Economic Valuation of

Ecosystem Services

Property Rights, and Externalities

Aseffa Seyoum (PhD), Natural Resource Economist

Property Rights
There is more to property rights than ownership.
• In general there are four different classes or regimes of property
rights based on who holds these rights:
• Private property rights: Rights held by individuals and business
enterprises, usually with a legally recognized owner.
• Common property rights: Rights held by an identified group of
proprietors.
• State property rights: Rights held by government.
• Open access: No specific property rights recognized, and thus the
re- source is open to all under the common-law rule of capture
with no capacity for management or exclusion.
 Property Rights
• It is not unusual to unbundle a portion of these rights and assign them to non-
owners. For example, someone with a valid fishing or hunting license is an
authorized user with certain rights to harvest fish and game, while government
retains proprietary rights to the wildlife in a public trust capacity.

• Usufructuary rights: refer to certain use and withdrawal rights granted to

property that is owned by others. For example, treaties ceding Indian lands to
the federal government sometimes include clauses granting Indian tribes
usufructuary rights for hunting, fishing, and gathering on the ceded lands.

• These arrangements reflect a melding of pre-contact Indian customary land

tenure systems governing the harvest of resources from land and water, and
Euro-American property rights systems.
 Property Rights
• According to Schlager and Ostrom (1992) , there are five important
property rights that when bundled together make up ownership:

• Access: The right to enjoy benefits of the property that do not

subtract from benefits that others can enjoy, such as walking along
the beach. Authorized entrants have access rights, such as those
that are purchased with entry fees at national parks.

• •Withdrawal: The right to withdraw the product of the property,

such as harvesting fish from a fishery. Authorized users have both
access and withdrawal rights, such as those that are acquired with
the purchase of a fishing license or a firewood gathering permit
from a national forest.
 Property Rights
• Management: The right to regulate use and improvements. Ostrom
(1997) uses the term claimant to refer to those who hold access,
withdrawal, and management rights, such as farmers who participate in
the management of government-owned irrigation systems.

• Exclusion: The right to determine who has access and who can be
excluded from using the property. Ostrom (1997) uses the term
proprietor to refer to those who hold access, withdrawal, management,
and exclusion rights.

• Alienation: The right to sell or lease. “Owners” possess all the rights of
proprietors along with the right of alienation. Private property falls
under this category, though owners can also be governments or
communities.
Property Rights
• An important step in protecting the environment is assigning appropriate
property rights.

• The type of property rights regime that is appropriate depends on factors

such as the nature of the resource, the culture and values of society, and
the costs of monitoring and excluding use.

• Failure to assign appropriate property right is one of the underlying cause

of market failure to efficiently allocate resources and externalities.
 Externalities
 Externalities are positive or negative impacts on society that
occur as a by-product of production and exchange.

 These effects are called externalities because they are not

included in the factors that underlie market supply and demand,
and their omission leads to the market failing to efficiently
allocate resources.

 As a result of externalities and, the common property and

public good characteristics of at least some of these services,
we can not relay on market forces to allocate goods and
services to their most highly valued uses, and to reveal prices
that reflect their true social values.
 Externalities
 Externalities arise when a real variable (not a price) chosen by
one economic agent enters the utility or production function
of other economic agents.

 Inefficiencies can occur when there is no requirement to, or

incentive for, the first agent to take the effect on others into
account when making choices.

 It is the externalities and public good character of many

environmental services that are responsible for the failure of the
market system to allocate and price resource and environmental
services correctly, and that create the need for economic
measures of values to guide policymaking.
Externalities
Effect of externalities on opportunity cost estimation:

 Factor markets exhibit positive externalities of supply,

expenditures overestimate the opportunity cost.

 In factor markets which exhibit negative externalities of supply,

expenditures underestimate opportunity costs

 To determine opportunity costs in such cases, one has to apply

the general rule that opportunity cost equals direct
expenditures on the factor minus (plus) gains (losses) in
social surplus occurring in the factor market.
 Externalities
 Externalities is one of the cause of market failures. In case of
market failure due to either of the above factor including
externalities, price does not equal marginal social cost, allocative
inefficiency results.

 A variety of circumstances can lead to inefficiency; absence of a

working market such as public goods characteristics, natural
monopolies, markets with few sellers, and information
asymmetries as well as distortions due to government
interventions (such as taxes, subsidies, regulations, price ceilings,
and price floors) are other reasons for market failure.
Externalities
There are two supply curves:
 The supply curve based on marginal private cost. This is the supply curve
that firms supply along in the absence of environmental regulation or
reputational enforcement. MPC=Marginal private cost (borne by the firm,
passed along to consumers via market price)

 The supply curve based on

marginal social cost. This is the
supply curve that reflects the
full social cost of production.
MEC=Marginal external cost
(uncompensated costs borne
by the environment and society

Marginal private and social cost in the presence of an externality

 Externalities
 Externalities lead to divergence of private and social discount
rate. The divergence emanates from the private and social risk
difference.

 For resources to be allocated efficiently the private discount

rate of net benefits should be appropriate for the society.

 If private discount rate is greater than social discount rate,

firms extract and sell natural resources faster than it would be
efficient

 If private discount rate is less than social discount rate firms

would be excessively conservative.
Positive Externalities
 Positive externalities are unpaid-for benefits to other members of
society generated as a side effect or consequence of an economic
exchange, such as between a buyer and a seller

 A positive externality can be defined as an unpaid-for benefit enjoyed

by others in society that is generated as a by-product of production and
exchange. Positive externalities are also known as external benefits.

 Since those who receive positive externalities do not pay for them,
market demand does not include external benefits.

 The sum of private benefit and external benefit is called social benefit
 For instance, nearby residents and visitors enjoy the scenic of
natural forests, wildlife, and watershed benefits but do not have
to pay for them when buyers in a market purchase goods, the
market demand for the good reflects only the private benefits
that flow to the buyers. The scenic of natural forests, wildlife,
and watershed benefits is a positive externalities or external
benefits.

 Those who receive positive externalities do not pay for them,

market demand does not include external benefits.

 If market demand does not reflect the benefits to society, but

only the private landowner, the positive external benefits are not
“internalized” into the market demand curve the natural forest
will be allocated to agricultural land.
 Positive externalities and market failures
 Demand curve based only on private benefits is smaller than (to
the left of) the demand curve based on social benefits.

 The vertical Note: MEB is

difference between marginal external
the private-benefit benefit, the external
and the social-benefit benefit per acre of
forest land in this
demand curves is
case
marginal external
benefit.
 Positive Externalities
 Buyers’ willingness-to-pay only reflects their private benefits, only the
market demand based on private benefits will exist in the market.

 Demand based on private benefits is smaller than the demand based on

social benefits, an otherwise well-functioning competitive market will
underprovide those goods (pastureland, education, vaccinations) that
generate positive externalities.

 What are some possible interventions that could help secure the socially
optimal quantity of forestland in a market process?
Solution:
 One common government intervention is to provide subsidies to those
who provide society with positive externalities
 intervened in the market by using tax revenues to subsidize buyers, then
market demand would reflect social benefits
 Negative Externalities
 Negative externalities are defined as an uncompensated harm
to others in society that is generated as a by-product of
production and exchange.

 An uncompensated cost borne by members of society (or the

aspects of the natural world they care about) that comes about
as a byproduct of economic exchange, such as through market
transactions.
 Pollution is the prime example of a negative externality
 The harms created by pollution are known as external costs
 Also effect of dame construction on down stream production
 When production of a good or service generates significant negative
externalities, profit-maximizing firms in a competitive market will
supply too much of that good or service.

 Under unregulated competitive market , external costs are not

accounted for in the firm’s marginal cost, which means that the firm’s
supply decision ignores external costs.

 A profit maximizing firms produce at a point where MR (price) ≥ MC.

 Market exchange generates negative externalities, market supply fails

to reflect the true social cost of producing the good generating the
externality, and so too much of the good is produced.

 Consumers will pay a subsidized price and so will consume too much.
 Negative Externalities
 Competitive markets are inefficient when there are negative
externalities

 One supply curve is based on firms’ marginal private costs, with

marginal external costs borne by the environment and society.

 The other supply curve is based on marginal social costs. This

latter supply curve is operational only if firms are made to
internalize their negative externalities.

 The quantity of goods and services produced where the private-cost

supply curve crosses the demand curve is the market equilibrium
quantity when firms are allowed to freely pollute, indicated by QP. The
corresponding equilibrium price when there are unresolved negative
externalities is indicated by PP.
 Negative Externalities
 The quantity of goods and services produced where the social-cost supply
curve crosses the demand curve is the market equilibrium quantity when
firms are forced to fully internalize all their external costs, indicated by QS.

 PS in Figure indicates
the corresponding
equilibrium price
when there are
unresolved negative
externalities.

 This difference in output is denoted by the letter A in figure and reflects excess
production that occurs in competitive markets where firms are allowed to freely
emit negative externalities.
Negative Externalities
 When firms can freely pollute they will supply along the private-cost supply
curve, leading to an equilibrium quantity of the good or service being
produced and sold that is larger than when firms are made to supply along
the social-cost supply curve.

 When firms can freely pollute and supply along the private-cost supply curve,
the equilibrium market price PP only reflects marginal private cost, whereas
when negative externalities are internalized the equilibrium market price PS
reflects the full marginal social cost of production.

 The difference in these two equilibrium prices is denoted by the letter B in

above figure, and indicates the distortion of the price signal sent to
consumers in the marketplace.
 This distorted price signal creates an incentive for consumers to buy too
much of the good or service in question. As we will see in a moment, the
market is not efficiently allocating scarce resources when there are
unresolved negative externalities.
 Negative Externalities
 Suppose firms are allowed to freely pollute, and so they supply along the
private-cost supply curve, yielding an equilibrium price and quantity as
shown in following figure.

 The buyers and the sellers receive a gross gain from trade equal to the large
triangle abc . The portion of this triangle above the dashed price line is a
simplified approximation for consumer surplus, while the portion below the
price line is producer surplus.

 The parallelogram bcde in figure gives us the total dollar figure for the harms
to human health and the environment caused by negative externalities.

 Total external cost is equal to marginal external cost (height cd or be)

multiplied by the equilibrium quantity produced when firms operate on the
private-cost supply and freely pollute (length 0QP along the horizontal axis).

 After accounting for total external costs, the true net gains from trade to all
members of society when firms freely pollute is area abc minus area bcde.
 Negative Externalities
 Suppose that firms are forced by regulatory intervention or market
reputation to internalize their external costs and supply along the
social-cost supply curve. one way to internalize negative externalities is
by way of a Pigouvian tax equal to marginal external cost.

 When firms supply along the social-cost supply curve, equilibrium

output is found at point f (in the figure presented on the next slide)
where the social-cost supply curve crosses the demand curve.

 Since firms have paid the tax to society they have (at least in theory)
compensated society for their pollution, and thus have internalized the
external costs. The total gains from trade when firms fully internalize
their external costs are given by the triangle afd.

 Output set where the social- cost supply curve crosses the demand
curve is the efficient level of output.
 Negative Externalities
 Area afd, the gains from trade when negative externalities are fully
internalized and firms supply along the social-cost supply curve, is larger
than area [(abc)–(bcde)], the true gains from trade to all members of
society when firms freely pollute.
 Internalizing externalities
improves the welfare of
society.
 The difference between
area afd and area [(abe)–
(bcde)] is the little
triangle bfe, known in
microeconomic theory as
deadweight social loss,
and it represents the
resource allocation
inefficiency caused by
negative externalities.
Negative Externalities
 Policy interventions such as environmental tax, pigouvian tax to
capture externalities and to ‘internalize’ the negative externalities
through environmental tax:
 Marginal external cost should have to be known precisely
 The political system should produce an efficient environmental
policy
 The capacity to monitor emissions, charge appropriate tax, and
enforce this system