period.
2. A sustainable state is one in which resources are managed so
as to maintain production opportunities for the future.
It is discussing about distributional ethics is in terms of cake –eating
problems. It is assumed that quantity of a nonrenewable resource is
available, how should the resource be distributed over time? The
present cake division problem is in appropriate because the present
generation can have no firm knowledge of what future people
preference will be, or of what technologies will be available. The present
generation does not have the right to deplete the opportunities afforded
by the resources base since it does not „own‟ it. „Preserving
opportunities for future generations as a common sense minimal
notion of inter generational justice‟, Page (1977).
3. A sustainable state is one in which the natural capital stoke is
none declining.
„Sustainable activity is: that level of economic activity which leaves the
environmental quality level in tact , with the policy objective
corresponding to this notion of being the maximization of net benefits

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of economic developments, subject to maintaining the service and

quality of natural resources over time‟, Barbieer and Markadya
(1990). A non declining natural capital stock would be a necessary
condition for sustaining the economy‟s productive potential if natural
capital is both essential to production and not substitutable by other
productive resources. As natural capital stock depletes, the degree of
substitutability may fall too. Therefore, even if there were strong
evidences that substitution possibilities have been high, this does not
constitute grounds for asserting that will remain so in the future.
Economic progress and development may well lead societies to place
increasing emphasis and value on the amenity services yielded by
natural capital. As a result this believe pessimistic about substitution
possibilities between natural capital and other forms of resources.
UNESCO, stronger version of this „every generation should leave water,
air, and soil resources as pure and unpolluted as when it came on
earth. Each generation should leave undiminished all the species of
animals it found on earth.‟
4. A sustainable state is a one in which resources are managed so
as to maintain a sustainable yield of the resource services.
A sustainable yield refers to a constant flow of services from a resource
stock which is being maintained at a constant level through time. For
example, a forests stand, when subjected to a suitable thinning and
replanting regime, can deliver a constant flow of felled timber.
The maximum sustainable yield of a resource is the highest feasible
flow of services that can be maintained over time from some
environmental system. Some writer advocates that stocks should be
managed to deliver maximum sustained yield, equating such yields
with optimal practice.

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5. A sustainable state is a one in which satisfies minimum

condition of ecosystem stability and resilience through time.
A safe minimum standard of conservation is a mater of resources and
economic policy. It is achieved by avoiding the critical zone-that is, the
physical conditions, brought about by human action, which would
make it uneconomical to halt and reserve depletion. Sustainability is a
relation ship between human economic system and larger dynamic, but
normally slower changing ecological systems in which human life can
continue indefinitely, human individual can flourish, and human
culture can develop; but which effects of human activities remain with
in bounds, so as not destroy the diversity, complexity, and function of
ecological life support system as being ecologically sustainable if it is
resilient. By implications therefore, any behavior which reduces the
system resilience is potentially unsustainable.
6. Sustainable development as capacity and consensus building.
This concept focuses on process rather than out come or constraints. It
differs from the other concepts by viewing the issue primarily in terms
of institutions and processes. Sustainable development is a
development of a socio-environmental system with a high potential for
continuity because it is kept with in economic, social, cultural,
ecological and physical constraints. (Formal but not operation)
Sustainable development is a development on which the people
involved have reached consensus. (Procedural but does not guarantee
stability)

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2.4 Conventional Approaches to Sustainability

1. Recognizing that human societies are parts of ecosystems
determining the carrying capacity of those ecosystems, and then
legislating to prevent human activity exceeding carrying capacities.
2. Conceptualizing environmental decline as external costs,
evaluating these costs, in monetary terms, and then using a price
mechanism to internalize these costs.
 1st strategy is not sufficient because its success is dependant
on persuading citizens of the need to respect carrying
capacities. It is flawed because carrying capacities are unknown
and simply technical data but depend on human choice.
 2nd conventional approach is also of limited use fullness
for similar reasons and ultimately because it overestimates the
possibilities of pricing under difficult social circumstances.

2.5 Types of Capital and Conventional Measures of National

Account
1. Natural Capital: any naturally provided stock, such as water
systems, fertile land, crude oil &gas, forests, earth‟s atmosphere
it self etc. this category often called as natural resources. It can
be decomposed in to renewable and non renewable stock
resources but flow renewable resources are not capital stocks,
however this services of natural capital. Here human population
do not included in this category.
2. Physical capital: plant, equipment, building and other
infrastructure, accumulated by devoting part of current
production to capital investment.
3. Human capital: stocks of learned skills embodied in particular
individuals which enhance the productive potential of those
people.

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4. Intellectual capital: it is disembodied skills and knowledge.

This comprises the stock of useful knowledge, which we might
call as state of technology. These skills are disembodied in that
they do not reside in particular individuals, but are part of the
culture of the society. They reside in the books and other cultural
constructs, and are transmitted and developed through time by
social learning processes.
GDP measures the market values of final goods and services produced
with in the country in a given period of time. GNP measures a market
value of all final goods and services produced by the citizens of a
country irrespective of where they live. The main difference between
GNP and GDP is: GDP is territorial while GNP is bounded by
citizenship. The conventional government measures of macro economic
performance such as GNP convey no information on the state of the
environment and hence considered inappropriate for evaluating long
term welfare aspects and sustainability for planning and policy design.
The omission of such aspect may lead to result in sub optional
allocation and unsustainable extraction and use of natural resources.
2.6 Weakness of the Conventional Measures of National Account
In measuring national wealth national income accounts record only
human made capital and ignore natural capital. Although the national
account make allowances for depreciation of human made capital in
arriving at estimate of net national produce or national income; they
make no allowance for the depreciation of natural resources. In deed
the value of marketed natural resources asset included in national
income thus the national account is over stated. Costs of
environmental protection like, defense expenditure are included in
measuring national income while the cost of environmental damage is

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not included. Which means no allowance is made for waste disposal,

pollution and anti pollution measures.

Unit Summary
Alleviating poverty and promoting sustainable development are the best
solutions to protect the environment. These can be achieved through
appropriate policies that seek to harness the positive links between
development and the environment by correcting or preventing policy
failures, improving access to resources and technology, and promoting
equitable income growth. Further, policies targeted at specific
environmental problems: regulations and incentives that are required
to force the recognition of environmental values in decisions making
must also be put in effect.
Self-Test Exercise
Answer the following questions.
1. What is sustainable development?
2. What are the objectives of sustainable development?
3. What are the various concepts of sustainability?
4. Explain the different types of capital.
5. What is weakness of the conventional measures of national account?

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CHARTER THREE
III. ECONOMIC EFFICIENCY, PROPERTY RIGHT, MARKET

FAILURE AND ENVIRONMENTAL PROBLEMS

Objectives:
At the end of this chapter you will be able to:

 Explain about the theory of static and dynamic economic

efficiency,
 Define Property Right
 Explain the characteristics of property rights,
 Explain the different classifications of externalities and their
effect on efficient allocation of resources,
 Define what public goods are,
 Describe characteristics of pure public goods,
 Explain common property resources and exploitation of open
access resources,
 Understand tragedy of the commons,
 Understand method of correcting market failure.
3.1 Introduction
In this chapter, we will introduced and explain the concepts of
efficiency and optimality as they relate to the allocation of the resource
at a point in time, and over time. We noted that, under certain
conditions, a system of markets would realize efficiency in allocation,
where those conditions are not satisfied, market failure is said to exist.
Nobody believes that those conditions are satisfied in any actual
economy. Economists think about public policy mainly, but not entirely
in terms of correcting market failure so as to realize efficiency in
allocation. Economists also consider public policy in relation to
optimality when analyzing measures intended to redistribute income
and wealth so as to promote some concept of fairness of justice.
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Therefore, this chapter mainly focuses on property right, externalities,

market failure and environmental problems.
3.2. Efficiency, discounting & intergenerational equity
3.2.1. Theory of Economic Efficiency

At any point in time, an economy will have access to particular

quantities of a set of productive resources. Individuals have preferences
about the various goods that it is feasible to produce. An allocation of
resources describes what goods are produced, which combinations of
inputs are used in producing those goods, and how the out puts are
distributed between persons. The theory of Economic Efficiency was
first systematically developed by Vilferdo Pareto. According to him
Economic Efficiency (Pareto Optimum) is achieved when resources are
allocated in such a manner that no individual can be made better off
without making another individual worse off, and the production of no
good can be increased without decreasing the production of another
good. Whereas Social optimum is achieved when resources are
allocated efficiently and the resulting income distribution is considered
as equitable by the society.
3.2.1.1. Static Economic Efficiency

Static Efficiency is a static allocation of resources refers to the

allocation at some single point in time. What conditions would have to
be satisfied in order that an allocation of resources is efficient?
Let consider an economy in which there is
 Two persons (A and B),
 Two goods(X and Y) are produced, and
 The economy uses two inputs (Capital and Labour) to produce
each product.
 These productive resources are available in fixed quantities.

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Assumptions:
1. There is no externality in either consumption or production; this
means the consumption or production activities of one agent do
not affect other agents‟ utility in an uncompensated way.
2. Bothe goods are private goods, which mean there are no public
goods in the allocations.
Individuals utility depends on the quantity of goods that he/she
consumes in a particular point of time, thus UA= UA (xA, yA) ,
and UB =UB (xB ,yB )
Similarly the production function of these two goods X and Y are
X=X (Kx,Lx) ,and Y=Y (Ky,Ly) , where X is the amount of
good „x‟ produced using Kx and Lx amount of capital and labour
respectively. Y is total amount of good „y‟ produced by Ky and Ly
amount of capital and labour respectively. This model (2*2*2), static
efficiency can be achieved when the following three conditions are
satisfied simultaneously. (I.e. efficiency in consumption (exchange),
Efficiency in production, and Product mix efficiency (production
consumption).
3.2.1.2. Efficiency in consumption
It requires that all individuals place the same relative value on all
products. Consumption efficiency is achieved when the ratio of
marginal utilities of these two goods (X and Y) are the same for each
consumer.
(Ux/Uy)A= (Ux/Uy)B , where UxA=dUA/dxA, UxB=dUB/dxB ,
and UyA=dUA/dyA,
UyB=dUB/dyB
Or MRSxyA=MRSxyB

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Unless this condition is satisfied, consumers will exchange goods at the

margin in such a manner that both can gain therefore neither of them
worse off (suffers).

3.2.1.3 Efficiency in production

Pareto optimality in allocations of factors of production requires that

factors are so allocated to the various goods that it is not possible to
increase the output of any commodity with out causing a decrease in
the production of another. Let we assume that two factors of
production (i.e. capital and labour) to produce two goods (X and Y).
Production efficiency is achieved when the ratio of the marginal product
of each economic resource is the same in the production of both goods.
(MPL/MPK) x= (MPL/MPK)y
Or
(MRTSLK)x =(MRTSLK)y , where MPLx=dX/dL , MPKx=dX/dL,
MPLy=dY/dL ,and
MPKy=dY/dL,

NB: unless this condition is satisfied, producers are able to exchange

some labour so that the amount of both goods would be increased
using the same amount of inputs.

3.2.1.3 Product-mix Efficiency

It requires that the subjective value of production X in terms of

production Y should equal to its marginal cost. It also requires that
there must be an equality of the rate at which consumers‟ value one
commodity in terms of another with opportunity cost of one good in
terms of another. It is achieved when (Ux/Uy)= (MPLy/MPKx) or
MRTxy=MRSxyA=MRSxyB

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NB: there is no need of identifying individuals because at efficient

allocation the ratios of their marginal utilities are equal.
3.2.2 Dynamic Economic Efficiency

An allocation of resources across „n‟ time period is dynamically efficient

if it maximizes the present values of net benefits that could be received
from all the possible ways of allocating those resources over the „n‟
periods. The decision at this moment affects the benefit that the
resources provide for the coming generation. It indicates that time is
important factors in dynamic efficiency. For non-renewable energy
resource if they are once used by the present generation, they will not
be available for future generation. Dynamic efficiency method provides
a means of considering not only the magnitude of benefits and costs
but also timing. The idea of present value enables us to compare net
benefits from one period to another.
The present value of x birr earned after n period is:

where r is interest rate.

The present value of a one period time net benefit earned after n period
is PV (Bn) = Bn/ (1+r) n.
Where PV (Bn) = present value of net benefit.
Bn= net benefit
n= number of years
r= interest rate
The process of determining the present value is said to be discounting.
The interest rate r is called discount rate. Resources allocation over n
period of time is referred to as inter temporally allocation efficient as it
maximizes the present values of net benefit that could be achieved from
all the possible means of distributing these resources over the n period
because dynamic efficiency supposes that the main objective of the

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society is to balance the use of resources at this moment and the

coming period by maximizing the present values o0f net benefits earned
from the use of resources, mainly non renewable resources. Total
benefit is the total willingness of the consumer to buy different levels of
out put with their respective prices. It is measured by the area under
the demand curve or it is the integration of the demand curve. Total
cost is the cost of production. The present values of the net benefit (B0,
B1……, Bn) received over a period of n years is computed as
NPV= B0+B1/ (1+r) +B2/ (1+r)2+…..Bn/(1+r)n .
PV (B0, B1……,Bn)=summation of the net benefits.
Consider a simple model to define an efficient allocation of non
renewable resource
1. The resources can be used in n time period.
2. The marginal cost of extracting the resources is constant and it is C
per period.
3. There is a fixed supply of the resources to allocate between n
periods. Given amount of supply qt.
4. The total demand function is linear and constant.
Step one
According to the dynamic efficiency criteria the efficient allocation is
the one that maximizes the present values of the net benefit for the
n period is simply the sum of the PV of the n period.
- Given inverse demand function Pt=a-bqt
- Total cost of extracting any amount of qt is TC=Cqt
- Marginal cost is some fixed amount C
Step two
Total supply of the resources is limited
Q=∑qt; where qt=q1+q2+…..+qn
Step three

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Compute the net benefit

Net benefit= Total benefit- Total cost
Total benefit is the area below the demand curve,
TBt =∫ (a-bqt)dqt
=aqt-bqt2/2
Therefore, NBt=aqt-bqt2/2-Cqt= (a-C) qt-bqt2/2
Step four
Find the present values
PV (NBt) =NBt/ (1+r)t=∑(aqt-bqt2-Cqt)/(1+r)t
Then maximizing the present values of the net benefits
L=∑aqt-bqt2/2-Cqt/ (1+r)t+λ (Q-∑qt)
FOC
dL/dqt=a-bqt-c/(1+r)t - λ =0
dL/dqt=Q--∑qt=0

3.3 Well Defined Property Rights as a Unique Feature of

Competitive Market
Property right: Is defined as a bundle of entitlement defining the
owners‟ rights and privileges and limitations for the use of resources. It
is the bundle of characteristics that convey certain powers to the owner
of the right. The manner in which producers and consumers use
environmental resources is decided by the existing property rights in
the society which direct the use of resources. By examining such
entitlements, and how they affect human behaviour, we will better
understand how environmental problems arises from government and
either with individuals, as in a capitalist economy, or with the state, as
in a centrally planned socialist economy. The sources of environmental
problems in a capitalist economy is the market system it self or, the
pursuit of profits. Though the pursuit of profit may some times be

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inconsistent with fulfilling these needs, it is not always inconsistent.

Goldman suggests that the centrally planning system creates different
but not less potent, divergence between individual and collective
incentives for example as of 1970; 65% of all factories in the largest
soviet union, discharged their waste in to the water with out any
attempt to clean it up. They did this because the managers were being
judged solely in terms of out put, not in terms of the harm they caused
to the environment. So that not private enterprise but industrialization
is the primary cause of environmental disruption.
When well defined right are exchanged, as in the market economy, this
exchange facilitates efficiency, which is the society objective. Let us
examine the incentives consumers and producers face when a well
defined system of property rights is in place. The seller has the right to
prevent the consumer from consuming the products in the absence of
payment; the consumers must pay to receive the products. Given a
market price, the consumer decides how much to purchase by
choosing that amount which maximizes his or her individual net
benefit.
Price Consumer’s surplus
SS
Producer’s
surplus
DD

0 Qd Quantities

The price level which producers and consumers face will adjust until
supply equals demand. Given the price consumers maximizes their
surpluses, producers maximizes surplus and the market clears. Is this
allocation efficient? Yes, according to static efficiency the net benefit is
maximized by the market allocation and it is equal to the sum of
consumers and producers surpluses. How the net benefits are
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distributed between consumers and producers? Efficiency is not

achieved because consumers and producers are seeking efficiency. In
the system with well defined property right and competitive markets in
which to sell those rights in competitive markets, producers try to
maximize their surpluses and consumers try to maximize their
surpluses. The price system, then, induces those self interested parties
to make choices which are efficient from the point of view of society as
a whole. It channels the energy motivated by self interest in to socially
productive paths.

3.4. Characteristics of Property Rights

The structure of property rights which can result in efficient allocation

of resource in a well functioning market economy has four main
characteristics.
1. Universality: refers to resources are privately owned and all
entitlements are completely specified.
2. Exclusivity: refers to all benefits and costs created as a result of
owning and using the resources should accrue to the owner and
only to the owner, either directly or indirectly by sale to others.
3. Transferability: refers to all property rights should be
transferable from one owner to another in a voluntary exchange.
4. Enforceability: refers to property rights should be secured from
involuntary seizure or encroachment by others.
The owners of resources has a right to practice the above
characteristics of well defined property rights and have a power full
incentive to use that resources efficiently because a decline in the value
of that resources represents a personal loss. Farmers who own the land
have an incentive to fertile and irrigate it because the resulting
increased production raises income level. Similarly they have incentive
to rotate crops when that raises the productivity of their land.
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3.5. Externality as a Source of Market Failure

Exclusivity is one of the chief characteristics of an efficient property

right structure. This characteristic is frequently violated in practice,
one broad class of violation occurs when an agent making a decision
does not bear all the consequences of his or her action. Suppose two
firms are located along the river basin, the first produce steel and the
second is producing fishery products. Both parties use the river
through different ways. The steel firm uses it as a receptacle for its
wastes, while the fishery firm is used for productive harvesting of fish
resources. If these two facilities have different owners, an efficient use
of the water is not likely to result. Because the steel plant does not bear
the cost of reduced business at the fishery firm resulting from waste
being dumped in to the river. This situation is called externality.
An externality exists when ever the welfare of some agent, either a firm
or household, depends not only on his or her activities, but also on
activities under the control of some other agent. Externality is an
action taken by the firm or individual which do not have a direct
relation or link with the given firm. Or any cost or benefit to a firm
made unconsciously by other agent.

When externality occurs?

1. Externality raised when the production or consumption

decision of one agent affect the utility or production
possibility of another agent in unintended manner and
when no compensation is made by the producer of external
effect to the affected body.
2. Externality occur when one of the characteristics of
efficient property right ( i.e. exclusivity) fail to function
properly, which means if the cost or benefit of owning or

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using the resources belongs to other party which do not

have the property right.
The effect of this external cost by the steel industry can be seen in the
figure below.

Price ($/unit) MSC

MCP

DD

Quantity
Q* Qm

Steel production inevitability involves producing pollution as well as

steel. The demand for steel is shown by the demand curve DD, and the
private marginal cost of producing the steel (exclusive of pollution
control and damage) is depicted as MCP. Because society considers
both the cost of pollution and the cost of producing the steel, the social
marginal cost function (MSC) includes both of these costs as well. If the
steel industry faced no out side control on its emission levels, it would
seek to produce Qm. That choice in a competitive setting would
maximize its private producer‟s surplus. But that is clearly not
efficient, since the net benefit is maximized at Q* not at Qm. So that it
can be concluded that market allocation of commodities causing
pollution externalities;
 The out put of the commodity is too large.
 Too much pollution is produced
 The prices of products responsible for pollution are too low

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 As long as the costs are external, no incentives to search for ways

to yield less pollution per unit of out put are introduced by the
market.
 Recycling and reuse of the polluting substances are discouraged
since a release in to the environment is so inefficiently cheap.
The effects of a market imperfection for one commodity end up affecting
the demand for raw materials, labor; and so on… the ultimate effects
are felt through the entire economy.
3.6. Classification of Externality
External effects can be positive or negative. It may be external
diseconomy or external economy. If the utility or production of some
party is decreased by the decision taken by the other party this
externality can be called as external diseconomy or negative externality.
If the utility or production of some will have a benefit to other it is
called external economy or positive externality; In this case the market
will under supply the resources. There is another class of externality,
that is pecuniary externality, this type may not relate to pollution, but
it arises when the external effect is transmitted through altered prices.
Like the entry of new firm will drives up the prices of land, that is the
negative effect on all those paying rent and therefore it is external
diseconomy.
A. Negative Externality
When there is negative externality, marginal social costs (MSC) are
higher than marginal private costs (MPC). The difference is marginal
extraction cost. ( I.e. MSC=MPC+MEC) the efficient level of out put will
be lower than the profit maximizing level of output.

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MSC MPC

Pe B

Pb E
MSB=MPB, dd

Qb Qe

In competitive market the equilibrium out put will be Qe, when

MPB=MPC, at point E with Pe equilibrium price. But, efficiency is
achieved when MPB=MSC implies the efficient level of out put will be
Qb and price will be Pb at point B, which is point of efficiency. The
industry which maximizes its profit is producing excess production
results in economic inefficiency. Consequently, externality generates
long run as well as short run inefficiency.
B. Positive Externality
It exists when marginal social benefits (MSB) are higher than marginal
private benefits (MPB). This difference is the marginal external benefit
(MEB). That is MSB=MPB+MEB. The efficient level of out put will be
higher than the profit maximizing level of out put. The industry
maximizes profit when MPB=MC. This means Qe, and Pe are profit
maximizing level of out put and price respectively.

MPC=MSC
Pb
Pe

MSB
MP

Qb Qe

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3.6.1 Public goods

Externality and pure public goods results in market inefficiency or
market failure. According to Samuelson pure public goods is defined as
“individual consumption of such a good leads to no subtraction from
any other individuals consumption of that good” but private goods
consumption by one individual leads to a reduction in the availability of
this good for another consumer. According to Samuelson, peace and
security of a nation, National defence, Air pollution control, street light,
public television, infrastructure, knowledge from education,
environmental amenities etc are examples of public goods.
Private goods are divisible in consumption but pure public goods are
not. Pure public goods are different from common property resources
because the availability for the total may be reduced as a result of
individuals use. For example, grazing land, by single individual leads to
a reduction of the total by equivalent amount.
3.6.1.1. Characteristics of pure public goods
1. Non-rivalness in consumption (indivisibility): a good is said to
be non- rival in consumption when the marginal cost of providing
the good to another individual to consume the good is zero. This
means there is no opportunity cost of consumption of such a
good. For example a broadcast radio or television signal is an
example of non-rival consumption good. However, it can be
observed that the common property resources are rival in
consumption. One person‟s cattle on the grazing land are in
competition with the other cattle of other persons.
2. Non-excludability: exclusion principle can not be applied on
pure public good in contrast to private good, due to different
reasons.

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A. It might be technically difficult to exclude beneficiaries. Take

case of street lighting and light house, it is difficult to exclude
one from using street light while he is on the journey on the
street. Public goods also non reject able.
B. Even if technically feasible, it becomes expensive to exclude,
i.e. the cost of exclusion over rides the benefit earned from its
application. Therefore public good is a good for which
exclusion is either technically not feasible or too expensive to
apply even if technically feasible.

NB: some goods are exclusive but non rival. For example in low traffic
period, travel on the bridge is non rival but it is exclusive because the
bridge authority can exclude people from using it. Some goods are also
non exclusive but rival, for example air is non exclusive but rival if the
by products of one firm negatively affects the quality of the air and the
ability of other firms to use it, fishing in an ocean is non exclusive but
rival. Therefore, goods provided by the government do not necessarily
fulfil the above two characteristics of pure public goods. The existence
of pure public good would results inefficient level of production (under
supply) of public good, because individuals have the incentive to free
ride. Individuals can be benefited with out paying for it. Those who
benefits with out payment are called Free riders. With free rider
problems, private firms can not earn sufficient revenue from selling a
public good. Hence they lack the incentive to produce the socially
optimal level of public good. It would therefore be under supplied.
3.7. Imperfectly Defined Property Rights
Private property is, of course, not the only possible way of defining
entitlements to resources use. Other possibilities include.
1. State property regimes: where the government owns and
controls the property. It exists not only in former communist

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countries but also to varying degrees in virtually all countries of

the world. Resource usage and management are under the
control of government. Parks and forests are frequently owned
and managed by the government in capitalist as well as socialist
countries. Problems with both efficiency and sustainability can
arise in state property regimes when the incentives of the
bureaucrats who implement and or make the rules for resources
use diverge from the collective interest.
2. Common property resources: are those which are owned in
common rather than privately. Entitlements to use common
property resources may be formal, protected by specific legal
rules, or they may be informal, protected by tradition or custom.
Ex. grazing land. Resources are jointly owned and managed by
specific group of co-owners. The resources are not efficiently
used; no one has got incentive to protect the improper use of
these resources. It some times called Tragedy of commons.
3. Resnullius property resources (open access): there is in
which no one owns or exercise control over the resources. It can
be exploited on the first come first served basis, because no
individual or group has the legal power to restrict access. The
result will be over exploitation of this type of resources.

3.8. Common Property Resources

Property rights can not be assigned to any individual for some
commodities. Individual can not sell his or her right to the benefit of
the property to another member of the group, because the benefits of
the property are made equally available to all members of the group.
The problem which arises from the use of common property resources
is the tragedy of commons. For example as the grazing land is free for
each member, individual will tend to over graze the meadow. The result

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is the property is rapidly deteriorates and this unregulated self interest

behaviour of each individual produces a less than optimal solution for
the group as a whole. This problem is resulted from indivisibility of the
common property and the size of the beneficiary group. If the size of the
beneficiary group is small it is easy to reach consensus and agreement
but it is not possible if not. Common property right are used up to the
where marginal utility (price) is equal to zero. Such rights are desirable
where there are no scarce resources. How ever, these rights will lead to
misuse of resources such as over grazing, over hunting, over fishing
etc. the tragedy of common is that the on regulated behaviour of self
interested utility maximizing individuals will result in the deterioration
in the quality of common property resources. David Hume observed
that it was government role to regulate individual behavior there by
reducing the tragedy of commons.
3.9. Exploitation of Open Access Resources
Supposes that private individuals are the owner of fishery
1. Private owner ship of the fishery, when an individual owner
has an exclusive right on the fish stock, he can exclude others
from eating fish in the area. The objective of this owner is to
maximize the return from fishery. Apparently the return is
maximized where; MP equals MC (point D). Therefore, the
efficient level of fishing effort that maximizes net benefit is b*
boats. This allocation yields a scarcity rent equals to area ABCD.
The owner has an incentive to protect the scarcity rent by
restricting fishing effort at b*.

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Benefits & Costs

A C
MC=AC
B D
AP
MP Fishing Effort (No boats)
b* b

2. Open Access Fishery, open access means fishing is open to any

who would like to do so. All fishers have unrestricted access to
the fishery. In this case, the resulting allocation would not be
efficient. Individual fishers, with out exclusive rights, would
exploit the resources until their average benefit (AP) equaled
average cost (AC). Implying a level of effort equal to ‟b‟. Excessive
exploitation of the fish stock occurs because individual fishers
can not appropriate the scarcity rent; therefore they ignore it.
The over all return to the fishery is maximized where MP=MC at
b* boats. Beyond this point (and up to b), these cost of extra
effort (boat) put in to fishing is greater than the return that it
achieves (i.e. MC exceeds MP). In open access the point where
AP=AC at point „b‟ as a result profit is zero. While in private
individual we have seen profit is the area ABCD. Thus under
open access condition, the level of effort is „b‟, at this level of
effort the fishery is over exploited.

3.10. Tragedy of the Commons

Two characteristics of open access allocation of resources
A. In the presences of sufficient demand, open access
(unrestricted) access causes resources to be over exploited.
B. The scarcity rent is dissipated; no one appropriates the rent,
so it is lost.

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Unlimited access destroys the incentive to conserve. An individual

exploiting an open access resources would not have any incentive to
conserve because benefit derived from restrain (conservation) would, to
some extent, be exploited by others. Thus, open (unrestricted) access to
resources promotes an inefficient allocation.

Open access leads to the most serious problem in natural resources

use. Open access resources have given rise to what has become known
popularly the „Tragedy of commons’. Each agent harvesting an open
access resources does not take in to account the cost he imposes in
terms of reduced productivity of resources on the other agent who are
harvesting the resources. Each agent harvest too much from an
efficiency perspective; there by drawing down (reducing) the stock of a
resources. This can lead to the exhaustion (depletion) of the resources.
Such an out put come is refined to as tragedy of commons. Thus
Everybody‟s property is Nobody‟s property.
What solutions do you suggest for tragedy of commons?
1. Privatization ( private property)
2. Central government management (state property)
3. Effective local self governance (common property right)
What are the differences between common and open access
resources?

In common property resources the rights to the resources are well

defined, but owned by a number of individual over the same area.
These rights are fully defined and enforced either by local courts or
tradition and customs. Where as open access is completely non
exclusive. No one can be prevented from using or exploiting on open
access resources. How ever, common property resources may change to
open access if there is no well defined system of rules governing the use
of the common property resources or if the number of owners of the
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common property resources is large and every one of them has

incentive to break the rule so much so that the rules become
unenforceable.
3.11. Method of Correcting Market Failure
Market failure refers to those situations in which the conditions
necessary to achieve the market efficient solution fail to exist. There
are factors which bring the market failure includes
a. The existence of pure public goods and externality
b. Imperfect information
c. Imperfect information
d. Uncertainty

There are also solutions to the market failure

1. Assignment of property rights

The problem of over exploitation of resources can be solved with only

limited government intervention, through property right
2. Regulation

There is a general consensus that there are some problems particularly

those concerning the environment which needs government
intervention. It is possible restricting sulphur dioxide emission to the
atmosphere. This approach some times „command control approach‟
3. Internalizing the externality through merger.

This is by coming up the owners of the two firms in one and

maximizing their joint profit subject to the pollution the first firm
created to the other one.
4. Taxes and subsidies
Taxes imposed on pollution are costs and there by can discourage
pollution. Taxes add the pollution cost on the cost that a company has
to incur to continue in a market. This decrease profit of the company,
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Wolaita Sodo University,Dawuro-Tarcha Campus Department of Economics

finally it searches new method of production with less pollution.

Subsidies are another way of giving incentive for the producer to reduce
pollution, may be in credit but are not as such economically efficient.
5. Marketable permit

Companies buy a permit from the government that allows them to

discharge a certain amount of pollution. Companies can sell their
permit. For example companies can sell half of their permit to another
company who want increase production if they reduced their pollution
by half.
Unit Summary
Property right is defined as a bundle of entitlements defining the
owners rights, privileges and limitations for the use of resources. The
structure of the property right which can result in efficient allocation of
resources in a well-functioning market economy has four main
chrematistics. These are: universality, exclusivity, transferability and
enforceability. Property rights can not be assigned to any individual for
some commodities such as common property resources. For these
resources an individual cannot sell his/her right to the benefit of the
property to another member of the group.
Externally is arise when the production and consumption decision of
one agent affects the utility or production possibilities of another agent
in unintended manner and when no compensation is made by the
producer of the external effect to the affected party. Externality may be
positive or negative. Externalities are example of market failures.
Public goods, as defined by Samuelsson, are goods that individual
consumption of such a good leads to no subtraction for any other
individual consumption of that good. According to him, peace and
security of a nation, national defence, the law, air pollution control,
street light, fire protection, weather forecast, and public television are

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Wolaita Sodo University,Dawuro-Tarcha Campus Department of Economics

examples of public goods. They are non-rival and non-exclusive in

consumption. Market failure refers to those situations in which the
market fails to achieve efficiency. There are about four solutions which
are considered to correct market failure. These are assignment of
property right, regulation, taxes and subsidies, and marketable permit.
Self-Test Exercise
Answer the following questions.

1. What is Property Right?

2. Explain the characteristics of Property Rights.
3. What is Externality?
4. Explain the different classifications of externalities and their
effect on efficient allocation of resources.
5. When externality occurs?

6. What are public goods?

7. Explain the characteristics of pure public goods.

8. Explain common property resources and exploitation of open
access resources.
9. What are the differences between common and open access
resources?
10. What is tragedy of the commons?
11. What solutions do you suggest for tragedy of commons?
12. What are the methods of correcting market failure?

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