Contents

1 What Is Environmental Economics? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

1.1 What Is Environmental Economics? . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 Typical Environmental Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1.2.1 An Environmental Problem Caused by the Output Side . . . . 9
1.2.2 An Environmental Problem Caused by the Input Side . . . . . 16
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
2 Economic Instrument and Environmental Problems . . . . . . . . . . . . . . . 19
2.1 Economics and Environmental Problems . . . . . . . . . . . . . . . . . . . . . . . 19
2.1.1 Externality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
2.1.2 Market Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
2.1.3 Public Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
2.1.4 Information Asymmetry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
2.2 Economic Policy and Environmental Problems . . . . . . . . . . . . . . . . . 39
2.2.1 Internalizing Externality Through Direct Regulation . . . . . . 40
2.2.2 Internalizing Externality Through Economic
Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
2.2.3 Internalizing Externality Through Voluntary
Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
2.2.4 Policy Mix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
3 Economics and the Value of Nature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
3.1 The Value of Nature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
3.2 Revealed Preference Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
3.2.1 Replacement Cost Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
3.2.2 Travel Cost Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
3.2.3 Hedonic Pricing Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
3.3 Stated Preference Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
3.3.1 Contingent Valuation Method . . . . . . . . . . . . . . . . . . . . . . . . . . 73
3.3.2 Conjoint Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
3.4 Cost–Benefit Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
vii
viii Contents

4 Economics and Cross-Regional Environmental Problems . . . . . . . . . . 87

4.1 Economics and Global Warming . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
4.1.1 Global Warming as Global Commons . . . . . . . . . . . . . . . . . . . 87
4.1.2 Global Policy Toward Global Warming . . . . . . . . . . . . . . . . . . 89
4.2 Economics and Air Pollution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
4.3 Economics and Biodiversity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
4.3.1 Global Policy Toward Conserving Biodiversity . . . . . . . . . . . 99
4.3.2 What Are Ecosystem Services? . . . . . . . . . . . . . . . . . . . . . . . . 102
4.3.3 Economic Policy Toward Protecting Biodiversity . . . . . . . . . 104
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
5 Economics and Non-renewable/Renewable Resources . . . . . . . . . . . . . . 115
5.1 Economics and Non-renewable Resources . . . . . . . . . . . . . . . . . . . . . 115
5.2 Economics and Renewable Resources . . . . . . . . . . . . . . . . . . . . . . . . . 122
5.2.1 Economics and Forest Resources . . . . . . . . . . . . . . . . . . . . . . . 123
5.2.2 Economics and Fisheries Resources . . . . . . . . . . . . . . . . . . . . 133
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
6 Energy and Waste Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
6.1 Economics and Energy Resources . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
6.2 Waste Problems and Economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
7 Future Issues of Environmental Economics . . . . . . . . . . . . . . . . . . . . . . . 169
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176

Appendix: Solutions to Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191
About the Author

Kentaka Aruga finished his Ph.D. from the Department of Environmental and
Natural Resource Economics, The University of Rhode Island, USA, in 2010,
and is now working at the Graduate School of Humanities and Social Sciences,
Saitama University, Japan. He has been working on issues related to natural resource
markets such as soybeans, corn, seafood, energy, and metals, and how individuals’
environmental awareness is affecting their consumption behavior.
Another published book from Springer Inc.:
Aruga, K. (2017) Consumer Reaction, Food Production and the Fukushima
Disaster: Assessing Reputation Damage Due to Potential Radiation Contamination,
Springer International Publishing AG, Cham, Switzerland.

ix
Abbreviations

3Rs Reduce, reuse, and recycle

ABS Access and benefit sharing
AIA Advanced informed agreement
BC Biocapacity
BDO Biodiversity offset
BM Benchmarking
BPP Beneficiary pays principle
BWS Best–worst scaling
CAC Command and control
CBA Cost-benefit analysis
CBD Convention on biological diversity
CBFM Community-based fisheries management
CCS Carbon capture and storage
CCUS Carbon capture, utilization and storage
CDM Clean development mechanism
CEPA Communication, education, participation, and awareness
CFC Chlorofluorocarbon
CH4 Methane
CITES Convention on International Trade in Endangered Species of Wild
Fauna and Flora
CLRTAP Convention on Long-Range Transboundary Air Pollution
CMA Conference of the Parties serving as the meeting of the Parties to the
Paris Agreement
CMP Conference of the Parties serving as the meeting of the Parties to the
Kyoto Protocol
CO2 Carbon dioxide
COP Conference of the Parties
CS Consumer surplus
CVM Contingent valuation method
EANET Acid Deposition Monitoring Network in East Asia
EC External cost

xi
xii Abbreviations

EEKC Energy environmental Kuznets curve

EF Ecological footprint
EKC Environmental Kuznets curve
ET Emissions trading
FIT Feed-in tariff
FRM Faustmann rotation model
FSC Forest Stewardship Council
FV Future value
GF Grandfathering
GHG Greenhouse gas
GIAHS Globally Important Agricultural Heritage Systems
HCFC Hydrochlorofluorocarbon
HPM Hedonic pricing method
IPAT Impact, Population, Affluence, and Technology
IPCC Intergovernmental Panel on Climate Change
IQ Individual quota
IRCC International Recognized Certificate of Compliance
JI Joint implementation
kgoe Kilograms of oil equivalent
LMOs Living modified organisms
MA United Nations Millennium Ecosystem Assessment
MAC Marginal abatement cost
MAI Mean annual increment
MAT Mutually agreed terms
MC Marginal cost
MD Marginal damage
MEC Marginal external cost
MNB Marginal net benefit
MPB Marginal private benefit
MPC Marginal private cost
MR Marginal revenue
MSC Marginal social cost, Marine Stewardship Council
MSY Maximum sustainable yield
N2 O Nitrous oxide
OA Open access
OECD Organisation for Economic Co-operation and Development
PC Private cost
PES Payment for ecosystem services
PFC Perfluorocarbon
PP Private property
PS Producer surplus
PV Present value, photovoltaic
RA Rainforest alliance
RCM Replacement cost method
REDD Reducing Emissions from Deforestation and Degradation
Abbreviations xiii

RPS Renewable portfolio standard

SANZ Sustainable Aotearoa New Zealand
SC Social cost
SF6 Sulfur hexafluoride
SOx Sulfur oxide
SRAS Self-Report Altruism Scale
SRM Single rotation model
TAC Total allowable catch
TBL Triple bottom line
TC Total cost
TCM Travel cost method
TEEB The Economics of Ecosystem and Biodiversity
TFI Task Force on National Greenhouse Gas Inventories
TR Total revenue
TURFs Territorial use rights in fisheries
UNCCD United Nations Convention to Combat Desertification
UNCED United Nations Conference on Environment and Development
UNECE United Nations Economic Commission for Europe
UNEP United Nations Environment Program
UNFCCC United Nations Framework Convention on Climate Change
VEA Voluntary environmental agreement
WCC World Climate Conference
WDI World Development Indicators
WGI Working Group I
WGII Working Group II
WGIII Working Group III
WMO World Meteorological Organization
WTA Willingness to accept
WTP Willingness to pay
Chapter 1
What Is Environmental Economics?

In this chapter, first, I briefly explain the field of environmental economics and the
motivations for using economics to analyze environmental problems. Differences
among the relevant field such as environmental, resource, and ecological economics
will be discussed. Next, in Sect. 1.2, I introduce examples of environmental problems
like climate change, air pollution, and deforestation and describe the challenges they
pose.

1.1 What Is Environmental Economics?

Environment—as examined in environmental economics—can be defined as the

outside world in the context of things surrounding us and those interacting within
and between the surrounding environment, including ourselves. Furthermore, the
condition of our environment is affected by various external factors around us, such
as the quality of air and water and the types of biodiversity. If the surrounding air and
water are polluted, the environmental condition is considered bad, while if they are
clean, it suggests that the environment is in good shape. Similarly, an environmental
problem often implies that the surrounding environment is polluted or posing harm
to living organisms and that the environment is deteriorating. In this context, the
objective of environmental economics is to provide critical information and plans
for solving environmental problems.
Table 1.1 illustrates the types of environmental problems identified by the residents
of the USA. The table is based on a survey conducted by Gallup, a US analytic and
advisory company, between March 2, 2020, and March 13, 2020, on 1,019 adults
over 18 years of age (Gallup, 2020). The table shows that drinking water pollution is
considered the focal environmental problem. Conversely, the participants considered
global warming to be a negligible environmental concern. This implies that people are
more concerned about local environmental issues, such as the pollution of drinking

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 1

K. Aruga, Environmental and Natural Resource Economics,
https://doi.org/10.1007/978-3-030-95077-4_1
2 1 What Is Environmental Economics?

Table 1.1 Survey conducted on US residents about different environmental issues

Very serious (%) Fairly serious (%) Not so serious and not
serious (%)
Drinking water pollution 58 23 19
River, lake, and reservoir 55 26 19
pollution
Ocean and beach 52 29 18
pollution
Tropical rainforest losses 49 26 25
Air pollution 48 28 24
Extinction of plant and 47 28 25
animal species
Global warming and 46 19 34
climate change
Source Gallup (2020)

water, rivers, and lakes, compared to global issues such as tropical rainforest loss
and global warming.
A similar lack of interest in global environmental problems is apparent from
a survey comparing people’s interest in local and global environmental problems
in Japan. Figure 1.1 depicts how Japanese people think about these issues. The
data for the figure are based on a study of 2,546 respondents in Japan on their
interest in local environmental problems, such as pollution of drinking water, and
global environmental problems, such as global warming and rainforest destruction.
The respondents were asked to reveal their level of interest by picking one answer
from a Likert-type question scale ranging from 1 (indifferent) to 5 (interested). The
figure summarizes the percentage of respondents answering 1, 2, 3, 4, or 5, which
are defined as indifferent (1 and 2), neutral (3), and interested (4 and 5). Since
the percentage of people answering “interested” was higher for local environmental
issues, while people answering “indifferent” were higher for the global environmental

Fig. 1.1 Difference in the 60%

perception toward global and
50%
local environmental
problems among Japanese 40%
residents. Note The figure is
based on a survey conducted 30%
on 2,546 Japanese
respondents performed by 20%

the author (Aruga, 2020)

10%

0%
Indifferent Neutral Interested

Global environmental problem Local environmental problem

1.1 What Is Environmental Economics? 3

Fig. 1.2 Relationship

between the environment,
society, and economy

issue, the figure signifies that the Japanese people are more concerned about local
environmental problems than global ones.
Thus, environmental problems occur at both local and global levels, but the global
ones are still not significantly recognized by the public. However, as the dire effects
of climate change have recently manifested, it is now more critical than ever to cope
with global environmental issues. In this context, environmental economics is a field
that utilizes economics to analyze this urgent problem and uses some techniques and
methods as useful tools for planning environmental policies to address such issues.
Environmental economics is a part of economics, as it will be explained later under
Table 1.2. However, it is first crucial to establish why environmental problems began
to be recognized as pivotal issues in economics. Economics has traditionally been
used as an analytical tool for devising policies to effectively improve the economy
and society. It was inevitable for economics to cover environmental problems as its
subject as the two are intertwined; as shown in Fig. 1.2, before human economic
activities became one of the cornerstones of our society, the economy played only a
small role. Further, humans are only one small part of the entire natural environment.
However, as economic activities grew and became borderless, their impact on the
natural environment became not only overwhelming but also caused irreversible
damages to the environment. This is one of the reasons why environmental problems
have become an essential topic under economics.
Students of economics are taught that economic activities can be separated into
the producer and consumer sides; both producer and consumer activities are strongly
related to environmental destruction.
First, let us consider an example of how producer activity causes environmental
destruction. During the latter half of the 1950s to the 1970s, Japan suffered the so-
called four major pollution diseases: Minamata disease, Niigata Minamata disease,
Yokkaichi Asthma, and Itai-itai disease (Fig. 1.3); these were caused by the discharge
of harmful substances (such as mercury, sulfurous acid gas, and cadmium) gener-
ated by factories into the surrounding area during their production processes. The
pollutants released into the atmosphere, rivers, and nearby oceans were later iden-
tified as being the causes of asthma and mercury poisoning in people living in the
4 1 What Is Environmental Economics?

Niigata Minamata disease

Year of first occurrence: 1965
Location of occurrence:
Agano River basin
Cause: Methylmercury
Prefecture affected: Niigata

Itai-itai disease
Year of first occurrence: 1912
Location of occurrence:
Jintsu River basin
Cause: Cadmium poisoning
Prefecture affected: Toyama

Tokyo Yokkaichi Asthma

Year of first occurrence: 1961
Location of occurrence:
Yokkaichi city
Cause: Sulfur dioxide
Minamata disease Prefecture affected: Mie
Year of first occurrence: 1956
Location of occurrence:
Minamata bay
Cause: Methylmercury
Prefecture affected: Kumamoto

Fig. 1.3 Four major pollution diseases of Japan (https://d-maps.com/carte.php?num_car=29459&

lang=en)

surrounding areas. Thus, industrial pollution driven by the producer side of economic
activity caused tremendous damage to the surrounding environment.
Next, the environmental destruction caused by consumption activities is reviewed.
First, when purchasing a product such as a gasoline-powered vehicle—which emits
pollutants—the consumption of the product contributes to environmental pollution.
Second, although consuming a product such as coffee does not directly cause envi-
ronmental pollution, if its production process causes environmental destruction, such
as rainforests being destroyed for harvesting coffee beans, the consumption of this
product can cause indirect environmental damage. Therefore, to pursue an environ-
mentally friendly method of consumption, it is necessary to ensure that the production
process of the product does not contribute to environmental destruction.
1.1 What Is Environmental Economics? 5

Input Environment Output

Energy resource Air pollutants

Food resource Economy Water pollutants

Water Solid wastes

Amount of pollutants
Over-exploitation of
exceeding the restorative
natural resources can
capacity of nature can
cause environmental
lead to environmental
destruction.
destruction.

Fig. 1.4 Relationship between economic activity and environment

Thus, it can be said that the root of environmental problems lies in economic
activities. A well-known environmental economist, Charles Kolstad, states in his
book, “essence of the environmental problem is the economy—producer behavior
and consumer desires” (Kolstad, 1998, p. 1).
Figure 1.4 depicts how economic activity is related to environmental problems.
This figure shows the impact of economic activity on the environment when economic
activity is divided into input and output sides; economic activity may impose a burden
on the environment from both sides.
First, considering the input side, when a company engages in any production
activity, it utilizes energy, living organisms such as agricultural and marine resources,
and water resources. If nature can organically and independently restore the amount of
resources consumed, the production activity will not cause any environmental prob-
lems. However, economic activities often require resources in amounts that exceed
the restorative capacity of nature, and the pace of extraction surpasses the speed of
natural recovery; such injudicious use of natural resources causes their depletion.
For example, tuna catches have continued to decline globally in recent years, and it
is believed that this is because of overfishing tuna such that its natural biomass is
unable to recover (The Guardian, 2019); increased tuna production is also related to
increased tuna consumption. As tuna consumption increased, its production increased
accordingly, which likely led to its overexploitation. Thus, if production or consump-
tion causes overexploitation of natural resources, the input side of economic activity
can become the cause of environmental problems.
According to Fig. 1.4, the output side of economic activity also generates envi-
ronmental problems. It is rare for all the input resources to be used in a production
6 1 What Is Environmental Economics?

process. Thus, it is inevitable to dispose materials that are not used during produc-
tion. These waste materials, which are neither liquid nor gas, are termed solid waste.
This waste can lead to environmental problems because it often contains toxic or
hazardous substances that are difficult to degrade and decompose naturally. Thus,
landfills, where various solid wastes end up, not only damage the quality of the land
but also pollute their vicinity. Moreover, production processes also release gaseous
and liquid substances, which if toxic or hazardous can cause air and water pollution.
Even if they are not directly related to health hazards, such as carbon dioxide (CO2 ),
the gases emitted from economic activities are now fueling climate change.
Hence, both the input and output sides of economic activities can pollute the envi-
ronment. Based on this context, environmental economics can be broadly divided into
two areas that focus on environmental problems: those related to the input and output
sides of economic activities, respectively. Many environmental economics textbooks
encompass the environmental problems related to the output side. Therefore, to
avoid confusion, I term this field conventional environmental economics. Conversely,
resource economics, sometimes called natural resource economics (Field, 2015),
deals with issues primarily related to the input side. However, there are environ-
mental problems related to both the input and output sides simultaneously, such
as energy and water resource issues—and there are various problems that require
analysis through both conventional environmental and resource economics. Thus,
the field of environmental economics has recently developed along these two fields,
with many current environmental textbooks covering materials from them.
Next, the differences between these two fields are summarized in Table 1.2.
First, conventional environmental economics mainly considers economic measures
to reduce and alleviate the pollution caused by economic activities. For example, it

Table 1.2 Differences between conventional environmental and resource economics

Conventional environmental Resource economics
economics
Main subjects Dealing with methods to control Dealing with optimal use of
pollution and instituting natural resources such as
economic policies for adaptation renewable and non-renewable
to the deteriorating natural resources
environment
Example of topics covered Controlling greenhouse gas Agricultural resource; water,
emissions, air and water land, energy, and waste
pollution, acid rain, and management; and analyzing
conservation of rainforests and optimal use of such resources
biodiversity
Economic model Static model Dynamic model
Origin Developed in the 1960s as a Existed from the beginning of
subfield of economics and economics and developed
relatively new compared to through relevant fields such as
resource economics agricultural, energy, and land
economics
1.1 What Is Environmental Economics? 7

recommends implementing a carbon tax to incentivize people to reduce emissions

and analyzes the cost of implementing such policies. It also studies policies to adapt
to changes in the natural environment, such as planning to cope with heatwaves and
higher temperatures due to climate change. In contrast, resource economics mainly
deals with issues related to the production and utilization of natural resources. Under
resource economics, resources are classified into non-renewable and renewable cate-
gories according to their characteristics. For non-renewable resources, the focus is
on maximizing the profit of producers by extracting resources without completely
depleting them at once; for renewable resources, not only the maximization of the
producer’s profit is targeted, but also the quantum of harvest is considered to ensure
sustainability, such that the harvest level does not exceed the restorative capacity of
the resources.
Second, the economic models in conventional environmental economics are often
static models, where time is invariant; contrastingly, dynamic models are frequently
used in resource economics and often deal with an optimization problem to determine
the optimal harvest level of a natural resource when the stock of natural resources
changes over time.
Third, conventional environmental economics is thought to be triggered by the
growing interest in environmental issues in the USA since the 1960s, when serious
environmental problems such as air and water pollution became apparent, and the
importance of dealing with this issue in economics began to gain scholarly interest
(Pearce, 2002). The problems regarding resource economics have been tradition-
ally covered in economics since the eighteenth century when Thomas R. Malthus
advocated that food shortages will worsen as the population grows (Malthus, 1798).
Resource economics is rooted in agricultural and land economics. Although the main
scope of these fields was unrelated to environmental issues, recent aggravation of
environmental problems has gravely impacted agriculture, and environmental issues
have started to become a pivotal subject that must be addressed.
Next, I would like to explain how such differences in the two fields create a differ-
ence in the way an environmental problem becomes severe. As shown in Table 1.3,
in conventional environmental economics, environmental problems become evident
when the volume of emitted pollutants from economic activities exceeds the capacity
of nature to absorb and neutralize them. Thus, some action is required to mitigate the
adverse impact of economic activity on the environment, if the discharged pollutants
cannot be degraded or decomposed by nature. In contrast, under resource economics,
environmental problems are ascribed to the restorative capacity of natural resources.
The problem becomes apparent when the amount of resources utilized for economic
activities is greater than the natural pace of resource regeneration. As shown in
Table 1.3, if the consumption of natural resources is lower than their restorative
capacity, the impact of consumption on the environment will be minor; however, if
the consumption exceeds their restorative capacity, the resources can deplete, causing
environmental issues.
Finally, the field of ecological economics may also be taught under environ-
mental economics; however, the distinction between these fields is crucial. As seen
in Fig. 1.5, environmental economics belongs to the field of economics, but ecolog-
8 1 What Is Environmental Economics?

Table 1.3 Natural capacity and economic activity

Natural Size of the effect Economic Environmental
capacity activity impact
Conventional Cleansing > The volume of Environmental
environmental capacity emitted pollutants improvement
economics Cleansing = The volume of Maintaining
capacity emitted pollutants status quo
environment
Cleansing < The volume of Environmental
capacity emitted pollutants degradation
Resource Restorative > The volume of Environmental
economics capacity use and improvement
consumption
Restorative = The volume of Maintaining
capacity use and status quo
consumption environment
Restorative < The volume of Environmental
capacity use and degradation
consumption

Fig. 1.5 Difference between

environmental economics
and ecological economics

ical economics is driven by a branch of biology: ecology. Since economics is a

field that analyzes human economic activities, we analyze environmental problems
from a human-oriented perspective. Contrastingly, in ecology, environmental prob-
lems are examined from a nature-oriented perspective. Environmental problems are
considered to be caused by human activities that damage the ecosystem, which is a
community of living organisms within the environment. Therefore, some ecologists
who support extreme ecosystem conservation have called for the conservation of
ecosystems at the expense of economic activity. Nevertheless, economics has been
integrated with ecology as an effective instrument for analyzing and controlling
human economic activity. Accordingly, ecological economics is an interdisciplinary
field that incorporates economic methods into ecology.
1.1 What Is Environmental Economics? 9

From the descriptions above, it is evident that using economics as a tool for
analyzing environmental problems is gravely important. The details of the methods
used in economics to examine environmental problems are explained in the following
chapters, but before that, I discuss the currently prevalent environmental problems.

1.2 Typical Environmental Problems

In this section, I first examine the environmental problems caused by the output side
of economic activity, where the pollutants released during and after the production
process have adverse impacts on the environment. Next, the environmental problems
related to the input side of economic activity—such that the use of natural resources
for producing goods and services—are described.

1.2.1 An Environmental Problem Caused by the Output Side

Climate Change
Here, I would like to focus on the global warming or climate change issue as an
example of an environmental problem driven by the output side of economic activity.
Apart from this issue gaining traction recently, global warming is also related to other
environmental problems such as poor crops, forest fires, and ecosystem destruction.
Global warming is also related to the output side of economic activity because
its main contributors are greenhouse gas emissions from economic activities. The
temperature on earth is determined by the balance between the energy radiated from
the Sun toward earth and the energy reflected off from earth’s surface toward outer
space. Hence, when the greenhouse gas density in the atmosphere increases, earth’s
average temperature rises. As shown in Fig. 1.6, when the level of concentration of
greenhouse gases in the atmosphere increases, the gases act as a barrier, preventing the
reflected longwave radiation from bouncing off earth’s surface to escape into space.
This greenhouse effect is not always detrimental because, without it, it is estimated
that earth’s temperature will drop to −18 °C, and it is the greenhouse gases that have
kept the average temperature of earth at a comfortable temperature (15 °C) for life
to thrive. Therefore, greenhouse gases are indispensable for maintaining the balance
between the incoming radiant energy from the Sun and the energy reflected by earth’s
surface. However, in recent years, the greenhouse gases emitted from our economic
activities have exceeded the suitable amount required to maintain earth’s temperature,
and the radiant energy balance between earth and space began to collapse. Thus, the
heat that should be released to space remains on earth, leading to an increase in the
average temperature of earth.
Carbon dioxide (CO2 ) is often referenced as a typical example of greenhouse gas
because it has the largest percentage of global greenhouse gas (GHG) emissions.
However, according to Fig. 1.7, greenhouse gases other than CO2 also contribute
10 1 What Is Environmental Economics?

Sun Sun

Greenhouse gases
CO2 CH4
The heat is The heat gets
released outside Heat trapped by
Heat
the atmosphere. Heat Heat Heat greenhouse gases
and gets reflected to
the earth’s surface.

Earth Earth

Fig. 1.6 Mechanism of global warming

2%

6% Carbon dioxide (emitted from fossil fuel

and industrial processes)

16% Carbon dioxide (emitted from forestry

and other land use)

Methane

11%
65% Nitrous oxide

Fluorinated gases (F-gases)

Fig. 1.7 Global gas emissions by types of greenhouse gases in 2014. Source EPA (2020a)

significantly to global warming. Carbon dioxide is primarily emitted by burning

fossil fuels such as coal, natural gas, and petroleum. It is also emitted when forests
are burned or when plants and trees rot, and the carbon dioxide accumulated in the
rotting matter is released into the air. Methane gas (CH4 ) is emitted from fossil fuel
production and transportation processes, as well as livestock belching and flatulence.
Additionally, using nitrogen fertilizers and burning fossil fuels emit nitrous oxide
(N2 O). Fluorinated gases (F-gases) have various applications such as refrigerants for
refrigerators, heat-insulating materials, foaming agents for cushions, and cleaning
agents for precision parts. Historically, gases such as chlorofluorocarbons (CFCs) and
hydrochlorofluorocarbons (HCFCs) were used widely among the F-gases; however,
1.2 Typical Environmental Problems 11

Electricity and heat production

10% Agriculuture and other land use

25%
Buildings
21%

Transportation

Industries (iron and steel, chemical

14% 24% & petrochemical, etc.)

6% Other energy

Fig. 1.8 Global greenhouse gas emissions by economic sectors in 2014. Source EPA (2020b)

since it was discovered that they destroy the ozone layer, they were banned from
use by the Montreal Protocol, which was issued in 1989. Subsequently, hydrofluo-
rocarbons (HFCs) have been used as alternatives. However, since HFCs also have a
significant greenhouse effect, they are expected to be replaced by other gases such
as ammonia.
Looking at the global greenhouse gas emissions by economic sectors in Fig. 1.8,
25 and 24% of the global emissions are due to the burning of fossil fuels for electricity
and heat production, and agriculture and other land use, respectively. Further, 21%
of the emissions come from various industries, encompassing energy consumption
and business waste in the chemical and industrial sectors, and 14% are attributed to
emissions originating from the transportation of goods and people.
The total amount of carbon dioxide emitted worldwide in 2017 was 36.15 billion
tons (Our World in Data, 2019). Generally, the unit for carbon dioxide emission is
denoted in tons, but to have a better understanding of how much a ton of carbon
emission is, I would like to explain it by the amount of carbon dioxide emitted from
driving a car. A ton of carbon emission is about the same amount of emission released
from a car whose fuel consumption is 9.28 km per liter of gasoline (km/L) (21.88
miles per gallon (MPG)), being driven for 4000 km (2485 miles).
Figure 1.9 denotes how 36.15 billion tons of global greenhouse gas emissions
were emitted by major regions in the world in 2017; about half the world’s total
emissions were emitted from the Middle East and Asia including China, 21% from the
American continent, 16% from the European continent, and 4% from Africa. When
examining the emissions by country, China had the highest carbon dioxide emissions,
approximately 9.8 billion tons (27% of the total global emissions), followed by the
USA (2.5 billion tons: 6.9%), India (1.7 billion tons: 4.7%), Russia (5.3 billion tons:
14.7%), and Japan (1.2 billion tons: 3.3%).
As the impact of greenhouse gases on climate has become more severe, the World
Meteorological Organization (WMO) and the United Nations Environment Program
(UNEP) led to the establishment of the Intergovernmental Panel on Climate Change
12 1 What Is Environmental Economics?

4%

China

16% Asia (excluding China)

27%
Middle East
Africa
21% Northern, Central, and Southern America

21% Europe

7% Other
4%

Fig. 1.9 Global greenhouse gas emissions (total 36 billion tons) by region in 2017. Source Our
World in Data (2019)

(IPCC) in 1988 to address climate change issues at the global scale. The IPCC
makes it clear that the cause of global warming is related to human activity, stating,
“Human influence on the climate system is clear, and recent anthropogenic emissions
of greenhouse gases are the highest in history” (IPCC, 2014).
The IPCC aims to provide a comprehensive assessment of anthropogenic climate
change, impacts from climate change, and adaptation and mitigation measures based
on a scientific, technical, and socioeconomic standpoint. The IPCC consists of four
parts, as shown in Fig. 1.10. The first group, Working Group I (WGI), aims to assess

IPCC Plenary
(One chair and
three vice-chairs)

WG I
Task Force
(Working WG II WG III
Inventory (TFI)
Group I)

Assessing climate Assessing impact, Understanding Developing and

system and adaptation, and climate change refining methodology
change vulnerability to calculate and report
national greenhouse
gas emissions

Fig. 1.10 Structure of the IPCC

1.2 Typical Environmental Problems 13

the physical scientific basis of the climate system and climate change, and the second
group, Working Group II (WGII), evaluates the impact of global warming, such as
its effects on ecosystems, society, and economy, to propose adaptation measures.
The third group, Working Group III (WGIII), deals with mitigation measures against
climate change. Finally, the Task Force on National Greenhouse Gas Inventories
(TFI) develops and disseminates methods for measuring greenhouse gas emissions
and absorption for countries participating in the IPCC.
According to the IPCC (2014), “warming of the climate system is unequivocal,”
and many unobserved changes that occurred between 1950 and 2000 are unprece-
dented. In addition, the atmosphere and ocean are warming, the amount of snow and
ice is decreasing, the sea level is rising, and the global average surface temperature
of land and sea increased between 0.65 and 1.06 °C from 1880 to 2012. Assuming a
scenario where high levels of greenhouse gas emissions will continue, the IPCC also
predicts that the average global temperature will rise by 2.6°–4.8° by 2100. Even in
a scenario premised on implementing strict global warming countermeasures, it is
forecasted that the average global temperature rise will rise by 0.3°–1.7°. What kind
of problems will society face if the average global temperature continues to rise, as
is foreseen by the IPCC?
The first problem is a rise in the sea level because it is expected that the increased
global temperature will warm the seawater, which will melt the glaciers of Antarctica
and Greenland and thermally expand seawater. If the global average temperature rises
by 2.6–4.8 °C, as predicted by the IPCC based on its scenario of high greenhouse
gas emissions, the sea level is expected to rise by more than 0.45–0.82 m. According
to Albert et al. (2016), as of 2014, five islands have sunk below the sea level in the
Solomon Islands due to rising sea levels caused by global warming. Additionally,
let us consider Antarctica as an example of why melting glaciers lead to sea-level
rise. The size of Antarctica is approximately 14 million square kilometers, which is
approximately 36 times the area of Japan or roughly the area of the USA and Mexico
combined.
Generally, what is most surprising is that the average thickness of the ice covering
Antarctica is estimated to be 2000 m. Thus, it is easy to imagine the threat when
calculating how much the average global sea level will rise if the glaciers of this
gigantic continent melt. Considering the specific gravity of ice (0.92), and dividing
the total volume of 14 million square kilometers times the 2 km thick of ice by the
surface area of the world’s oceans (approximately 360 million square kilometers),
the sea level of earth is estimated to rise by about 65 m on average; therefore, as
global temperature increases, rising sea levels due to polar icecaps melting can have
a significant impact on our lives.
Second, when the temperature rises, an updraft is likely to occur, forming rain
clouds, and eventually, the area underneath will experience heavy precipitation. It
is said that the recent flood disaster that occurred in western Japan in 2018, where
at least 225 people died (Bandaru et al., 2020), is related to global warming. While
climate change increases precipitation and causes damage in some areas, other areas
become more susceptible to dryness and drought due to reduced rainfall. Recent
forest fires in the USA and Australia are thought to be related to dryness and drought
14 1 What Is Environmental Economics?

caused by climate change (Sun et al., 2019). Hence, a temperature rise can lead to
increased flood and drought frequencies.
Third, if the occurrence of floods and heatwaves begins to increase as earth
becomes warmer, human and animal lives may be endangered, and infectious diseases
that were found only in tropical regions before the effects of global warming may
spread to other regions.
Fourth, when the average global temperature rises, it is feared that some of the agri-
cultural products might become unharvestable in some areas, which will have a large
adverse effect on the economy of such areas. In the same vein, the Nagano prefec-
ture—one of the major apple production areas in Japan—is coping with the discol-
oration of apples due to the increased average temperature. Although the farmers in
Nagano are trying to develop new apple species through selective breeding, climate
change portends a bleak future for them.
Finally, climate change is said to have negative impacts on the ecosystem, and
we will likely lose the benefits received from ecosystem services. These ecosystem
services will be explained in detail in Chap. 4 of this book, but in broad strokes,
they refer to the various benefits that can be obtained from ecosystems that are
established through the connections of diverse organisms. It is feared that global
warming will destroy such ecosystems by accelerating species extinct due to habitat
loss. For example, it is known that the recent decrease in the number of Pacific saury
in the waters near Japan and the decrease in the number of insects worldwide are
likely related to the effects of global warming on the ecosystem (Liu et al., 2019).
Since agriculture, forestry, and fisheries are strongly connected to the conditions of
the natural environment, these economic sectors will be directly influenced by the
damage to the ecosystems driven by climate change.
Climate change countermeasures can be classified into mitigation and adapta-
tion measures; the differences between them are presented in Table 1.4. The main
objective of mitigation measures is to reduce greenhouse gas emissions. For example,
emission control, policies to ensure the separation and recovery of greenhouse gases,
conversion to renewable energy, and carbon capture and storage (CCS) or carbon

Table 1.4 Classification of climate change countermeasures

Mitigation measures Adaptation measures
Contents Measures to suppress climate change Measures to cope with damages and
policies for adapting to the new climate
Examples Regulating automotive emissions Flood adaptation measures
Carbon capture and storage (CCS), Drought adaptation measures
carbon capture, utilization and storage
(CCUS)
Measures to reduce fossil fuel Heatstroke prevention
dependency, such as promoting
renewable energy
Improving mass transit Measures to mitigate the effect of rising
temperature on agricultural products
1.2 Typical Environmental Problems 15

capture, utilization and storage (CCUS) are implemented under this measure to alle-
viate the impact of climate change. In contrast, under adaptation measures, policies
are implemented to minimize damage on the premise that it is impossible to eliminate
the damage caused by climate change. For example, adaptation measures consist of
countermeasures such as the construction of embankments and dikes to face rising
sea levels and developing plants that can adapt to high temperatures. Recently, adap-
tation measures have become crucial since we are already being affected by climate
change.

Air, Soil, and Water Pollution and Waste Problems

In addition to global warming, which is related to the output of economic activities,
air pollution is another major concern. As shown in Table 1.5, various air pollution
problems exist, and these are caused by the pollutants emitted from production and
consumption activities. For example, when automobiles are produced, automotive
plants release sulfuric acid and other smokestack emissions that contribute to air
pollution, and gasoline automobiles used by consumers also emit pollutants, further
exacerbating the issue.

Table 1.5 Examples of air pollution issues

Description of the problem Source of pollution
Acid rain As air pollutants dissolve in Sulfur dioxide (SO2 ) and
rain clouds, the rainwater nitrogen oxides (NOx ) are
becomes acidic, and thus the present in vehicle exhaust
rain will cause damages to emissions and factories’ soot
forests, crops, and buildings
Photochemical smog A type of smog produced when NOx and hydrocarbons
the ultraviolet light from the (HCs) are contained in
Sun turns the pollutants into vehicle exhaust emissions
photochemical oxidants such as and factory soot
ozone and aldehydes. The
smog can affect human health
and cause damages to plants
Particulate matter 2.5 (PM2.5) Particulate air pollutants that Evaporation from vehicle
are 2.5 µm (one-thousandth of emissions, thermal power
1 mm) and smaller can affect plants, volcanic soot,
the respiratory system when solvents, and paints
they enter the human body
Yellow sand Originally, the problem was Desert sand blown inland
caused by desert sand being from East Asia
blown by strong winds into the
surrounding areas, causing
damages to humans and other
living beings. However,
recently, it has also become
related to deforestation and
desertification
16 1 What Is Environmental Economics?

Although not discussed in depth here, problems such as water and soil pollution
caused by discharged pollutants from industrial and agricultural production processes
are also environmental problems related to the output side of economic activities.
Since the agricultural sectors’ activity depends on water and soil, it often causes
water and soil pollution caused by spraying pesticides and chemical fertilizers.
Finally, I would like to explain the waste or garbage problems as an example of an
environmental problem related to the output side of economic activities. This problem
occurs when materials become obsolete after the product is produced and consumed,
and the redundant materials are discharged into the environment. Generally, wastes
are often treated in nearby areas, and they are usually considered a local environ-
mental problem. However, recently, the export of waste from developed countries to
developing countries has been increasing, because for the developing countries, it is
cheaper to export pollutants than to treat and dispose them in their own countries.
Consequently, this problem has evolved into a transborder environmental issue.

1.2.2 An Environmental Problem Caused by the Input Side

In this section, I explain deforestation and resource depletion as examples of

environmental problems related to the input side of economic activities.
Deforestation becomes an issue when the use of natural resources in forests
exceeds their regeneration speed. As explained in Table 1.3, when the volume of
resource use outpaces the restorative capacity of nature, the resource will be at risk
of depletion, as is the case with deforestation. Furthermore, deforestation exposes rare
animals and plants living in specific forests to the risk of extinction. However, defor-
estation in tropical rainforests has recently become especially grave. For example,
approximately 80% of deforestation occurring between 2010 and 2030 is concen-
trated in the tropical rainforests of Southeast Asia, South America, and Africa (WWF,
2015). The main cause of deforestation is the use of forestry for purposes other than
to use its natural resources. If forest resources are used for logging, then there will
be at least a chance that the forest can be recovered by loggers or timber companies,
if their timber harvesting is managed sustainably. However, forest land is often used
for other purposes than for their natural resources, and deforestation has become a
serious environmental problem in such cases. For example, the vegetation covering
forest land is cleared when the land is used for agriculture, constructing residen-
tial and commercial buildings, roads, ski resorts, golf courses, and so on, and many
species that live in the forests are eliminated or dislocated in the course of such
activities.
The environmental impacts of deforestation include soil erosion, loss of stream-
flow regulation,1 loss of biodiversity, and increased greenhouse gas emissions. First,

1 Forests are known to return less water to soils compared to grasslands or cultivated lands, as the
water will be infiltrated and retained by plants and trees in forest lands; forests can thus slow down
the surface runoff.
1.2 Typical Environmental Problems 17

when soil erosion occurs, the nutrients for the plants are lost from the soil, and the
land is devastated, eventually leading to desertification. Second, if the land loses its
stream-flow regulation from deforestation, the water from rainfall or snowfall will
directly flow downstream, and the area will likely suffer from flood damage. Third,
deforestation causes a loss of biodiversity. Since forests play the role of conserving
various species and ecosystems, deforestation means robbing the ecosystem of the
benefits that could have been enjoyed from such species. Finally, although mentioned
previously, since forests absorb carbon dioxide, cutting them down will increase the
carbon dioxide concentration in the environment. Furthermore, when plants and trees
rot after being felled, they contribute to increased greenhouse gas emissions because
the rotting process releases more carbon dioxide into the atmosphere.
As a final example of the input side of economic activities causing an environ-
mental problem, the resource depletion issue is examined, and it will be explained
further in Chap. 5. Natural resources can be classified into non-renewable and renew-
able resources, where the non-renewable ones are natural resources that take a very
long time to recover when they are used and decrease sharply as their use increases,
whereas renewable resources can recover independently with time.
Both types of natural resources are at risk of depletion. Crude oil and natural
gas are typical examples of non-renewable resources. These are indispensable to our
lives, but since the total amount of these resources will only decline as we use them,
it is only a matter of time before these resources are depleted. If resources are mined
rapidly, the speed of depletion will be quicker, so it is important to use the resource at a
pace where the exploitation is extended until alternative resources become available.
Similarly, renewable resources can also be depleted if resources are used at a faster
pace than the regeneration speed of natural resources and, thus, it is imperative to
utilize the resources at a sustainable pace. Among renewable resources, a recent
decrease in marine resources is becoming critical. For example, it is being claimed
that Pacific bluefin tuna and Japanese eel are threatened or endangered (Madigan
et al., 2017; Yu et al., 2020).
Overfishing, caused by the input side, is often suggested as the cause of dimin-
ishing stock in these resources, but it is also affected by decreased habitats due to
marine pollution and global warming. As the temperature of oceans increases, the
amount of dissolved oxygen in the water decreases. Therefore, as global warming
exacerbates, the amount of oxygen in seawater will decrease proportionally. This is
likely to have devastating effects on the habitats of marine resources.

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Aruga, K. (2020). Is environmental awareness a good predictor of an individual’s altruism level?
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Bandaru, S., Sano, S., Shimizu, Y., Seki, Y., Okano, Y., Sasaki, T., Wada, H., Otsuki, & T., Ito,
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Chapter 2
Economic Instrument
and Environmental Problems

In economics, many environmental problems are related to market failure. The

concept of market failure was first advocated by Bator (1958) when referring to
cases where goods and services are not allocated efficiently. In economics, the term
efficiency is often used to describe a situation where there is no opportunity for one
agent to benefit at the cost of another. This concept comes from the term Pareto
efficiency named after Vilfredo Pareto (1848–1923). Market failure occurs when the
economic activities of one producer or consumer leave other producers or consumers
in a worse-off condition or when there is an opportunity for one or another to benefit
by changing their economic behavior.
In this chapter, we focus on four typical market failure issues that are often
discussed in economics textbooks and explain how they are related to environ-
mental problems. The four market failures that will be introduced in this chapter
are externalities, market power, the existence of public goods, and information
asymmetry.

2.1 Economics and Environmental Problems

In this section, we examine how the four typical market failures in economics become
factors leading to environmental problems.

2.1.1 Externality

An externality is a situation where a decision maker’s behavior or economic activity

influences another economic agent’s decision-making. As shown in Fig. 2.1, an
externality occurs when the economic activity of one producer affects the economic
activity of a consumer or another producer. However, the concept of externality in

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 19

K. Aruga, Environmental and Natural Resource Economics,
https://doi.org/10.1007/978-3-030-95077-4_2
20 2 Economic Instrument and Environmental Problems

Consumer

Producer A’s
activity Impact

Producer B

Fig. 2.1 A simple graphical description of externality

economics becomes an issue if the action of an economic agent affecting another

does not occur through the market mechanism. To explain this more in detail, we
introduce two different types of externalities. One is the pecuniary externality, and
the other is the technological externality.
Figure 2.2 illustrates the difference between pecuniary and technological exter-
nalities. As an example of a pecuniary externality, consider the impact of a railway
company building a new station on a realty agent’s land nearby. Assuming there
exists a constant demand for the land in the area near this new station, if the price
of the land near the new station increases after the station’s construction, the realty
agent will benefit from this increase in the price of the land. The economic activity
of a railway company will thus have a positive impact on the realty agent. This
type of external impact of one agent on another is not considered an externality in
economics since the external effect of the railway company is realized and reflected
in the market price, such as an increase in the price of the land. To provide another
example of a pecuniary externality, let us look at a case where a Chinese aquaculture
company buys up a large quantity of elvers (baby eels). This causes the price of elvers

Pecuniary externality

Producer A’s An impact on

Market
activity other agents

Technological externality

Producer A’s An impact on

activity other agents

Fig. 2.2 Pecuniary and technological externalities

2.1 Economics and Environmental Problems 21

to skyrocket, and it negatively impacts its competitors in the aquaculture industry. In

this example, the impact of the action of the Chinese aquaculture company on other
aquaculture companies has already been incorporated by the market as soaring elver
prices. As explained in these examples (see also the top part of Fig. 2.2), a pecuniary
externality occurs when the effect of an agent’s economic activity is reflected in the
market price and the impact on the other agents is already realized via the market.
As shown in the lower part of Fig. 2.2, a technological externality occurs when the
behavior of one economic agent influences another agent without going through the
market mechanism. We will explain this using a classical example often described in
economics textbooks. Consider a situation where there is an apiarist adjacent to an
orchardist, and pollination activities of the bees in the orchard have a positive effect
on the orchardist. In this example, the orchardist benefits from the externality caused
by the apiarist. Despite the externality, it is unlikely that the orchardist will repay
the apiarist for the benefits derived from the externality since the external effect is
not brought about by the apiarist but by the honeybees raised in the bee yard. This
type of externality, where the external effect of one agent to another is not reflected
in the market, is called a technological externality. In economics, this technological
externality is abbreviated as an externality. Similar to economics textbooks, from
now on, when the word externality is used in this textbook, it will refer to this
technological externality.
Externalities are classified as positive or negative. A positive externality occurs
when the economic activity of one agent has a positive effect on other agents. A posi-
tive externality is also called an external economy. The previous externality example
of the apiarist and orchardist is an example of a positive externality. Conversely,
a negative externality occurs when the economic activity of one agent negatively
impacts the other agents’ activity. Negative externalities are also known as external
diseconomies. For example, environmental problems such as noise, pollution, and
ecosystem destruction caused by economic agents are negative externalities.
Most environmental problems cause negative externalities, but the nature of the
problem differs depending on the number of economic agents that cause the external-
ities and those who are impacted by them. Table 2.1 summarizes the degree of ease
in negotiation based on the number of perpetrators and victims of the externalities
and provides examples of relevant environmental problems. As shown in Table 2.1,
if there is a large unspecified number of perpetrators and a few identifiable victims
impacted by the externality, it will be difficult to start negotiations between the stake-
holders to identify a perpetrator to reimburse victims for the losses caused by the
externality. For example, consider the case of a lake that attracts many tourists from
outside the area, but the residents suffer the consequences of pollution caused mostly
by tourists littering in and around the lake. In this case, it will be difficult for the
residents living near the lake to identify the perpetrators of the pollution because the
perpetrators are strangers to the residents; in such cases, identifying the perpetrators
of the externality could be a very arduous task. Similarly, negotiations to solve the
externality also become difficult when there are many unspecified victims in addition
to a large number of perpetrators. Global warming is a typical example because the
issue is often between the people of the present generation emitting greenhouse gases
22 2 Economic Instrument and Environmental Problems

Table 2.1 Externality problem in different conditions

Economic Number of agents Number of agents Number of agents Number of agents
agent
Culprit Many unspecified Many unspecified A few identifiable A few identifiable
culprits culprits culprits culprits
Victim A few identifiable Many unspecified A few identifiable Many unspecified
victims victims victims victims
Negotiation Relatively high High Relatively low Low
difficulty
An example Illegal dumping, Damages related to Pollutants from Pollutants from the
causing pollution climate change an adjacent upper reaches of a
damages to the caused by various factory inflicting watershed causing
surrounding economic agents damage to damages to the
residents adjacent farmers residents in the
middle and lower
reaches

versus a future generation that may have to face the severe impact of climate change.
Here, the perpetrators and victims have no way to negotiate due to the generation
gap.
If the externality occurs between adjacent agents, it will be possible to identify
the perpetrator and victims and initiate negotiations between the stakeholders to
find a solution for the externality. It will also be easier for the stakeholders to have
discussions about the externality issue when the number of perpetrators is small
enough to be identifiable and there is a large number of victims claiming damages
caused by the externality.
Thus, to find solutions for externalities, it is important to identify the stakeholders
involved in the issue. However, besides identifying the stakeholders, we need to
know the amount required to compensate for the damages caused by the externality.
Therefore, the external cost, which is an important concept for understanding the
economic loss caused by externalities, will be explained next.
An external cost is a cost that must be recovered to compensate for damages related
to a negative externality, such as pollution. External costs can become very large if the
externality causes a serious environmental problem; moreover, such problems often
need to be dealt with beyond the local level. In such cases, the external costs must
be treated by the whole society. Hence, an external cost is considered part of a social
cost. Social cost is the sum of private and external costs. Private cost is a cost that
arises when a producer produces goods without considering the externalities. Thus,
when denoting social, private, and external costs as SC, PC, and EC, respectively,
the relationship between the social, private, and external costs can be expressed as
Eq. (2.1):

SC = PC + EC. (2.1)
2.1 Economics and Environmental Problems 23

As we learn in microeconomics, a cost function is often expressed as a function

of the output produced. Denoting Q as the output quantity, Eq. (2.1) can be rewritten
as follows:

SC(Q) = PC(Q) + EC(Q). (2.2)

By partially differentiating both sides of Eq. (2.2) by Q, we obtain an equation that

expresses the relationship between the amount of change in the cost when producing
one additional product:

∂SC(Q) ∂PC(Q) ∂EC(Q)

= + . (2.3)
∂Q ∂Q ∂Q

∂SC/∂ Q is the marginal social cost (MSC), which is the change in the total social
cost by a unit of change in the product output. Similarly, ∂PC/∂ Q and ∂EC/∂ Q
are the marginal private cost (MPC) and marginal external cost (MEC), respec-
tively, which are the changes in the total private and external costs when one addi-
tional output is produced. The relationships between MSC, MPC, and MEC can be
summarized by Eq. (2.4):

MSC = MPC + MEC. (2.4)

By denoting the three costs as marginal costs, the relationship between the three
costs can be expressed as shown in Fig. 2.3. The figure is similar to the graph used
in demand and supply curves where the vertical and horizontal axes represent the
price and quantity of goods, respectively. In Fig. 2.3, the price axis denotes the three
marginal costs, D represents the demand curve for the product, and MPC represents
the supply curve for the product when there is no externality. Thus, MEC can be

Fig. 2.3 Relationship

among MSC, MPC, and
MEC
24 2 Economic Instrument and Environmental Problems

Fig. 2.4 Externality and

welfare loss

presented as the vertical difference between the MSC and the supply curve (MPC),
and the MSC can be obtained by adding MEC to MPC.
Using this relationship that is similar to a demand–supply relationship, we can
determine why externality leads to market failure. If there is an externality, natural
resources will be in excess supply or excess demand when the effects of the exter-
nality are not considered during economic activities, leading to an overexploitation
of natural resources. However, since externalities are often not valued in the market,
economic agents tend to act by only considering their private costs. Goods will conse-
quently be oversupplied and overconsumed, thus exceeding the socially optimal level
of natural resource use. To explain why having an externality is not economically
efficient, as shown in Fig. 2.4, the gray triangle represents the economic welfare loss
when there is an externality. This area represented by the gray triangle is also known
as the deadweight loss and corresponds to the social damage to society caused by
the externality.
Using Fig. 2.5, we examine why externality results in deadweight loss. When
externality is not present in the economy, the total surplus (sum of producer and
consumer surpluses) is represented by the gray triangle in Fig. 2.5a. This is because
the market equilibrium in a case without an externality is the intersection of the D
and the MPC curves. However, if there is an externality, the area represented by
the gray triangle in Fig. 2.5b arises as an external cost that negatively impacts the
economy. Thus, when there is an externality, the total surplus of the economy will
be reduced to the gray area depicted in Fig. 2.5c, and the total social surplus will be
the difference between the triangle areas in Fig. 2.5b, c. Subtracting the gray area in
Fig. 2.5b from Fig. 2.5c, the gray triangle in Fig. 2.5d is further subtracted from the
gray triangle in Fig. 2.5c. Thus, the gray triangle in Fig. 2.5d depicts the area that
adversely impacts the economy and becomes social damage to the economy. Thus,
when there is an externality, the market fails to achieve social efficiency, and this is
why an externality is known as one of the drivers of market failure.
2.1 Economics and Environmental Problems 25

P P
MSC MSC

MPC MPC

D D
Q Q

(a) Social welfare without externality (b) Total external costs

P P
MS MSC

MPC MPC

D D

Q Q

(c) Social welfare with external costs (d) Welfare loss by externality

Fig. 2.5 Mechanism of social damages driven by the externality

What can we do to resolve externalities? As previously explained, externalities

become an issue because, although they have a firm negative effect on the economy,
externalities are not appropriately addressed by the market. Therefore, to cope with
externalities, their impacts need to be evaluated in the market. The process of eval-
uating the costs driven by externalities and applying measures to achieve a socially
efficient allocation of the resource is called the internalization of externalities. The
term internalization is used because it involves a process of evaluating externalities
in monetary terms and treating effects considered to be outside the market as inside
the market. To internalize externalities, it is necessary to evaluate the effects of exter-
nalities properly that have not been evaluated in the market, as illustrated in Fig. 2.6,
and carry out production based on the impacts of the externalities.
Last, we would like to consider what will be a feasible production level when there
is an externality in the economy. The gray area in Fig. 2.7 illustrates the social damage
or deadweight loss caused by the externality. Thus, internalization in this economy
can be achieved if social damage can be eliminated. To do that, it is necessary to
26 2 Economic Instrument and Environmental Problems

Internalization

Pollutants Negative Market evaluation

emitted from externality on the of damages caused
a factory. neighboring by the pollution.

Fig. 2.6 Internalization of external costs

Fig. 2.7 Optimal production

level in case of a negative
externality

encourage the producer to recognize the externality and to act based on the social
cost curve (not based on the private cost curve). When the producer considers the
external cost, the optimal production level will change from Q* to QS ; the producer
will produce at the Qs level, and the area depicted by the gray triangle in Fig. 2.7
disappears. Therefore, to internalize externalities, producers need to evaluate exter-
nalities properly and conduct their production activities based on the social cost
curve.

2.1.2 Market Power

Market power is a condition where either a producer or a consumer dominates

the market and controls the price of a certain product or service. A market struc-
ture controlled by one producer is called a monopoly. A monopoly market is often
controlled by a dominant supplier; however, if the market is dominated by a consumer,
such a market is called a monopsony market. Furthermore, in a condition where the
2.1 Economics and Environmental Problems 27

market for a certain product or service is dominated by two economic agents, the
market is called a duopoly, and when it is dominated by two or more economic
agents, it is called an oligopoly. When a monopolistic producer or consumer is
present in a market, the market price is influenced by these economic agents. Thus,
since producers and consumers have the power to control the market, these agents are
called price makers. In economics, markets can be classified based on the number of
producers that dominate the market (see Fig. 2.8). As the number of producers in the
market increases, the market power of a producer weakens and competition within
the market intensifies, and when no producer has the power to control the market,
the market approaches perfect competition.
In contrast to the price taker in a monopolistic market, producers and consumers
in a perfect competition market are called price takers since agents do not have
the power to control the market price and have to accept the prices determined by
the market. Table 2.2 summarizes the differences between monopoly and perfect
competition markets. As shown in Table 2.2, in a monopoly market, producers not
only have the power to control the price but also differentiate the goods they produce
and have access to information that other producers do not have. Moreover, in a

Two or more
Single Two
than two A large number of producers
producer producers
producers

Monopoly Monopolistic Perfect

Duopoly Oligopoly
competition Competition

Few Many
producers producers

Fig. 2.8 Classification of markets based on the number of producers in a market

Table 2.2 Monopoly and

Monopoly Perfect competition
competitive markets
market
Producer’s market High Low
power
Type of goods sold Heterogeneous Homogeneous
Information Imperfect Perfect information
information
Entry barriers Strong No barriers
28 2 Economic Instrument and Environmental Problems

monopoly market, there are often barriers to entry that prevent new producers from
entering the market.
Here, we would like to give examples of factors that allow a single producer
to become dominant in a market. In the first case, the producer becomes the sole
owner of the resources essential for producing a product. If a producer discovers an
undiscovered new resource that is unique and only available on the property of this
producer, there will be no chance for other producers to compete with this producer.
Thus, under conditions where a single producer dominates a certain resource or
technology that is essential for producing a product, the producer will likely dominate
the market for such products. Second, a monopoly can occur in cases where the
government imposes severe entry restrictions. For example, if a governmental permit
is required to enter a market and the government issues the permit to only one
company, this market will be controlled by this single company. For example, Japan’s
tobacco industry has long been dominated by Japan Tobacco Inc., which has its roots
in the Monopoly Bureau established by the Japanese government in 1898 to sell leaf
tobacco. Third, a market becomes monopolized when the production process for a
product is unique. This happens in commodity markets that require very specialized
technologies and expertise to produce goods or markets that have very high start-up
costs (fixed costs). Examples include large industries such as public utilities and
railway services. When a producer runs its business on a large scale such that the
cost per unit of output (average cost) decreases as production output increases, this
condition is called economies of scale. When this economy of scale is sustained
in a market, smaller producers that are unable to compete with the monopolistic
company will withdraw from the market, and the market becomes dominated by the
large producer taking advantage of economies of scale. This type of monopoly where
the market becomes monopolized due to the effects of the economy of scale is known
as a natural monopoly.
The reason why monopoly is considered a problem in economics is that since
the dominant producer can control the market price, the price can become very high,
making it impossible for consumers to obtain the good. In addition, since competition
is low in a monopoly market, the dominant producer can also lower the product
quality to reduce its production costs. In addition, even if the product is produced
in a way that is harmful to the natural environment, consumers cannot boycott the
product if the product is something essential for daily living and other companies
are not selling an alternative. Thus, it would be difficult for consumers to appeal
to the company to change its production process to reduce environmental damage.
Furthermore, in a monopoly market, price and volume become inefficient compared
to a perfect competition market.
Let the price and volume of a product in a market be P and Q, respectively. Since
the dominant supplier in a monopoly market can influence the price by changing its
production volume, the price in a monopoly market can be expressed as P(Q). When
the total cost of producing this product is TC(Q), the profit of the company π can be
expressed as Eq. (2.5):

π = P(Q)Q − TC(Q). (2.5)

2.1 Economics and Environmental Problems 29

In this equation, P(Q)Q denotes the product of price and volume, the total revenue
of the dominant producer. The total revenue is often defined in economics as TR. The
derivative of TR by Q, which is the unit change in TR when the production volume
increases by one unit, is called marginal revenue. Denoting marginal revenue as MR,
the relationship between TR and MR is as follows:

TR(Q)
MR(Q) = . (2.6)
Q

Similarly, the unit change in the TC from a unit change in product volume is called
the marginal cost (MC), which can be defined as

TC(Q)
MC(Q) = . (2.7)
Q
π
In general, a producer’s profit is maximized when Q
= 0, so the condition of a
profit-maximizing monopoly producer is as follows:

π TR(Q) TC(Q)
= − = MR − MC = 0. (2.8)
Q Q Q

Thus, the condition MR = MC holds in the monopoly market.

By contrast, in a perfect competition market price does not depend on the produc-
tion volume, and the condition of the producer’s profit maximization can be expressed
as follows:
π
= P − MC = 0. (2.9)
Q

Hence, the price is equal to the marginal cost (P = MC) in a competitive market.
As an example of monopoly and competitive markets, let us consider a case
in which the demand curve is Q D = −P + 350 and the marginal cost curve is
MC = Q + 50. Here, the marginal cost curve can be viewed as the supply curve for
this market. In the monopoly market, the product is produced at a level where the
condition MR = MC is preserved. Hence, the production volume when the market
is at equilibrium can be obtained by solving Eq. (2.10):

π ((−Q + 350)Q)
= − Q − 50 = −3Q + 300 = 0. (2.10)
Q Q

Hence, the optimal production level in a monopoly market is achieved when the
production level is 100.
The optimal level of production in a competitive market is achieved when P = MC
is sustained in the market. Thus, by solving Eq. (2.11),

P = −Q + 350 = Q + 50, (2.11)

30 2 Economic Instrument and Environmental Problems

Fig. 2.9 Optimal prices in

monopoly and competitive
markets

the optimal production volume in the competitive market becomes 150.

Figure 2.9 summarizes the equilibrium production volumes and prices in the
monopoly and perfect competition markets described in the numerical example. In
Fig. 2.9, point A is the production volume and price in the monopoly market. The
production volume at point A corresponds to that of point B, which is the intersection
of the marginal revenue (MR) and marginal cost (MC) curves. As the optimal volume
in the monopoly market is 100, the price at point A can be obtained by solving 100
= −P + 350. Thus, the price at point A is PM = 250. Market equilibrium is achieved
at point C in a perfect competition market. The production volume at point C is 150,
and the price at this point can be presented as 150 = −P + 350. Hence, the optimal
price level (PC ) in the perfect competition market is 200. From this example, it is
evident that in a monopoly market, the production volume decreases, while the price
is set at a higher level compared to the perfect competition market.
Next, we would like to explain why the production volume in the monopoly market
is inefficient compared to perfect competition. Figure 2.10a, b shows the total social
surplus in perfect competition and monopoly markets, respectively. It is clear that
when a product is produced based on the optimal volume in a monopoly market (Q M ),
the social surplus will decrease by the gray area presented in Fig. 2.10c. Therefore, a
deadweight loss will be created under monopoly market conditions, where the total
social surplus realized is smaller than in a perfect competition market.
For the last part of Sect. 2.1.2, we would like to discuss whether it is undesirable
for society if goods are produced at a lower level, as in the case of a monopoly. From
the perspective of economics, it is certainly desirable to produce more goods since
increased production will increase the producer’s profit; however, if production leads
to resource depletion or causes environmental damage, a reduction in production can
benefit society—whether it is related to the decision of the monopoly producer or
not. In such cases, decreasing production can lead to a desirable outcome. In Russia,
for example, the government implemented a policy to monopolize the sale of caviar
by limiting sales to the government only. This policy was meant to safeguard the
2.1 Economics and Environmental Problems 31

Fig. 2.10 Welfare loss in a monopoly

parent fish, the sturgeon, from extinction. Therefore, although a monopoly distorts
the market, it is sometimes desirable to monopolize the market to reduce the use of
resources and help restore the stock of endangered natural resources. This point will
be explained further in Sect. 5.2.2 of Chap. 5, which deals with economic models of
fisheries resources.

2.1.3 Public Goods

Public goods in the pure sense are goods and services that satisfy the following two
properties: non-excludable and non-rivalrous conditions. Non-excludability means
that it is not possible to prevent people who are not paying for the goods and services
from using them. Non-rivalry means that the opportunity to use goods or services
does not decline when other people consume them. In other words, goods and services
are non-rivalrous if they can be used simultaneously, and the consumption of one
32 2 Economic Instrument and Environmental Problems

consumer does not affect the availability for other consumers. Figure 2.11 depicts
the classification of goods and services based on these two properties.
For example, a public TV program satisfies both non-excludable and non-rivalrous
conditions. Everyone can watch a particular program without paying, and someone
else watching TV does not reduce other people’s opportunity to watch the program.
Furthermore, national defense is often considered a public good because it is non-
excludable in the sense that everyone can enjoy public safety preserved by the national
defense. It is also non-rivalrous because other people will not be affected when
someone receives the service from the national defense. By contrast, groceries sold at
supermarkets have both excludable and rivalrous characteristics. They are excludable
because people who do not pay cannot obtain the products. Furthermore, they are
rivalrous because one may lose the chance to buy a product if the product is sold out
after many people chose to buy it. Goods that have both excludable and rivalrous
properties are called private goods.
In addition, goods that are non-excludable but rivalrous are called common (pool)
resources. For example, fish caught in a common fishing zone belong to this category.
Since it is not possible to exclude people from entering common fishing grounds, the
fish in this area are non-excludable but rivalrous, since most marine resources have
limits to their stock and if a large amount of fish is harvested by certain fishermen, the
chances of other fishermen catching fish will become lower. Finally, club goods are
those that are excludable but non-rivalrous. For example, to use a private golf club
users need to pay a membership fee, so it excludes non-members from playing the
course. However, since the number of people playing the course will be limited in a
private golf club, the opportunity to play the course will not be restricted when other
members play the course. Thus, this category of goods is considered non-rivalrous.
Common resources and club goods are also called quasi-public goods because they
satisfy one of the properties of non-excludability and non-rivalry.
Next, we would like to examine why public goods can lead to market failure
and create an unfavorable situation for the environment. This is related to the non-
excludable characteristics of public goods. The first problem that arises from this

Fig. 2.11 Public goods and Excludability

private goods High Low

High
Common pool
Private goods resources
Food, clothing, (Quasi-public
cars goods)
fisheries, mines
Rivalry
Club goods
(Quasi-public (Pure) public goods
goods)
Lighthouses, public
cable TV, private TV, national defense
Low golf clubs
2.1 Economics and Environmental Problems 33

property of non-excludability is the tragedy of the commons. The second problem is

the free-rider issue.
The commons are natural resources accessible in a common area and are often
shared and managed by a community. As illustrated in Fig. 2.11, common resources
have a non-excludable property, meaning that they are accessible to everyone without
the need to pay for the right to use them. However, it does have a rivalrous condition—
the size of the available resources will decline as more resources are extracted from
the area. Thus, in general, there are no restrictions to use common resources, but the
resources in an area can be exhausted if many people extract them from the commons
without considering the decline in the available natural resources in the area. As a
result, resources in the common area can diminish. Such a phenomenon in which
the rivalrous characteristic of commons leads to the overuse and depletion of natural
resources in the commons is called the tragedy of the commons.
The concept of the tragedy of the commons was first proposed by Hardin (1968).
Table 2.3 shows some examples of the tragedy of the commons and the nature of
the common good. A typical example is a pasture shared by cattle farmers in a
community. As it is difficult to prevent the members of this community from grazing
their cattle in this pasture, if the competition between the members becomes more
severe, members could continue to increase the number of cattle until all the grass in
the pasture has been grazed. The tragedy of the commons is related to the negative
externality problem mentioned earlier since the cause of the problem is related to
neglecting the environmental damage caused by overusing a natural resource in

Table 2.3 Examples of the tragedy of the commons

Examples Content
Pasture depletion When multiple farmers graze cattle on a shared pasture and the farmers
compete to release their cattle into the pasture, the pasture can
eventually become overgrazed, and this will cause economic damages
to these farmers
Air pollution The atmosphere is considered a commons. Since there are no
restrictions on the use of the atmosphere, the factories will emit
pollutants until it leads to serious air pollution in the area
Forest destruction Commons in a mountain area can be depleted if certain people
overextract forest resources in the mountain
Depletion of fish stock Anyone can fish in open fishing grounds but if many fishermen fish in
the area the stock of fish can be exhausted, which will in turn negatively
impact all fishermen who rely on the resource
Global environment If the global environment is considered as commons, a climate change
and destruction of rainforests can be thought of as an example of the
tragedy of the commons since the cause is related to the non-excludable
property of not being able to restrict the use of atmosphere and
rainforests of certain people in our planet
a Commons that are mostly accessed by certain local residents such as villagers are called local
commons, while commons that are accessible by people from all over the world such as the high
seas are called global commons
34 2 Economic Instrument and Environmental Problems

Fig. 2.12 Market failure due

to the tragedy of the
commons

the common area; this overuse of natural resources can be considered a negative
externality.
Therefore, the tragedy of the commons can also be explained as a type of exter-
nality issue. Figure 2.12 shows how the tragedy of the commons leads to market
failure. In Fig. 2.12, the supply curve without the effects of resource depletion can
be viewed as the marginal private cost (MPC), while the marginal social cost (MSC)
curve denotes the supply curve when the tragedy of the commons affects the supply
curve. As the available amount of resources declines due to the effect of the tragedy
of the commons, the MPC will shift toward the MSC. This shift is related to the
external cost of resource depletion that arises when the tragedy of the commons
is present. An example of such external costs could be that the water of the lake
becomes dirtier after the number of fishermen in the lake increases or that forest
resources are depleted after an increase in the number of loggers harvesting timbers.
In both instances, it would become more difficult for producers to extract resources
from the commons. Thus, the optimal volume of production when considering future
resource depletion should be Q ∗ , but in the case of the tragedy of the commons, the
producer neglects the external cost and maintains production at Q c . As a result, there
will be overproduction, causing damage to the natural resources. The gray area in
Fig. 2.12 presents such social damage to the economy.
There are three ways to avoid the tragedy of the commons. The first is to set prop-
erty rights for shared resources. Allocating a property right for common resources
will make them become exclusive and restrict the use of the resources. Thus, this
will protect common resources from depletion. Using the example of a common
forest, if private ownership (owned by a company or individual) or public ownership
(if owned by a local or national government) is given to a common forest, people
will need to obtain a permit from the owner to use the forest; hence, assuming the
2.1 Economics and Environmental Problems 35

owner is willing to protect the forest, it is less likely that the forest will become
depleted through overuse. The second way to avoid the tragedy of the commons is
to put regulations on accessing shared resources. For example, in the case of marine
resources, if there is a law that prohibits fishermen from fishing during a certain
period or restricts the use of a certain type of fishing gear, regulations can protect
marine resources from overextraction.
The first and second methods are considered top-down regulations, as the rules
to restrict the use of natural resources will be enforced by local and national govern-
ments. By contrast, the third method to preserve common resources from the tragedy
of the commons is to manage resources through a voluntary mechanism rather than
implementing enforceable restrictions. One of the famous examples of this type of
treatment for preventing resource depletion from overuse is the method proposed by
Elinor Ostrom (1990), who was the first woman to win the Nobel Prize in Economics
in 2009. Based on field research conducted in various regions across the world,
Ostrom (1990) has suggested that areas where common resources have been managed
without leading to the tragedy of the commons tend to share eight common princi-
ples. These principles are summarized in Table 2.4. According to Ostrom (1990), as
long as the common resources are managed under these principles, it is less likely
that the tragedy of the commons will occur even if the resources are self-managed
by communities adjacent to them.
Next, we would like to discuss the free-rider problem that arises due to the non-
exclusive nature of public goods. Since anyone can enjoy public goods without paying
a usage fee, there is no incentive for one person to spend money toward the burden
received from the goods and services. Many public services such as defense, police,
and firefighting are tax-based, but even people who do not pay taxes can benefit from

Table 2.4 Eight principles for managing a commons

1 Clearly defined boundaries: The boundaries regarding the use of shared resources
(including what kind of individuals can use them) are clear
2 Local conditions: The rules for permitting the use of shared resources and allocating
resources are based on local conditions and provision rules
3 Collective choice arrangements: Most individuals affected by the operational rules
should be able to participate in the making of the operational rule
4 Monitoring: It is possible to monitor whether the users of the shared resource adhere to
the operational rules of the self-government system
5 Graduated sanctions: Sanctions for the users of the commons who violate the rules of
self-government management must be gradually implemented, depending on the content
6 Conflict resolution mechanism: If there is a conflict between the users, there should be a
low-cost local forum where the members can resolve the conflict
7 Minimal recognition of rights to organize: Permissions from an external government
agency are not required to apply the rules of self-government
8 Nested enterprises (for commons that are part of larger systems): Self-government is
organized and managed in multiple layers of nested enterprises
Source: Ostrom (1990, p. 90)
36 2 Economic Instrument and Environmental Problems

such services. Under these circumstances, some people try to receive the benefits of
public goods for free, without paying their share of the burden. A free ride is such an
act of people who use a service without paying for the service despite receiving the
benefits of certain goods and services. The problem of free riders rises when many
people start to realize that they can receive the benefit of public goods for free after
observing the behavior of free riders. Many public goods and services are based on
funds or taxes collected from a mass people, so if many people begin to free ride these
goods and services, there will be a smaller amount of money available to provide the
goods and services. Eventually, it will become impossible to provide them, and no
one will be able to acquire the benefits from the goods and services.
Table 2.5 shows the gains and losses of residents when funds are collected to
conserve the environment of a city. In the example, it is assumed that the residents’
decisions to make contributions are made at the same time and that they have no
information about other residents’ choices. The numbers in Table 2.5 represent the
satisfaction level of the residents as a result of the environmental conservation funded
by the residents’ contributions. Under the conditions presented in Table 2.5, consider
a case where resident 1 does not free ride and contributes to the environmental
conservation fund. In this case, if resident 2 also decides to contribute, the gain will
become 3. By contrast, if resident 2 chooses to free ride, this resident will gain 4,
which is higher than the level of satisfaction gained from contributing to the fund.
Therefore, resident 2 will free ride if one expects resident 1 to contribute. Similarly,
looking at the best choice when resident 1 chooses to free ride, resident 2 will be
better off if resident 1 also decides to free ride since the loss is −1 if resident 2 decides
to contribute, while there will be zero loss if resident 2 also free rides. Therefore,
whatever choice resident 1 makes, the optimal decision for resident 2 is to free ride.
This example shows that many environmental conservation programs are at risk of
not being able to gather sufficient funds because it is difficult to resolve this type of
free-rider issue when funds are managed through contributions.
What are the possible solutions for the free-rider problem? First, there will be no
free riders if the government can provide all the services free of charge. The second
method is to establish a rule that penalizes free riders. If a large fine is charged to free
riders, this will disincentivize free riding. The third solution is to entrust the service to
the private sector so that a cost will be imposed on whoever uses the service. In fact,
in a town in Tennessee, USA, even the town’s firefighting service has been privatized.

Table 2.5 Public goods and

Resident 2
free riders
Make a To free ride
contribution
Resident 1 Make a (3, 3) (−1, 4)
contribution
To free ride (4, −1) (0, 0)
Note The numbers in parentheses represent the utility gains or
losses of residents 1 and 2, respectively
2.1 Economics and Environmental Problems 37

When there is a fire at a resident who had not paid the firefighting service fee, the
city refuses to save the house from the fire. Considering this example, privatizing all
public goods may not be the best solution for the free-rider problem.
To provide public goods at an appropriate level, people need to recognize the
benefits that society can enjoy when everyone contributes to society. It is also obvious
in Table 2.5 that the total welfare of the residents is maximized when all residents
decide to contribute to environmental conservation. Thus, stakeholders must build a
mechanism for supplying public goods and services where everyone benefiting from
them is willing to cooperate and provide funds to keep them sustainable.

2.1.4 Information Asymmetry

Information asymmetry occurs when the amount of information held differs between
the agents on the supply and demand sides of the market. Information asymmetry
leads to market failure when the information accessible to the supply and demand
sides is asymmetric, and it becomes difficult to establish trust in the quality of the
goods. If the agents are not confident about the quality of goods and services traded,
the volume of trade will be larger or lower than the efficient volume or the trading
itself could come to a halt, leading to market failure.
To explain this, we look at the marginal private benefit (MPB) and marginal social
benefit (MSB) curves depicted in Fig. 2.13. In economics, the marginal benefit curve
generally represents the consumer demand curve, so the MPB and MSB curves may
be regarded as similar to the demand curve. Now suppose MPB and MSB demon-
strate the benefits consumers obtain from buying a car from a car dealer. In Fig. 2.13,
it is assumed that MPB is the demand curve when consumers do not have all the infor-
mation about the car (asymmetric information), and MSB is the demand curve when

Fig. 2.13 Asymmetric

information and market
failure
38 2 Economic Instrument and Environmental Problems

consumers have all the information about the car (perfect information). Denoting
marginal social curve (MSC) as the supply curve of the car market, the transaction
volume of the car is QIA when the information about the car quality is asymmetric.
Meanwhile, the volume of trade becomes Q ∗ when there is no information asymmetry
between the consumer and the car dealer.
If this information were the volume of greenhouse gases emitted by a car with
low fuel efficiency, it would mean that environmentally conscious consumers would
be deceived by the car dealer to buy more than they truly demanded because all
information about the car’s efficiency was not disclosed. Thus, the shift in demand
from QIA to Q ∗ is the difference in demand when all the information about the car
is provided to consumers. Hence, information asymmetry can result in a socially
undesirable level of trade, causing market failure.
Information asymmetry can be classified into two types: One is the informa-
tion asymmetry that occurs before the transaction of goods and services (before the
contract) between the seller and buyer, and the other occurs after the transaction (after
the contract). The differences between these information asymmetries are summa-
rized in Table 2.6. Information asymmetry that occurs before a contract is treated as a
problem of hidden information. A phenomenon called adverse selection is a typical
example of hidden information. An adverse selection occurs when the seller of a
product exploits asymmetric information to sell goods that are not worth their price,
and when the buyer realizes that they have been deceived by the seller, they stop
buying the products. Hence, when there is such hidden information in the market,
only poor products at low prices remain in the market. To give an example related to
an environmental issue, consider a case where the number of dealers falsifying the
fuel efficiency of their cars increases in the market because those that have the tech-
nology to reduce the volume of gasoline will add additional costs. Thus, it becomes
more difficult for dealers to compete with dealers who falsify fuel efficiency infor-
mation since the dealers providing true information to the consumers will have to
procure fuel-efficient cars that will be more costly. In such a case, only car dealers
hiding the true information about the fuel efficiency of their products will survive
market competition.
Measures to deal with this type of asymmetric information that exists before
concluding a transaction are called signaling and screening. Signaling is one way
to deal with an adverse selection issue where the agent that is dominant with the
information provides a signal that assures that the goods and services sold do not
contain false information. For example, ecolabeling is one way to signal consumers
that certified products are produced in an eco-friendly way. Another measure to
address the problem of adverse selection is a screening measure. Screening is a way

Table 2.6 Types of

The period when the Typical example
asymmetric information
issue arises
Hidden information Before the contract Adverse selection
Hidden action After the contract Moral hazard
2.1 Economics and Environmental Problems 39

in which the agent that lacks information on the goods or services obtains information
from an informationally dominant agent. For example, if a consumer purchases a car,
the buyer can ask the car dealer to present a certificate that assures that the information
on the car’s fuel efficiency is not falsely reported. In this way, the consumer can learn
if the car meets the vehicle emission standard.
Another typical example of information asymmetry is moral hazard, which occurs
when an agent resorts to immoral behavior after a contract has been concluded. This
problem is related to hidden action that is not apparent at the time of the contract
but becomes evident after the contract (see Table 2.6). This type of problem arises
because there is a factor that motivates an economic agent to disregard the risks
involved in immoral behavior. For example, if a construction company has insurance
to cover the compensation cost to residents if soil contamination occurs during its
construction activity, the construction company may pay less attention to reducing
the risk of soil contamination since the cost of the damage is covered by the insurance.
In such a case, an agent might behave immorally by causing adverse impacts to other
economic agents. To avoid such moral hazards, it is necessary to monitor agents with
hidden agendas and to set rules before the contract is concluded so that the agents
will not neglect the cost of taking risky actions.

2.2 Economic Policy and Environmental Problems

In this section, we explain the policy instruments for internalizing the externality.
Among such instruments, we examine the three instruments shown in Fig. 2.14.
The first is direct regulation, which is often conducted through legislation. The
second is an economic instrument that involves the use of a market mechanism.
The final instrument is voluntary, such as voluntary action and negotiations between
stakeholders.

Economic
Direct regulation Voluntary means
instrument

•Total emission •Tax (Pigouvian tax) •Voluntary actions

regulation •Subsidy •Negotiaions
•Emission standard •Emissions trading between
regulation system stakeholders

Fig. 2.14 Policy instruments for internalizing the externality

40 2 Economic Instrument and Environmental Problems

2.2.1 Internalizing Externality Through Direct Regulation

Direct regulation is a type of policy instrument where a regulatory authority, such

as the government, explicitly limits the emission level of a pollutant to a regulation
level to cope with externalities caused by the pollutant. It is a measure that directly
regulates economic activities that are becoming the source of externality by law.
Since the government commands the polluter to reduce its emissions to a level stated
by the government, this direct regulation measure is also known as command and
control (CAC). This instrument is often implemented by regulating the total number
of emissions, where the upper emission limit is set for each industry or trader (total
emission regulation). Another example of direct regulation is to put restrictions on
the polluter’s unit of production or the concentration levels of the pollutant emitted
from a vent (emission standard regulation).
Let us consider how this direct regulation measure can internalize an externality
using Fig. 2.15. Similar to Fig. 2.5, where the effect of externality on social welfare is
shown, MPC and MSC in Fig. 2.15 represent the private marginal cost curve and the
social marginal cost, respectively, and D represents the demand curve. Figure 2.15a

Fig. 2.15 Internalizing externality through direct regulation

2.2 Economic Policy and Environmental Problems 41

illustrates a situation where production continued before the direct regulation was
imposed by the regulator. Here, the production level is carried out at Q B and the gray
area in the figure denotes the social damage to the economy. To extinguish this social
damage, the polluter needs to reduce its production level from Q B to Q A as shown
in Fig. 2.15(b). To do this, what kind of direct regulation should the government
implement?
To limit the production level to Q A , the regulator needs to establish a regulation
that restricts the maximum production level of the producer to below Q A . If such
a restriction is imposed in the market, the production level of the producer cannot
exceed Q A , so the supply curve becomes a vertical line at Q A . Thus, the supply
curve becomes a bent curve as presented in the gray line in Fig. 2.15b. As a result,
the total social surplus when direct regulation is introduced is the sum of the gray
and shaded areas in Fig. 2.15c. Since the shaded area is an external cost for society,
the area of the gray area excluding the area of the shaded area eventually becomes
social welfare when a direct regulation is imposed on this economy.
The advantage of direct regulation is that it is easier for the regulator to achieve
its target emissions level than through other regulatory instruments, as long as the
emission levels of the polluters can be measured and monitored. Another advantage
of direct regulation is that it can be enforced promptly. This is advantageous because
regulators sometimes need a quick response to restrict pollutants that can cause
serious damage to the ambient environment.
Since polluters do not need to control their emissions to levels below the regulatory
level, there is no incentive for polluters to introduce additional emission reduction
technologies that would allow them to reduce their emissions below the regulatory
level. Thus, the direct regulation measure has a weakness for incentivizing polluters to
develop and promote technologies to help improve their emissions reduction levels.
Another issue with direct regulation is that it is difficult to determine the optimal
regulation level or to choose the standard emission level based on the emission level
of one of the polluters. To provide an example of the government coping with the issue
of setting the right regulation standard, the Japanese government started a program in
April 1999 called the Top Runner Program under the revised Energy Conservation
Law. In this program, the regulation standards were set based on the most fuel-
efficient products available at the time of the regulation. For electric appliances such
as TVs, air conditioners, and refrigerators, producers had to meet the standards of the
most energy- and fuel-efficient products, and a penalty was imposed on companies
that were not able to achieve this product standard. Although the program improved
the energy-saving technology of the targeted products, it has been suggested that
the program increased production costs because it required companies to develop
energy-saving technologies.
42 2 Economic Instrument and Environmental Problems

2.2.2 Internalizing Externality Through Economic

Instruments

Here, four types of economic instruments for internalizing externalities are described.
The first measure is an environmental tax or a so-called Pigouvian tax (Pigou 1932),
the second measure is a subsidy, the third measure is a deposit system, and finally,
an emissions trading system is explained.

Environmental Tax
An environmental tax is a tax levied on the emission of substances that have an impact
on the environment to control polluters’ emissions levels. The tax is often imposed
on the emissions level. Producers that are affected by this regulation have to pay
more taxes when their emissions level increases, which serves as an incentive for the
pollutant emitters to reduce their emissions. The environmental tax is also called a
Pigouvian tax (Pigou, 1932), after Arthur Pigou, who insisted on the internalization
of external diseconomies in the form of taxation.
Environmental taxes have been introduced in various countries, where Finland’s
carbon tax, established in 1990, is said to be one of the first (Barker et al., 2007).
In Finland, 1.12 Euros of a carbon tax is levied per metric ton of CO2 emissions.
Environmental taxes have subsequently also been introduced in countries such as
Sweden, Denmark, Germany, Italy, the UK, and France. In Japan, an environmental
tax was implemented as the Tax for Climate Change Mitigation in October 2012
(Kojima & Asakawa, 2021). This environmental tax was implemented by adding
289 JPY per ton of CO2 emissions to the existing petroleum and coal tax (Ministry
of the Environment, 2017). However, to prevent a sharp rise in fossil fuel prices, the
tax was introduced in three stages from October 2012 to April 2016, and the level
of per-unit tax was lower than 289 JPY when the tax was first implemented in 2012.
The actual carbon tax burden on an ordinary household is estimated at approximately
100 JPY per month (Ministry of the Environment, 2017).
Next, similar to the case of direct regulation, Fig. 2.16 provides a graphical illus-
tration of how taxation can internalize externalities. Let MPC, MSC, and D, respec-
tively, represent the marginal private cost, marginal social cost, and demand curves
of a certain product. To internalize the social damage caused by an externality in this
economy, the production volume needs to be restrained from Q B to Q A . To achieve
this goal, it is necessary to shift the marginal private cost (MPC) curve to the point
where the marginal social cost (MSC) and the demand curve intersect. Therefore,
the regulator will impose a tax per unit of production that shifts the MPC to MPCT
(see Fig. 2.16a). Assuming that a t JPY tax is levied on every unit of production,
the private marginal cost curve will shift upward by t JPY, and in this case, the total
tax revenue from the environmental tax will be t Q A JPY. This amount is the area of
the parallelogram presented in Fig. 2.16b, and the dotted area represents the sum of
consumer and producer surpluses after taxation. Since the production will continue
under the MPC curve even after the environmental tax is introduced, the dark triangle
in Fig. 2.16c becomes the amount of external cost the society of this economy will
2.2 Economic Policy and Environmental Problems 43

P P
MS MS
MPC MPC
MP MP
t CS+PS

D Tax D
revenue
Q Q

(a) Supply curve after taxation (b) Consumer and producer surpluses and
tax revenue

P P
MS MS
MPC MPC
MP MP
CS+P Social
surplus
Pure tax revenue
after the deduction
of external cost D D
External cost
Q Q

(c) External cost and tax revenue (d) Social surplus after taxation

Fig. 2.16 Internalizing externalities through taxation

face. When part of the tax revenue will be used to compensate for this external cost,
the total tax revenue left to the regulator corresponds with the gray triangle area in
Fig. 2.16c. The social surplus after an environmental tax is the dotted triangular area
in Fig. 2.16d, which is the sum of the consumer and producer surpluses (CS + PS)
after taxation and the pure tax revenue obtained by the regulator when the external
cost is deducted from the total tax revenue.
The advantage of an environmental tax is that it can effectively regulate the envi-
ronmental impact by imposing an environmental cost that is commensurate with the
number of pollutants emitted by each polluter. Another advantage of the tax is that
the polluter can reduce their tax payment by developing an environmentally efficient
technology.1 Since the polluter’s tax payment depends on the amount of pollutants
emitted, the tax provides incentives for the polluter to introduce technologies that
reduce the volume of pollutants emitted during the production process. However, the
tax system has a problem when setting the optimal tax rate, since it is difficult for the

1 Product value
Environmental efficiency (eco-efficiency) is defined as Environmental impact (ESCAP, 2009). A
product is considered more efficient when this index is higher.
44 2 Economic Instrument and Environmental Problems

Table 2.7 Advantages and problems of direct regulation and environmental tax
Direct regulation Environmental tax
Advantages • The regulation target can be achieved • It is possible to impose a cost burden
with certainty that is commensurate with the polluter
• The regulation can be applied • Promotes the development of
promptly environmental mitigation
technologies in the long term
Problems • Provides poor incentives to develop • Difficult to determine the correct
environmental mitigation technologies environmental tax rate
• Difficult to reduce emissions • The cost of setting the tax rate
efficiently because the regulation does becomes enormous
not motivate the polluters to reduce • It can hinder economic growth and
pollutants beyond the regulation international competitiveness in the
standard short run

regulator to estimate the actual external cost originated by the polluters; in reality, it
is difficult to forecast how producers will shift their production levels after the tax is
implemented. Furthermore, estimating and forecasting the right tax rate can be costly
because it is often difficult for the regulator to determine the actual effects of the tax
on production levels. Last, environmental tax can be disadvantageous for producers
because it can negatively impact economic growth and international competitive-
ness in the short run. This is because the tax will introduce an additional cost on
production and the price of the product will become higher than that of countries not
introducing tax regulations.
From the above explanations, it is evident that both direct regulation and environ-
mental tax are effective in internalizing externalities. However, there are some differ-
ences between these instruments in their impact on polluters. Table 2.7 summarizes
these differences. As shown in Table 2.7, direct regulation is effective in quickly
achieving the regulation target, but it lacks strength in promoting environmental
technology and an efficient allocation of the external costs among the polluters. The
environmental tax has the advantage of promoting environmentally efficient tech-
nologies and in the efficient allocation of external costs; however, there is an issue in
achieving the reduction target set by the regulator and can hinder economic growth
and international competition. Thus, these instruments are not a panacea for control-
ling externalities, and regulators need to be flexible about which instruments should
be used in various situations.

Subsidy
Here, as another example of internalizing externalities through an economic instru-
ment, we consider how a subsidy measure can help mitigate the effects of environ-
mental impacts caused by externalities. A subsidy can become an effective tool—like
direct regulation and an environmental tax system—to solve externalities if the regu-
lator can reduce the level of pollutants emitted by the producers to a socially desirable
level by providing a subsidy for these producers.
2.2 Economic Policy and Environmental Problems 45

Figure 2.17 illustrates the case of how an externality can be internalized through
a subsidy measure. Let us consider a situation where the producer is subsidized s
JPY if it reduces its production level by one unit. In Fig. 2.17, MPC and MSC again
denote the marginal private and social cost curves, and D is the demand curve of
this economy. To internalize the externality in this economy, the regulator needs
to provide a subsidy that will shift the production level from QB to QA , which is
the intersection of the demand and marginal social cost curves. Thus, the optimal
subsidy rate imposed per unit of production is indicated as s in Fig. 2.17a, shifting
MPC to MPC S . With this subsidy rate, the regulator will need to spend in total
s Q A JPY, which corresponds to the gray parallelogram area (see Fig. 2.17b). CS
and PS in Fig. 2.17b are the producer and consumer surpluses, respectively. As the
dark triangular area in Fig. 2.17c represents the external cost in this economy, this
part will be used to cover the cost, and the subsidy amount given to the producer
is the area where this dark triangle is deducted from the gray parallelogram area in

Fig. 2.17b. Therefore, the producer surplus after subsidization becomes the PS area

in Fig. 2.17c; the social surplus is the sum of PS and the consumer surplus. This
social surplus is represented by the dotted triangle in Fig. 2.17d. Comparing this
area with the case of environmental tax, assuming that the MPC, MSC, and D are
the same as in Fig. 2.16d, the final social surplus for subsidization is the same as
for taxation. However, in the case of subsidization, the regulator will need to spend
money for producers to internalize the externality, whereas in the case of taxation
the regulator can collect the money from producers.
In addition to these differences in the allocation of money spent on taxes and
subsidies, there are several differences between them. Table 2.8 summarizes these
differences. As shown in Table 2.8, an environmental tax will shift the entire industry
toward an environmentally efficient one in the long run compared to subsidy measures
and, hence, can be considered a more effective instrument for regulating environ-
mental impact. The reason for this difference is that the environmental tax can incen-
tivize producers to develop and implement environmentally efficient technology
because introducing such technologies will reduce their burden of paying for the
external costs. In certain cases, a subsidy can deprive producers of the opportunity
to develop environmentally efficient technologies and prevent producers that do not
meet the latest environmental standards from leaving the market.

Deposit System
Next, as the third economic instrument for coping with an externality, we describe
the deposit system (Fig. 2.18). The deposit system is a type of hybrid measure that
combines environmental tax and subsidy methods. It has the same characteristics as
the environmental tax and subsidy and induces producers to reduce their production
levels and raise the product prices to mitigate the environmental impact of exter-
nalities. However, the deposit system is unique in the sense that it also provides
incentives for consumers to internalize an externality. Although consumers often
have to purchase a product at a higher price after the deposit system is introduced, it
also allows them to receive a refund for taking actions that reduce the environmental
46 2 Economic Instrument and Environmental Problems

Social
surplus

Fig. 2.17 Internalizing externalities through subsidization

Table 2.8 Difference in the impact on the industry between subsidization and taxation
Subsidy Environmental tax
• Producers can receive a subsidy without • Introducing technologies that lower
developing technologies to reduce environmental impacts will reduce the
environmental impacts producer’s tax payments
• Some new producers might enter the market • Producers lacking technologies to reduce
for the sake of receiving a subsidy environmental impacts will leave the market
• The industry can shift toward an • The industry might shift toward an
environmentally inefficiency one environmentally efficient one

impact. This refund feature of the deposit system can be viewed as a type of subsidy
for the consumer.
As an example, let us consider a deposit system for a beverage bottle. Suppose a
juice is produced for 120 JPY is sold at 150 JPY with a deposit charge of 30 JPY.
Here, the charge added to the cost has the same effect as the Pigouvian tax levied
2.2 Economic Policy and Environmental Problems 47

Pigouvian Deposit Collection Refund from

Selling
tax 30 JPY depot deposit (subsidy)
price

Cost
120 JPY

Fig. 2.18 Graphical abstract of the deposit system

on the product. Since the price becomes higher than other products by adding this
charge, the amount of money collected from this charge can be used to compensate
for the external costs. In addition, the deposit system provides a mechanism for
consumers to contribute to reducing the environmental impact by returning the used
juice bottle to a collection depot. Consumers can get a refund if they return the
bottle, which will help increase the recycling rate of the bottle. In Europe and some
regions of the USA, container collection machines are available at grocery stores,
and consumers can easily receive their deposit refund by simply putting the bottles
into these machines. This refund system is similar to a subsidy system and gives the
consumers an incentive to recycle, which will contribute to mitigating environmental
externalities.
In this way, the deposit system internalizes externalities from both a producer and
consumer perspective. The initial deposit charge acts as an environmental tax for
the producer, and the deposit refund is utilized as a subsidy for consumers, which
encourages them to take actions to reduce environmental impacts from the externality.

Emissions Trading
An emissions trading system is the last example of a mechanism that internalizes
externalities through economic instruments to reduce emissions efficiently. In this
case, the government issues an emissions permit for the pollutants and allows them
to trade this permit in the emissions trading market. Pollutants that need to increase
emissions will buy permits from those that can reduce emissions and sell their permits.
This system allows for the control of the emissions level as a whole.
There are two types of emissions trading: cap and trade, and baseline and credit
systems. The cap and trade system sets a maximum allowable emission level, which
is often called the cap, for a certain country or region where the regulation authority
plans to limit the emission levels of pollutants. The authority distributes emissions
permits to the economic stakeholders based on the cap, and these stakeholders can
trade their permits in an emissions market as long as the total emission levels do not
exceed the cap set by the authority. Figure 2.19 illustrates how this system works. As
shown in Fig. 2.19, the upper limit of total emissions in an economy is fixed in the
cap and trade system, and the total emissions are regulated so as not to exceed this
cap. In Fig. 2.19, polluter A has a smaller quantity of emissions than planned, so the
reduced emissions can be sold to others as an emission permit. By contrast, polluter B
has a larger amount of emissions than planned, so it will need to purchase emission
permits in the emissions trading market. Thus, as shown in Fig. 2.19, polluter A
will sell its permit to polluter B and polluter B will pay the price of the permit to
48 2 Economic Instrument and Environmental Problems

polluter A. The level of emissions for polluter A has decreased, but for polluter B
it has increased, so the total emissions of polluters A and B have not changed. The
cap and trade system can facilitate efficient transactions between polluters without
exceeding the upper limit of the total emissions set for the economy.
The baseline and credit system is a mechanism where an emission standard, called
the baseline, is set by the regulatory authority for the pollutants. This mechanism
stipulates each pollutant to limit its emissions to the fixed baseline given by the
authority. In this system, a credit is given to a polluter that reduces its emissions
more than its baseline level. The polluter can in turn sell this credit to other polluters
that are not able to meet their baseline level. The difference between the two systems
is that in the baseline and credit system an aggregate maximum allowable emissions
level for all the polluters is not fixed, while it is fixed in the cap and trade system.
Let us look at how the baseline and credit system works. Figure 2.20 illustrates a

A fixed emissions level (cap)

Polluter A Polluter B
Emissions permit
Sells its permit Buys permits
obtained by from polluter A
reducing its and increases its
emissions level Payment emissions level.
to polluter B.

Fig. 2.19 Cap and trade system

A sells its emission credit to B buys an emission credit from

A B B
emissions
Excess

Amount of
Credit
Credit

credit
purchased
Actual emission level of B

Actual emission level of B

Baseline of polluter A

from A
Baseline of polluter A
Baseline of polluter B

Baseline of polluter B
level of A
Actual emission

level of A
Actual emission

(a) Before the credit trading (b) After the credit trading

Fig. 2.20 Baseline and credit system

2.2 Economic Policy and Environmental Problems 49

case where polluter A’s actual emissions level is smaller than its baseline emissions
while polluter B’s emissions exceed its baseline. As shown in Fig. 2.20a, polluter A
receives a credit for having lower emissions than its default baseline level. Polluter B
needs to purchase a credit to cover the emissions that exceed its baseline. The credit
given to polluter A for reducing its emissions is the same as the amount of emissions
that will cover polluter B’s excess emissions. Therefore, polluter B can meet its
baseline level by purchasing an emission credit from polluter A (see Fig. 2.20b). If
there is a total maximum allowable emission level in the credit trading market, the
baseline and credit systems become equivalent to the cap and trade system. However,
such a cap does not usually exist in the credit trading market, and when new polluters
enter the credit market it becomes difficult to capture the total emissions of the credit
market’s participants. Under such conditions, there is a possibility that the total
emissions of the participants in the credit market become higher than the initial
level.
The economic benefits brought to economic agents by introducing the baseline and
credit system are illustrated in Fig. 2.21. Figure 2.21 shows the marginal abatement
cost (MAC) curves for reducing pollutant emissions of producers A and B. r0A and
r0B signify the actual emissions level of producers A and B, and r1A and r1B denote
the emissions baseline given to producers A and B, respectively. Similar to Fig. 2.20,
in Fig. 2.21 the actual emissions of producer A are lower than the baseline, while
the emissions of producer B exceed its baseline level. In this example, it is desirable
for A to sell its emissions credit to producer B so that B can compensate for the

Fig. 2.21 Economic benefits of emissions trading (benefits of A and B depicted separately)
50 2 Economic Instrument and Environmental Problems

amount of emissions exceeding its baseline. Let P be  the price

 of a credit per unit
of emissions. When A sells its credits to B, A gains r1A − r0A • P. However, when
A sells its emissions credit, A needs to reduce its emissions from r1A to r0A , which
will require an abatement cost. This cost is equivalent to the gray area shown in the
chart on the left in Fig. 2.21. Hence, the net benefit of producer A from selling its
emissions credit becomes the shaded triangular area, in other words,  the area left
after subtracting the gray area from the amount of credit sold to B ( r1A − r0A • P).
Similarly, let us look at the benefits of producer B from emissions trading. When
there is no emissions trading, producer B’s total abatement cost is the sum of the
area depicted by the gray square and the shaded triangular area in the chart on the
right in Fig. 2.21. However, when producer B can buy an emissions credit from A,
the cost of emissions will only be the cost of purchasing the credit. This cost accords
with the gray area, so producer B can reduce the cost of emissions by an amount that
corresponds to the shaded triangle area. Therefore, engaging in emissions trading is
also beneficial for producer B.
The economic benefits of emissions trading can also be explained using a figure
that integrates the figures of producers A and B into one. In Fig. 2.22, producer A’s
emission level starts from the left (OA ) and producer B’s emission level starts from
the right (O B ). In Fig. 2.22, O A r0A and O B r0B denote the actual emissions levels of
producers A and B, and O A r1A and O B r1B are their baseline missions, respectively.
Similar to Fig. 2.21, producer A’s benefit from emissions trading is the area repre-
sented by the marginal abatement cost less the amount of credit traded (), which corre-
sponds to the area of triangle acd. Producer B’s benefit from emissions trading is a
reduction in the abatement cost obtained by purchasing the emissions credit, which
corresponds to the area of triangle dcb in Fig. 2.22. Hence, the total economic
benefit that originates from emissions trading is the sum of the benefits obtained by
producers A and B, which corresponds to the area of triangle acb.
The price of emissions credit in Figs. 2.21 and 2.22 is determined based on the
equimarginal principle. This principle states that when multiple producers are trying
to achieve a certain reduction target at a minimum cost, the optimal strategy is to
equalize the marginal costs of all producers involved in the target. Hence, if two
producers A and B follow the equimarginal principle, the condition for identifying
the optimal baseline emissions of these producers becomes MAC A = MAC B , where
MAC A and MAC B denote the marginal abatement costs for producers A and B,
respectively. Why does this principle optimize the cost?
Let us find this reason in Fig. 2.23. Figure 2.23a depicts the baseline distribution
when the baselines are determined based on the equimarginal principle. As shown in
Fig. 2.23, the price of the emissions credit accords with the intersection point of the
marginal abatement costs of producers A and B. Producer A’s baseline emissions are
identified at levels when A’s marginal abatement cost curve is lower than the optimal
credit price (P ∗ ), while those for B are given when its marginal abatement costs
are lower than the optimal credit price. The total abatement cost is represented by
the dotted triangle in Fig. 2.23a. Figure 2.23b, c illustrates cases where the baseline
emissions are not distributed based on the equimarginal principle. Figure 2.23b, c
presents cases where baseline emissions are determined at MAC A > MAC B and
 2.2 Economic Policy and Environmental Problems

Fig. 2.22 Economic benefits of emissions trading (benefits of A and B integrated)

51
52 2 Economic Instrument and Environmental Problems

Fig. 2.23 Equimarginal principle

MAC A < MAC B , respectively. In both cases, the sum of the abatement costs of
producers A and B becomes larger than that of the equimarginal principle. Therefore,
the marginal abatement cost is minimized when MAC A = MAC B , and this is why
determining the producer’s baseline emissions based on the equimarginal principle
becomes optimal.
In the real world, it is often not easy to estimate the marginal abatement costs
of every producer, and thus, the issue of setting the initial distribution of emissions
allowances for producers is not an easy task. So next, we will discuss the method for
allocating emission allowances for the stakeholders.
2.2 Economic Policy and Environmental Problems 53

There are two main options for allocating initial emission allowances. The first
option is to distribute the allowances for free, and the other is to have the stakeholders
purchase the allowances through auctions.
For the case of free distribution, we will examine the grandfathering (GF) and
benchmarking (BM) allocation methods. The GF method is a way of setting a baseline
emission allowance for a producer based on its past emission record and reduction
rate. The baseline level is often calculated using Eq. (2.12). The reduction rate in the
equation is the required reduction rate set by the regulatory authority that needs to
be satisfied for the producer to receive an emission allowance. The past emissions
level is the average of the emissions of the past several years because determining
this level based on a specific year will cause biases.

baseline emission = past emissions level × (1 − reduction rate) (2.12)

In the BM method, the baseline emission is determined by the activity level of the
producer and the benchmark. Equation (2.13) summarizes the way baseline emissions
are calculated based on this method.

baseline emission = activity level × benchmark (2.13)

In Eq. (2.13), the activity level is an indicator that reflects the level of past produc-
tion volumes or the future projections of the producers, and the benchmark is an
emission standard set for each industry or product based on the level of CO2 emis-
sions per unit of production. For example, some benchmarks are set to meet the best
available technology at the time of distributing the emission allowance.
Table 2.9 summarizes the difference between the GF and BM methods. The major
difference between these two methods is that in the former, as emission allowances are
set based on past emissions, the producers will not benefit by taking an action before
the allowance is allocated. By contrast, BM will induce producers to take reduction
actions beforehand as those not satisfying the benchmark will have a lower emissions
allocation.

Table 2.9 Difference between the grandfathering and benchmarking methods

Grandfathering Benchmarking
Emissions reduction Producers that had not Producers not meeting the
incentives before the implemented emissions reduction benchmark might receive a lower
allowance allocation measures in the past can obtain emissions allocation, so they have
higher emission allowances, so an incentive to take reduction
there is no incentive for them to actions
take reduction actions
Confronting issues Since the allocation is determined It can encourage producers to
by the historical emissions level, develop and improve reduction
the method can lead to inefficient technologies, but it is difficult to
and unfair allocations obtain information for setting
benchmark standards
54 2 Economic Instrument and Environmental Problems

A second option for allocating the emissions allowances is auctioning. One

example of the auctioning method is the sealed-bid auction, where the stakeholders
present the price they want for the allowance privately, and the allowance is allo-
cated to those submitting the highest price on the bid. Another example of an auction
is an ascending auction (English auction), where the price is determined in an open
competition and the auction continues until no other bidder competes with the bidder
claiming the highest price. Unlike the sealed-bid auction, participants can acquire
price information in the ascending auction.
The first problem of auctioning is that the cost of obtaining the allowance can
be too high, and in some cases, producers cannot pay for the allowance and will
have to withdraw from the market. The second issue is whether the participants
of the emissions trading market should be limited to those who will be affected
by the emissions reduction regulation or should allow anyone to participate in the
emissions trading market. The third issue is whether there should be an upper limit
on the number of allowances a producer can buy from the emissions trading market.
If there is no upper limit, there is a possibility that one company will dominate the
emissions allowance. Last, there is an issue of whether to set upper and lower limits
for auction prices to stabilize the price or to encourage more producers to take part
in the emissions trading market.

2.2.3 Internalizing Externality Through Voluntary

Approaches

A voluntary approach is a mechanism that voluntarily internalizes externalities. In this

approach, the emitters set emission reduction targets by themselves and voluntarily
make efforts to reduce pollutant emissions that will lead to internalizing externalities.
According to the Organisation for Economic Co-operation and Development (OECD
2003), a voluntary approach can be categorized into four approaches: a unilateral
commitment by the emitters, private agreements between the plaintiff and victim of
the issue, negotiated agreements between the industry and public authorities (local
and central governments, etc.), and public voluntary programs under the guidance
of public institutions.
In the first approach, unilateral commitments by the emitters are primarily a system
where the polluters set their emission reduction targets and declare to comply with
the rules. To ensure the credibility of their environmental efforts, polluters may hire
a third party to monitor their process.
The second approach, having a negotiation between the plaintiff and the victim of
an environmental problem, is a method of correcting externalities following the Coase
theorem. This theorem was claimed by Ronald Coase, a Nobel Laureate, whose detail
is explained in Coase (1960). The Coase theorem states that as long as the possession
of the right to use the environment is apparent a socially efficient (Pareto-optimal)
allocation can be achieved through negotiations between the plaintiff and the victim
2.2 Economic Policy and Environmental Problems 55

of the issue without governmental intervention. Assuming no transaction costs, the

Coase theorem shows that negotiations between the parties involved with an exter-
nality issue can lead to a solution, whether the property rights of the environment
belong to the plaintiff or the victim of the issue. The assumption of no transac-
tion cost means that there is no negotiation cost such as identifying the perpetrator
causing externality, verifying the causal relationship between the externality and the
perpetrator’s activity, costs for estimating the damages from the externality, fees to
conduct a trial, and opportunity costs like foregoing the value if the time spent in
negotiations. The transaction costs of the negotiation are presented in Table 2.10.
Although the assumption of no transaction cost is somewhat unrealistic, the Coase
theorem provides an important implication that the externality can be solved volun-
tarily through negotiation between the stakeholders involved in the issue. Figure 2.24
provides a graphical overview of this theory. The figure shows a case where a factory
is adjacent to a farm and the factory emits pollutants that inflict damages to the
farmer’s harvest. In this example, the farmer receives external damage compensation
for the factory owner’s activity. The reason why a negotiation can help distinguish
externality in this example is that if either the factory owner or the farmer decides
to bear the external cost as a result of the negotiation, the externality can be distin-
guished. For example, if the factory agrees to pay for the externality, the farmers can

Table 2.10 Transaction costs

Transaction costs
of negotiation
• Cost of identifying the perpetrator (more difficult when there
are multiple perpetrators)
• Verification cost of the cause and the activity conducted by
the perpetrator
• Cost of estimating the damages
• Cost of the trial
• Opportunity cost of negotiation

Factory owner Farmer

Perform
environmental
measures

Distinguish
Farmer Factory externality

Perform
environmental
measures

Fig. 2.24 An overview of the Coase theorem

56 2 Economic Instrument and Environmental Problems

use this money to resolve issues by implementing a pollution neutralizer to reduce

the effects of the pollution. Similarly, if the farmer decides to pay the factory owner
to reduce the activity causing the externality, this will lead to resolving externality.
Hence, it does not matter whether the factory owner or the farmer pays for the exter-
nality—the issue can be resolved if a negotiation leads to an agreement that some
money will be put aside to internalize the externality.
The third voluntary approach, namely negotiated agreements between the industry
and public authorities, is a way for an industry to make a contract with the govern-
ment to voluntarily address environmental issues. This type of voluntary approach to
coping with environmental problems has been discussed in the context of voluntary
environmental agreements (VEAs) (Karamanos, 2001). Some VEAs are established
between nonprofit organizations and governments and a company and nonprofit
sectors. The main benefit of this approach is that, unlike the top-down command
and control type of regulation, the institutions being regulated by the government
have a chance to bargain for a reduction in the statutory requirements or get involved
in the regulation process.
The fourth voluntary program under the guidance of public institutions is an
attempt to internalize externalities by having companies participate in environmental
standards and environmental conservation plans set by environment-related organi-
zations. Since companies are not obliged to participate in the program, this is also
seen as one of the ways to internalize externalities voluntarily.
The voluntary approach is superior in that agents that need to deal with the envi-
ronmental problem can address environmental problems voluntarily, which is less
strict than a top-down regulation because the agents can set environmental standards
that are within their capacity. However, since this approach is not compulsory, the
effect of environmental regulation can be less effective if the agents are lenient and
only set low-level environmental standards.

2.2.4 Policy Mix

In Sect. 2.2, three types of environmental regulation instruments were introduced:

direct regulation, economic instruments, and voluntary means. This section looks at
a policy that uses a mix of these instruments. As discussed earlier, none of the three
instruments are perfect, and when dealing with environmental problems in practice,
different conditions require different instruments; thus, in many cases, environmental
issues need to be dealt with by combining several instruments.
However, mixing instruments work in both positive and negative directions, and
combining them is not always better than implementing them independently. When
a mixture of instruments is known to have a positive effect, it is desirable to mix
them because there is a chance that the effects will multiply. Meanwhile, mixing
instruments can also cause an adverse effect, or if the effect of instruments moves in
the opposite direction, the mixture will have no impact on resolving an environmental
2.2 Economic Policy and Environmental Problems 57

problem. Therefore, policymakers need to be aware of the outcomes and effects of

combining different environmental regulation measures.

Exercise 2.1
A producer of certain goods maximizes its profit in a monopoly market. Let P and
Q be the price and quantity of the goods, respectively. When the producer’s average
cost curve and the demand curve of the market are defined as AC = 21 Q − 2 and
Q = 10 − P respectively, answer problems a through c.

(a) Solve the optimal price and quantity of a perfect market.

(b) Solve the optimal price and quantity of a monopoly market.
(c) Solve the size of the deadweight loss from monopoly.

Exercise 2.2
Suppose a factory produces goods under the private cost function C P = 21 Q 2 +
Q where Q and C P are the quantity of output and the private cost, respectively.
Currently, the factory is causing environmental pollution in the surrounding area,
and the external cost (EC) of this pollution is defined as EC = 4Q. Let P be the
price of the goods produced in the factory. When the demand curve for the goods is
Q = 20 − 2P, answer the following problems.

(a) What is the size of the social damage caused by the producer’s activity?
(b) Solve the optimal level of production when the regulatory authority decides to
internalize social damage through direct regulation.
(c) Let T denote the environmental tax levied on each unit of the goods
produced. If the regulatory authority decides to internalize social damage by
an environmental tax, solve the optimal value for T.
(d) Assume that environmental pollution has been resolved by the environmental
tax, as explained in problem c. Solve the value of tax used to resolve the
pollution.

Exercise 2.3
Let MAC A and MAC B be the marginal abatement cost curves of factories A and B
located in a river basin, and E A and E B be the amount of pollutants emitted from
factories A and B, respectively. The MAC A and MAC B are defined as follows:

3 A 2
MAC A = E , MAC B = E B .
5 5
When the total allowable emissions of pollutants are restricted to 60, answer
problems a through c using the figure below.
58 2 Economic Instrument and Environmental Problems

Emissions Emissions
cost cost

(a) Calculate the optimal emissions level for factories A and B.

(b) An emissions credit system is introduced in the river basin, and the credits
are distributed to the factories based on the equimarginal principle. When the
current emissions level of factory A is 40, what kind of emissions trading will
be conducted between the two factories?
(c) When emissions trading explained in problem b is conducted, what are the
benefits received by factories A and B.

References

Barker, T., Junankar, S., Pollitt, H., & Summerton, P. (2007). Carbon leakage from unilateral Envi-
ronmental Tax Reforms in Europe, 1995–2005. Energy Policy, 35, 6281–6292. https://doi.org/
10.1016/j.enpol.2007.06.021
Bator, F. M. (1958). The anatomy of market failure. The Quarterly Journal of Economics, 72,
351–379. https://doi.org/10.2307/1882231
Coase, R. H. (1960). The problem of social cost. The Journal of Law and Economics+, 1–44.
Economic and Social Commission for Asia and Pacific, ESCAP. (2009). Eco-efficiency indicator:
Measuring resource-use efficiency and the impact of economic activities on the environment,
United Nations, Bangkok.
Hardin, G. (1968). The tragedy of the commons. Science, 162, 1243–1248. https://doi.org/10.1126/
science.162.3859.1243
Karamanos, P. (2001). Voluntary environmental agreements: Evolution and definition of a new
environmental policy approach. Journal of Environmental Planning and Management, 44, 67–84.
https://doi.org/10.1080/09640560124364
Kojima, S., & Asakawa, K. (2021). Expectations for carbon pricing in Japan in the global climate
policy context. In T. H. Arimura and S. Matsumoto (Eds.), Carbon Pricing in Japan (pp. 1–21),
Springer Nature Singapore Pte Ltd.
Ministry of the Environment. (2017). Chikyu-ondanka-taisaku no tame no zei no dounyu (Intro-
duction of the Tax for Climate Change Mitigation). https://www.env.go.jp/policy/tax/about.html.
Accessed April 19, 2021.
OECD. (2003). Voluntary approaches for environmental policy: Effectiveness, efficiency and usage
in policy mixes. OECD.
Ostrom, E. (1990). Governing the commons: The evolution of institutions for collective action.
Cambridge University Press.
Pigou, A. C. (1932). The economics of welfare (4th ed.). Macmillan & Co.
Chapter 3
Economics and the Value of Nature

In this chapter, we will learn how environmental economics measures the value of
the natural environment, such as the value of fresh air, the abundance of parks, and
the conservation of the ecosystem, which are not properly evaluated in markets.
Evaluating the value of nature by converting its value to monetary terms is called
environmental evaluation or environmental assessment. Environmental assessment
is essential for conducting environmental policy because it enables us to learn the
degree of the importance of conserving various types of environmental resources
and to understand the potential damage to the environment by certain development
projects.
We first explain the concepts necessary for understanding the methods used in
the environmental assessment, such as the definitions of various values of nature,
willingness to pay, and willingness to accept. We then examine the major methods
used in environmental economics to evaluate the value of nature and assess the
environmental impact of economic activities, such as the revealed preference method,
the stated preference method, and the cost–benefit analysis.

3.1 The Value of Nature

Before explaining how environmental economics assesses the value of nature, let us
look at how the value of nature is classified in Fig. 3.1.
The value of nature is classified into use value and non-use value according to
usage for people at present. Natural resources that are recognized as valuable for
people at present are classified as having use value, while those that are not perceived
as valuable are categorized under non-use value.
The use value is further divided into three categories: direct use value, indirect
use value, and option value. The direct use value is the value possessed by all goods
that we normally consume. This value sustains all goods that benefit people from
their direct use, such as food, water, and clothing. The indirect use value is the value

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 59

K. Aruga, Environmental and Natural Resource Economics,
https://doi.org/10.1007/978-3-030-95077-4_3
60 3 Economics and the Value of Nature

Direct use value such

Direct use value as food, water, wood,
medicines, etc.

Indirect use value such as

Use value Indirect use value watershed protection,
recreational function, etc.
Values that
originate through
human use. Value that will be created
Option value by future use such as
genetic resources.
Value of nature
Values passed to the
Bequest value future generation by
Values that
conserving nature.
exist irrelevant
to human use.
Non-use Benefits obtained from the
value Existence value wellbeing of nature.

Values generated from

Stewardship value a stewardship role of
conserving life.

Fig. 3.1 Classification of the value of nature

that does not directly originate from obtaining the goods but benefits us in an indirect
way, such as the forest soil temporarily storing water after rainfall to prevent floods
and the forest functioning for recreational purposes. The option value is a value not
recognized at the moment, but a value presumed by conserving nature for future use,
such as the option to use nature for ecotourism and drug development.
Non-use value is also subdivided into three categories: bequest value, existence
value, and stewardship value. The bequest value is the value of nature that may not
be useful for the present generation but is bequeathed to future generations given its
potential to bear value in the future. Existence value is the value of the wellbeing of
a living organism, regardless of whether people come in contact with the organism,
such as cold water and deep-sea corals. Finally, as stewardship refers to the act of
supervising or taking care of something, the stewardship value is the value derived
from the responsibility of humans to conserve nature.
As explained above, various values exist regarding the value of nature. Values
other than the direct value do not have markets to evaluate the value of nature. In
such cases, we need to use special techniques, and this chapter will introduce such
methods to assess the values. Before going into the details of the methods, two
concepts should be explained: willingness to pay (WTP) and willingness to accept
(WTA), which are important for understanding the methods used for environmental
assessment.
WTP is the maximum amount that an individual or group wants to pay to retain the
value of an environment. For example, in Fig. 3.2, the maximum amount a resident
wants to pay to have a park nearby is the resident’s willingness to pay for this park.
3.1 The Value of Nature 61

I want to have What will be

a park nearby. the maximum
payment?

Fig. 3.2 Willingness to pay

The willingness to pay can be measured not only when the environmental value
increases but also when it decreases. For instance, the maximum amount of money
an individual wants to pay to prevent the loss of a certain environmental value will
be the individual’s WTP for this value.
Conversely, WTA is the minimum amount of compensation required for an indi-
vidual or a group to accept the loss of an environmental value under a specific condi-
tion. For example, Fig. 3.3 describes how much money will be needed to persuade
a resident to accept the removal of a nearby park when this resident protests against
the removal. The WTA in this example is the amount of money that will satisfy the
resident to accept the removal of the park nearby.
Let us look at the difference between WTP and WTA using an indifference curve.
Before explaining this comparison, an explanation of an indifference curve for begin-
ners in economics is necessary. When an individual’s utility level is determined by
two goods, an indifference curve is an isoquant curve, where any bundle of utility
on this curve becomes identical. To explain this in detail, please refer to Fig. 3.4. In
economics, utility represents the level of satisfaction of an individual with a certain
bundle of goods. Assuming that an individual’s utility level is determined by two
goods, goods x1 and x2 , a typical utility function can be denoted as in Fig. 3.4a.

Removal of a park Dissatisfaction Accept the park

removal

Money

Fig. 3.3 Willingness to accept

62 3 Economics and the Value of Nature

U
2

1 2 3
2
3
2
1

1
1

(a) A utility function (b) An indifference curve

Fig. 3.4 A utility function and an indifference curve

In this figure, the U-axis is the utility level, while the x1 and x2 axes represent the
amount of x1 and x2 goods. When the utility function is defined as in Fig. 3.4a, the
indifference curve is a curve obtained when cutting this utility by the x1 x2 -plane.
Figure 3.4b shows the indifference curve in two dimensions from the utility axis.
Because any point on the U-axis cut by the x1 x2 -plane will have the same utility
level, all combinations of goods on the indifference curve have the same utility. In
Fig. 3.4b, the utility of an individual increases as the indifference curve shifts toward
the upper right direction.
Now, consider the indifference curve presented in Fig. 3.5, where the utility of
an individual is determined by the area of the neighboring park (G) (m2 ) and the
amount of money possessed (M) ($). In the figure, point A represents the utility of
an individual when the lawn area is 200 m2 and this person possesses $500, and
point B represents a case in which the area of the park is 500 m2 and the amount of

Fig. 3.5 An indifference M

curve determined by lawn
area (square meters) (G) and
money (M) ($)

50 A

B
200

G
200 500
3.1 The Value of Nature 63

money is $200. Per the definition of the indifference curve, the utility obtained by
the individual at points A and B is the same.
Using the indifference curve, the individual’s WTP for changes in environmental
value can be explained. The environmental value here is assumed to be an increase
in the area of the park, as shown in Fig. 3.5. In Fig. 3.6a, it is assumed that an
individual is initially at point A, where the area of a neighboring park is G0 and the
amount of money possessed is M 0 . The utility obtained at point A can be expressed as
U0 = U (G 0 , M0 ). Suppose that the individual is willing to have a larger park near his
house and the expansion of the park will improve his or her living environment. Let
point B in the figure be a case where the park is expanded to G1 , thereby improving
the ambient environment. Then, the utility level at point B will be U1 = U (G 1 , M0 ),
which has a higher utility level compared to U 0 . An individual’s WTP in this example
is the maximum amount one is willing to pay for an environmental improvement:
an expansion of the park from G0 to G1 . As the utility increases from U 0 to U1 due
to the park expansion, the WTP corresponds to the amount of money an individual
is willing to pay to achieve this shift. Because this difference is in accordance with
the difference in money between points B and C (see Fig. 3.6a), this shift can be
expressed as Eq. (3.1):

WTP = M0 − M0 . (3.1)

This difference is the same as the difference in the amount of money between
points A and C; it can be considered the amount of money an individual is willing to
give up on behalf of the park expansion. Since points A and C have the same utility
level, the WTP for this individual’s environmental improvement can be expressed as
Eq. (3.2):

M M

A B B A
0 0
0
1 WTP
WTP ′
′
0 0 C
C 1
0
G G
0 1
1 × 0

(a) WTP for an environmental (b) WTP to prevent an environmental

improvement degradation

Fig. 3.6 Willingness to pay under the indifference curve

64 3 Economics and the Value of Nature
 
U (G 0 , M0 ) = U G 1 , M0 = U (G 1 , M0 − WTP). (3.2)
 
U (G 0 , M0 ) and U G 1 , M0 denote utility at points A and C, and Eq. (3.2) is derived
by applying M0 = M0 − WTP from (3.1).
Similarly, Fig. 3.6b presents the WTP for preventing environmental degradation
if a local government plans to reduce the area of the park. The figure shows a case
in which the individual’s utility decreases to U 1 if the area of the park is reduced to
G1 . Point B in the figure is on the utility curve U 1 , and its utility can be denoted as
U (G 1 , M0 ). Point C is the point at which an individual can enjoy the same park area
(G0 ) as point A while maintaining the same utility level as point B. However, the
amount of money possessed decreases from M0 to M0 at point C. Thus, the WTP in
this case is the amount that an individual is willing to pay to avoid the shift from G0
to G1 . This amount corresponds to the difference in money between points A and
C, which is the same amount in (3.1). Accordingly, the relationship stated in (3.2)
holds.
Next, let us look at the WTA using the indifference curve (see Fig. 3.7). First,
consider an example when a plan to expand the area of the park is aborted. In
Fig. 3.7a, the individual’s utility level was at point A (U0 = U (G 0 , M0 )) when the
plan to expand the park was announced. If the park was expanded per the initial
plan, the area of the park increased from G0 to G1 , and the individual’s utility rose to
U1 = U (G 1 , M0 ) (point B). However, if this plan was abandoned, the individual’s
utility would return to point A. The WTA is the minimum compensation required to
maintain the individual’s utility level, similar to the case in which the environment
is improved by park expansion. This amount is the difference in the money received
between points C and B in Fig. 3.7b, which is in accordance with the difference in
money between points A and C. Thus, WTA can be expressed as:

M M

WTA WTA

C
′ C ′
0 0

B A
0 0 B
A 0
1

0 1

G G
0 1 1 0

(a) WTA aborting an environmental (b) WTA an environmental deterioration

improvement

Fig. 3.7 Willingness to accept under the indifference curve

3.1 The Value of Nature 65

WTA = M0 − M0 . (3.3)

As seen in Fig. 3.7b, the value stated in (3.3) is the amount of money required to
maintain the individual’s utility at the same level as the case in which the area of the
park has been expanded from G0 to G1 , and hence, is the WTA to compensate for the
abortion of the park expansion plan. Using the relationship where the utility levels
of points B and C are the same and applying Eq. (3.3), the WTA of this example can
also be expressed as (3.4):
 
U (G 1 , M0 ) = U G 0 , M0 = U (G 0 , M0 + WTA). (3.4)

Similarly, Fig. 3.7b also illustrates the WTA, but this figure shows the WTA when
the area of the park is reduced and the individual’s living environment deteriorates.
In the figure, the individual’s utility was initially at point A, but after the reduction,
it decreased to point B. The WTA in this example is the amount of compensation
required to assure the same utility as obtained initially at point A, even when the
area of the park is reduced from G0 to G1 . Because point C has the same utility
level as point A, the amount of WTA to satisfy the individual is the difference in the
money received between points B and C. Therefore, using the relationship in which
the utility level of points A and C are the same, the WTA, in this case, can also be
expressed as Eqs. (3.3) and (3.4).
Both WTP and WTA are useful concepts for understanding changes in the value
of an environment. However, how do these concepts differ? To answer this question,
it is useful to understand the difference between WTP and WTA and the reason for
the difference.
The major difference between WTP and WTA is that WTP is a payment made by
an individual toward an environmental change, while WTA is the amount of money an
individual will request from an agent that is responsible for an environmental change.
In addition, WTP is on the demand side of environmental goods or services because
it is the amount of money one is willing to spend to purchase them. In contrast, WTA
is on the supply side, as it is the money required to have the individuals lose the
environmental goods or services they presently have. According to prospect theory
(Kahneman & Tversky, 1974), a well-known theory in behavioral economics, the
utility of losing a good is generally greater than gaining it. For example, how many
people participate in a bet that has a 1/2 chance of winning $1000 but a 1/2 chance
of losing $400? According to a study, although the expected value of the bet is
positive ($300), only a few people would be willing to place the bet. Kahneman and
Tversky (1974) suggest that the reason that most people avoid participating in a bet
with such uncertainty is that people tend to overvalue the loss of losing money. This
tendency for people to avoid losses over gains related to cognitive bias is called loss
aversion. Therefore, since WTA is an amount of compensation to avoid the loss of
an environmental value, while WTP is a payment toward a gain in an environmental
value, it is known that the WTA often becomes higher than the WTP.
Let’s look at the difference in the WTP and WTA when the indifference curve
represents two goods that are substitutes and complements. Figure 3.8 denotes an
66 3 Economics and the Value of Nature

Money WTA = WTP Money WTA > WTP

1 WTA WTA

0
WTP WTP

0 0 1

Environmental good Environmental good

(a) Substitute goods (b) Complementary goods

Fig. 3.8 Difference in the WTP and WTA under substitute and complementary goods

indifference curve for money and an environmental good. Figure 3.8a shows a case
in which goods have a substitute relationship. There is no difference between WTP
and WTA when the two goods have a substitute relationship. Goods are substitutes
when one good can be replaced by another when it is not available. Explaining this
with the example of goods in the figure, consider a case in which the environmental
good was a lawn and it was dying from drought, but after a certain amount of money
was spent on the land, the lawn was perfectly restored. This type of environmental
good, in which the change in the value of an environmental good can be restored with
money, can be considered as a substitute for money. In this type of environmental
good, the difference between the WTA and WTP is small because the environmental
loss can be compensated for by money.
Conversely, Fig. 3.8b depicts a case in which money and an environmental good
have a complementary relationship. When goods have a complementary relationship,
the utility of the individual cannot be satisfied if any one of them is missing. Thus, if
money and environmental goods have a complementary relationship, the loss of an
environmental good cannot be replaced by money. For example, if the environmental
good was a very rare bird and this bird’s habitat was destroyed due to urban devel-
opment, it would not be easy to restore the habitat of this bird with money. In such
a case, the amount of compensation to recover the loss of an environmental good
becomes enormous, and it will be very difficult to satisfy an individual to accept the
change. Thus, when an environmental good is not a substitute for money, the WTA
can become very large compared to the WTP.

3.2 Revealed Preference Method

The revealed preference method assesses the value of environmental goods or

services by evaluating the amount of money put toward these goods. This is achieved
3.2 Revealed Preference Method 67

by observing the actual actions of people toward goods and services, such as the
amount of money spent on them, or the cost required to maintain their value. Since
the revealed preference method is based on using data obtained from actual choices
people make in markets, in most cases, the environmental value is estimated using
existing data rather than conducting a survey to ask people for their willingness to
pay or accept environmental goods and services. In this section, as typical examples
of revealed preference methods, we focus on the replacement cost method (RCM),
travel cost method (TCM), and hedonic pricing method (HPM).

3.2.1 Replacement Cost Method

The replacement cost method (RCM) is a method of evaluating environmental value

based on the cost of replacing the value with another good.1 In this method, a good
with a market value that brings the same benefits as the target value will be chosen as
a substitute good. Then, the value of the environment is evaluated by the market value
of this substitute good. Thus, the RCM is a method that uses the market value of the
substitute goods as a proxy for that of the environmental goods because they often
do not have a market. For example, healthy forests can filter and regulate the flow
of water like a dam; accordingly, this forest watershed function can be evaluated
by estimating the cost of building a dam that will offer an equivalent function to
the forest controlling the water flow. Another example of the RCM is to evaluate the
value of a windbreak forest by estimating the cost of constructing a windbreak fence.
To apply the RCM, three conditions must be met (Shabman & Batie, 1978; Sund-
berg, 2004). First, there must be man-made objects that can completely replace the
functions of the environmental good being assessed for its value. Second, when
assessing the value of the environment, the artificial good used as a proxy for the
environmental good must have the lowest cost or price available in the market. Third,
the burden of covering the cost required to replace the value of the environmental
good must be accepted by the people who will be affected by the replacement.
The advantage of the RCM is that the value of the natural resource can be easily
evaluated if there is an alternative good, and because the value is replaced with the
market value of an existing good, it is easier for us to intuitively understand the value.
However, the method cannot be applied to evaluate the value of an environmental
good that does not have a substitute artificial good, such as a very rare animal or
plant.

1 The RCM is also often called as the alternative cost method.

68 3 Economics and the Value of Nature

3.2.2 Travel Cost Method

As can be inferred from the word travel, the travel cost method (TCM) evaluates an
environmental value based on the total cost of travel and the number of visits to the
location of the environmental goods and services. This method was first proposed by
Hotelling in 1947 to measure the recreational demand for US natural parks; however,
the foundation of the method lay in studies conducted in the 1950s, such as Trice
and Wood (1958) and Clawson (1959), among others (Smith & Kaoru, 1990).
The basic model of the TCM is based on the demand function, assuming the
demand consists of the traveler’s willingness to pay for the environmental goods
and services of the particular location. The method assumes that this demand for
environmental goods and services can be indirectly evaluated using an individual’s
cost of travel and the number of visits to the location providing the goods and services.
The amount of money spent on travel includes transportation to the destination,
accommodations, and opportunity costs (hourly costs), such as income that could
have been obtained if the individual did not make the trip.
Under these conditions, let Q n denote the number of visits to a certain tourist spot
with the environmental attribute; Pn is the cost spent on the spot; Sn is the cost spent
on alternative spots; X n is the visiting individual’s characteristics, such as age and
family structure; and In is the individual’s income. Then, the demand function of the
individual visiting the tourist spot can be written as the following equation:

Q n = f (Pn , Sn , X n , In ). (3.5)

The environmental value of the visited spot can be estimated by measuring the
consumer surplus of the demand curve presented in Eq. (3.5). For example, in Fig. 3.9,
when Pn0 is the travel cost of a specific individual to the spot at a certain point, and Pnc

Fig. 3.9 Environmental Travel cost

value estimated under the
travel cost method

Number of visits ( )
3.2 Revealed Preference Method 69

is the choke price, which is the price when demand diminishes, the environmental
value of this tourist spot can be estimated by calculating the shaded area. This area
corresponds to the consumer surplus of an individual visiting the spot. The demand
curve for the spot has a downward slope because the travel cost of each visit normally
decreases as the number of visits to the spot increases. This negative relationship is
sustained between the travel cost and the number of visits because people living
nearer are likely to visit the spot more frequently, and their average travel expenses
are lower than those visiting from further away. As seen in the figure, for individuals
whose number of visits to the spot is lower than Q 0n , the price of their visits will be
lower than the average travel cost Pn0 , gaining benefits from their travel. Thus, the
shaded area, which is the consumer surplus, represents the total gain of the people
visiting the spot.
Because the travel cost method measures the environmental value through the
consumer surplus in the demand curve for visiting a tourist spot, it can easily evaluate
the impact of an improvement or deterioration of the natural environment by esti-
mating changes in the consumer surplus. For example, Fig. 3.10 shows the changes in
environmental value when a wetland reclamation project was carried out at a tourist
site. In the figure, D and D  denote the demand curves before and after the project was
executed. The figure assumes that the number of visits will decrease if the wetland
is cultivated, since the site’s tourists were mostly attracted by the wetland plants and
animals, and the reclamation will deprive the habitats of these living organisms. This
environmental damage is shown in the shift in the demand curve from D to D  ; the
consumer surplus decreased to the shaded triangle area after the wetland reclamation
project. The environmental damage to the site by the reclamation project corresponds
to the area of the gray quadrangle in the figure; hence, the amount of environmental
damage can be calculated by the change in the consumer surplus.
As shown above, using the TCM, the environmental value can be evaluated if the
data for the number of visits and the travel cost to the tourist spots are accessible.
However, if the environmental goods and services are located in remote and unknown

Fig. 3.10 Evaluating a Travel cost

change in the environment
using the travel cost method

Number of visits
70 3 Economics and the Value of Nature

areas, there will be very few people visiting the spot, and it will be difficult to obtain
data to apply the TCM. Furthermore, estimating the environmental value through
TCM often involves biases because it is not easy to calculate the visitor’s opportunity
cost. In most cases, this cost will be obtained by directly asking the visitors about the
cost, but there is no guarantee that the visitors report an accurate opportunity cost.

3.2.3 Hedonic Pricing Method

The hedonic pricing method (HPM) is a method to estimate the value of a good using
related variables. It assumes that the price of the good is determined by its attributes,
and the value of the good can be estimated using these attributes. The application of
the method was first used by Court (1939), but it was not established as an economic
model until Lancaster (1966) and Rosen (1974) developed an analytical method to
properly link the model with economic theory (Chin & Chau, 2003).2 This method is
based on the premise that a consumer’s utility is determined by components related
to the goods. It became popular because it was used to evaluate the value of real estate
property using various factors that affect the property value, such as land location
and surrounding environment.
As an example of applying the HPM, consider a case in which the house price
is pT (10 thousand USD), the variables representing the floor and land areas are X 1
and X 2 , and the variable related to the surrounding air quality is X 3 . Assume that
X 1 , X 2 , and X 3 are evaluated by ranks 1–5, respectively. How each house element
(variables X 1 , X 2 , and X 3 ) affects house prices can be analyzed using the multiple
regression model shown in Eq. (3.6).3

pT = α + β1 X 1 + β2 X 2 + β3 X 3 (3.6)

All the coefficients of the explanatory variables in Eq. (3.6) are significant, and
the estimation result is as follows:

pT = 0.6 + X 1 + 2.5X 2 + 3X 3 . (3.7)

First, since the coefficient for X 1 is 1, it can be observed from Eq. (3.7) that if the
rank of the floor area increases by one, the house price will increase by 10 thousand
USD. Second, it is evident from the coefficient X 2 that the house price will increase
by 25 thousand USD if the rank of the land area increases by one. Finally, from the
coefficient X 3 , it can be understood that if the rank of air quality increases by one,

2 The word hedonic comes from the happiness or pleasure of having a good with a high quality
when Court (1939) applied the method to analyze the quality of automobiles.
3 A multiple regression analysis is a statistical method to analyze whether some variables are related

to the variable that is investigated. Please read introductory textbooks on statistics and econometrics
if you are not familiar with the method.
3.2 Revealed Preference Method 71

Fig. 3.11 Hedonic price Land price

function
Hedonic price function

B
A

Environmental

the house price increases by 30 thousand USD. If the data for the house price and
attributes affecting the price can be collected, we can determine how the house price
will be affected by changes in its surrounding environment using the HPM and basic
statistical analyses.
Next, based on the hedonic pricing model developed by Rosen (1974), we use a
hedonic price function in which the land price of a house is determined only by the
change in the environmental quality of the surrounding area, such as the freshness
of the air and the abundance of green space. This hedonic function is useful for
evaluating changes in environmental value. Let us assume that the hedonic function
of this land price can be illustrated as in Fig. 3.11. In the figure, the land price at
point B is higher than at point A because point B has a higher environmental quality.
The land price of point C is the highest since point C has the highest environmental
quality among the three points depicted in the figure. In the hedonic function, the
environmental quality increases as it moves toward the upper right, and the land price
increases accordingly.
Let us examine how the change in environmental quality can be evaluated using
the hedonic function shown in Fig. 3.12. In the figure, when the environmental quality
increases from E A to E B , the land price rises from pA to pB , and it is observable
that the change in the environmental quality is pB − pA . Here, we introduce an
indifference curve of a resident, which is determined by the size of the land price and
environmental quality. We assume that the indifference curve has a shape similar
to the U (p, E) curve in Fig. 3.12, where p and E denote the price of land and
the degree of environmental quality, respectively. Since an increase in the price is
unfavorable for the resident, while the improvement in the environmental quality
will be a desirable situation for the resident, the utility obtained by the resident will
be higher as the indifference curve moves toward the lower right of the figure.
Given this assumption with the hedonic price function having the form presented
in Fig. 3.12, when will the individual’s utility level be maximized? That is when the
combination of land price and environmental quality corresponds to the quantities
achieved at point A. This point is the tangent point, where the hedonic function and
indifference curves are tangent. When evaluating the change in the environmental
72 3 Economics and the Value of Nature

Fig. 3.12 Bias in the Land

evaluation using the hedonic
pricing method Hedonic price

Environmental
quality

quality with the indifference curve, the change in the quality from E A to E B will
increase the land price from pA to pA , suggesting that the value of the environ-
mental improvement is pA − pA . Meanwhile, if this environmental improvement
was evaluated using the hedonic price function, the change in the land price would
be from pA to pB . Therefore, as evident from the figure, the environmental change
will be overestimated by pB − pA , which corresponds to line A B when the value is
estimated using the hedonic price function.
Why is there a gap between the willingness to pay for an environmental improve-
ment evaluated under the indifference curve and that measured by the HPM? This
is because although there are various utility functions other than the one shown in
Fig. 3.12, the hedonic price function cannot capture all the preferences of individuals,
which will be expressed by diverse utility functions. If the individual’s preference is
homogenous, the hedonic price function becomes the same as the indifference curve.
Finally, the HPM is a convenient method to evaluate the environmental value
using existing data, but it cannot be used to evaluate all types of environmental
value, especially when no existing data is available. For example, as in the case of
global climate change, it is not possible to evaluate its impact by simply measuring
the changes in land prices. Hence, we need to keep in mind that the HPM is not
omnipotent in evaluating environmental value.

3.3 Stated Preference Method

The stated preference method is another tool for measuring environmental values. It
is a method that seeks to obtain information from people by conducting experiments
3.3 Stated Preference Method 73

and surveys inquiring about the potential benefits and losses received from certain
goods and services. It is often used when existing data for evaluating goods and
services are lacking, and it is not possible to use the revealed preference method to
indirectly assess the value of goods and services.
In this section, two frequently used methods under the stated preference method
are introduced: the contingent valuation method (CVM) and conjoint analysis.

3.3.1 Contingent Valuation Method

The contingent valuation method (CVM) is used to measure the value of a good or
service by asking people about their willingness to pay or willingness to accept a
hypothetical market, which is set in a survey created by an investigator. The term
contingent is used because contingent means dependent on or conditioned by some-
thing, and in the CVM, the market value of a certain good or service will be evaluated
based on a hypothetical situation constructed by the investigator. Studies utilizing
survey data to understand the value of public goods have existed since the 1940s,
such as Bowen (1943) and Ciracy-Wantrup (1947), but a formal method of the CVM
was first applied to estimate the recreational value of forests in Maine, USA by Davis
(1963) (Hoyos & Mariel, 2010). Since the CVM was developed for evaluating goods
and services that do not have a market, it is more often used for estimating non-use
values, but the method can also be applied toward measuring use values. For example,
the CVM can be used to estimate the environmental value that cannot be assessed
using data from an existing market, such as the value of clean and safe tap water,
clean air, maintaining the rural landscape, and so on.
Contingent valuation is generally carried out according to the procedure shown
in Fig. 3.13. To perform CVM, the investigator first needs to identify the target to
be measured. It is easy to specify a target if it is a certain good or service, but if it is

•Constructing a
Step 1 hypothetical
market

•Conducting a CVM
Step 2 survey

•Estimating the WTP or

Step 3 WTA

•Estimating the bid

Step 4 acceptance curve

• Estimating the total

Step 5 benefit or cost for the
aggregate population

Fig. 3.13 Procedure of the CVM

74 3 Economics and the Value of Nature

Fig. 3.14 Bid curve Acceptance rate

1.0

A
0.5

0.2
WTP ($)
50 80

a change in the environmental value of some sort, the investigator must ensure that
the survey respondents can clearly understand the difference between the current
situation and the situation after the change.
The second step is to obtain data for estimating the WTP or WTA toward the target
by conducting interviews, mail and Internet surveys, etc. When conducting such a
survey, it is important to conduct a pilot survey (preliminary survey) to check whether
the survey is appropriately designed to evaluate the respondents’ WTP or WTA. The
pilot survey is a good opportunity for the investigator to revise the questionnaire
if one finds that the respondents have difficulty in understanding the hypothetical
condition. For example, when evaluating a rare animal only a few people know
or the effect of a conservational development using professional technology, the
investigator must ensure that the respondents firmly understand the condition of the
target to be evaluated.
In the third step, the respondents’ WTP or WTA is measured based on the data
obtained in the second step. Statistical methods are used for this purpose. In the fourth
step, a bid curve for the target, which shows the relationship between the value of
WTP or WTA and its acceptance rate, is estimated. The bid curve is often called
the survival function because the curve has a downward slope similar to the typical
survival function, in which the vertical axis denotes the ratio of the respondents
willing to pay or accept the value of the target; this acceptance rate tends to decrease
as the value of WTP or WTA increases (see Fig. 3.14). The bid curve enables the
investigator to measure the median and average values of the WTP or WTA. Finally,
in the last step, the total value of the target is extended to accommodate the actual
population and evaluated based on the results of the WTP or WTA estimated under
the CVM.
The median and average values of the survey respondents’ WTP toward the target
can be measured using the bid curve in Fig. 3.14.4 As explained in step four of the
CVM, the bid curve is estimated based on the CVM survey data, where the horizontal

4The shape of the bid curve for the WTA will have a similar curve, thus only the case of WTP is
presented.
3.3 Stated Preference Method 75

axis presents the survey respondents’ WTP for the value of good or service to be
estimated, and the vertical axis denotes the ratio of respondents willing to pay the
amount of money presented in the questionnaire. In the figure, let the unit of the
WTP be US dollars. For example, at point A in the figure, 50 USD is the amount
of money presented to respondents in the survey, and 0.5 is the ratio of the number
of respondents who answered positively to the total number of survey respondents.
If the total number of survey respondents was 500, 0.5 of the vertical axis means
that 250 respondents answered “yes” to paying 50 USD for the good or service. The
median of the WTP is the value at which the acceptance rate is 0.5, thus 50 USD is
the median of the WTP in the figure. The average WTP is the expected WTP value
for all respondents. The total expected value of WTP corresponds to the shaded area
in the figure, and this value can be calculated as (1 − 0.2) × 80 ÷ 2 + 0.2 × 80 =
48.
As explained above, the CVM is a convenient instrument for estimating environ-
mental value by surveying respondents’ WTP or WTA. However, it can be difficult
to precisely estimate the value of the target because there are often cases in which the
respondents do not reveal their true WTP or WTA. This false reporting of WTP or
WTA frequently occurs in the CVM since the respondents are not required to make
the actual payment when they answer positively to paying in the survey.
The difference between the true WTP and WTP estimated by the CVM is called
bias. When using the CVM to evaluate the environmental value, we need to pay
attention to various biases that could arise when conducting a survey. These biases
are summarized in Table 3.1.
As shown in Table 3.1, strategic bias occurs when the respondent deliberately
answers a lower WTP against a good and service that will yield an adverse impact on
the respondent, such as an increase in future payments for environmental protection.
This type of bias can emanate in a case in which the respondents are the stakeholders
of environmental service. In such cases, they are responsible for covering the service’s
fee and their amount of payment will be determined based on the results of the CVM
estimation.
Part-whole bias originates when the scope of environmental value to be evaluated
differs between the investigator and respondent. For example, when measuring the

Table 3.1 Types of bias that could occur under the CVM
Strategic bias A bias that arises when the respondents intentionally overestimate or
underestimate the value to be estimated with the CVM
Part-whole bias A bias that occurs when there is a gap between the investigator and
respondent in the scope of the value estimated in the CVM
Payment vehicle bias A bias that arises when the respondents’ preference is affected by the
payment vehicle, such as donation, taxation, etc.
Hypothetical bias A bias that occurs in the WTP since the WTP in the CVM is not the
actual payment; it is only identified by the choice answered in the survey
Informational bias A bias that arises when the investigator cannot provide the correct
information about the value to be estimated with the CVM
Chapter 5
Economics
and Non-renewable/Renewable
Resources

Natural resources can be broadly classified into two categories. The first is non-
renewable resources such as oil, natural gas, gold, and silver, which take millions of
years to restore naturally once the resources are used. Non-renewable resources are
also known as depletable or exhaustible resources. The other is renewable resources
such as agricultural, forestry, and fisheries products. These resources will replenish
themselves in a finite amount of time. In this chapter, we study how economic models
can be used to determine the optimal level of use for these two types of resources.

5.1 Economics and Non-renewable Resources

A non-renewable resource is a resource that has a slow recovery rate; when the
resource is used, the amount of the resource available decreases. The quantity of a
given resource in period t can be expressed by Eq. (5.1).

Rt+1 = Rt − Q t + R (5.1)

In this equation, the quantity of a resource in period t is Rt , the quantity of the

resource in period t + 1 is Rt+1 , the change in the resource from period t to t + 1
is R, and the quantity of this resource used in period t is Q t . Because the amount
of resource recovery in a given period is very slow for a depletable resource and the
amount of change in the resource is R ∼ = 0, the amount of resource in period t +
1 for a non-renewable resource can be presented as Eq. (5.2).

Rt+1 = Rt − Q t (5.2)

Table 5.1 presents some examples of non-renewable resources. In the section

below, we examine the economically desirable level of use of these resources.

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 115
K. Aruga, Environmental and Natural Resource Economics,
https://doi.org/10.1007/978-3-030-95077-4_5
116 5 Economics and Non-renewable/Renewable Resources

Table 5.1 Examples of

Type of resources Examples
non-renewable resources
Energy resources Oil, natural gas, coal,
uranium, etc.
Mineral resources Copper, lead, zinc, rare
earth, etc.
Other types of non-renewables Aquifer water,1 fertilizer
resources, etc.

Fig. 5.1 Marginal cost and net benefit of a miner extracting a non-renewable resource

First, we consider an economic model to determine the optimal utilization path

for a non-renewable resource. Suppose that at time t, a mining company that is
making a profit by using a natural resource is selling the resource at price pt . Let the
quantity of the resource mined by this company be qt and the total cost of mining
be C(qt ). Then, when πt is the profit of the company, the profit can be denoted as
πt = pt qt − C(qt ). Thus, if the marginal net benefit and cost of this firm are MNBt
and MC(qt ), respectively, MNBt can be expressed by Eq. (5.3):

MNBt = pt − MC(qt ). (5.3)

Figure 5.1 illustrates the relationship between the marginal cost and the marginal
net benefit of Eq. (5.3). The marginal cost curve of the mining company is upward
sloping because the cost of mining generally increases as the level of natural resources
extracted from the mine increases. To understand why the marginal cost increases as
the volume of extracted resources increases, consider the case of crude oil mining.

1 Aquifer water is stored in deep underground strata; but, since it is groundwater that does not
receive natural recharge, water in aquifers diminishes in amount as its water use increases. Much of
the world’s irrigation depends on aquifer water, but recently, many aquifers are losing their water
due to increased groundwater exploitation.
5.1 Economics and Non-renewable Resources 117

The cost of extracting crude oil is comparatively cheaper when it is mined near the
surface, but as the mining progresses deeper underground, the cost of extraction
will increase because it becomes harder to find a purer crude oil and there will be
an additional cost to transport the oil from underground to the surface. Therefore,
as shown in Fig. 5.1, the marginal net benefit declines as the amount of extraction
increases owing to an increase in the marginal cost. Figure 5.1b shows a graph where
only the marginal net benefit is plotted. Similar to Fig. 5.1a, this figure shows that
the marginal net benefit decreases as the level of extraction increases.
Figure 5.1 depicts the relationship between the level of extraction and the marginal
net benefit obtained by the mining firm at a certain point t, but in reality, the miner
will continue to extract the natural resource until the natural resource is completely
depleted. How much of the natural resources should the miner extract in each period?
To answer this question, let us consider the optimal amount of extraction if a miner
intends to use the natural resource in two periods.
The optimal amount of extraction in the two periods is determined based on the
equi-marginal principle we explored in the emissions trading system in Chap. 2.
That is, the extraction is set at a point where the marginal net benefits of the first
and second periods become the same. Thus, denoting the marginal net benefits of the
first and second periods as MNB1 and MNB2 , respectively, the optimal extraction
level is determined at a point where the condition MNB1 = MNB2 holds. However,
this condition only sustains when the effect of interest on future value from resource
extraction is ignored. As explained in Sect. 3.4, to evaluate the marginal net profit
of the second period at present, the marginal net profit needs to be adjusted to the
present value. Hence, assuming the price and marginal cost of the resource for the
second period as p2 and MC(q2 ), respectively, and r as the interest rate, the present
value of the marginal net benefit of the second period becomes p2 −MC(q
1+r
2)
. Therefore,
PV
the marginal net benefit curve for the second period MNB2 can be drawn as a curve
shifting the MNB2 curve in Fig. 5.2 downward by 1/(1 + r). As a result, the optimal
extraction level is the point at which the MNB1 curve intersects the MNBPV 2 curve.
Point E ∗ in Fig. 5.2 represents the optimal extraction level when the resource is
extracted within two periods.

Fig. 5.2 Optimal extraction MNB for the MNB for the
level when the resource is first period second period
extracted in two periods

Shifting
118 5 Economics and Non-renewable/Renewable Resources

Based on this condition for deriving the optimal extraction level when the resource
is mined in two periods, the following equation is established:

p2 − MC(q2 )
MNB1 = p1 − MC(q1 ) = = MNBPV
2 . (5.4)
1+r

Generalizing this condition for the case when the extraction continues for period
t, the condition for the optimal extraction for the t period case is stated as Eq. (5.5):

pt+1 − MC(qt+1 )
MNBt = pt − MC(qt ) = = MNBPV
t+1 . (5.5)
1+r

The proof of this condition for period t is beyond the introductory economics level
set in this textbook, so please see Conrad (2010) if you want to learn the details of
this proof. By further transforming Eq. (5.5), the relationship presented in Eq. (5.6)
is obtained.
MNBt+1 MNBt+1 MNBt+1 − MNBt MNBt
MNBt = ⇔ = 1+r ⇔ = =r
1+r MNBt MNBt MNBt
(5.6)

Equation (5.6) points out that the optimal extraction path for the miner is to extract
the natural resource in a way where the marginal net benefits in each period grow at
the interest rate. This optimal condition for extracting non-renewable resources over
multiple periods—where the level of marginal net benefit should increase at the rate
of interest—is known as Hotelling’s rule, named after Hotelling (1931). When the
miner extracts the non-renewable resource based on Hotelling’s rule, the marginal net
benefit of each period needs to rise at the rate of interest; but, this requires a decrease
in the marginal cost of extraction for each period. For this purpose, the miner will
need to reduce the amount of extraction for each period because the marginal cost of
extraction increases as the level of extraction increases. Thus, to meet the condition
of Hotelling’s rule, the miner will extract a smaller amount of resources for each
period and extract less in the next period compared to the previous period.
Figure 5.3 illustrates the extraction path of the miner when it extracts the
non-renewable resource based on the Hotelling’s rule. Under this rule, because
(1 + r )MNBt = MNBt+1 , MNBt+1 > MNBt will hold. Hence, when assuming
pt = pt+1 = p, the marginal cost in period t must be larger than that for period t +
1. As the marginal cost increases with an increase in the extraction level, the amount
of resources extracted in period t + 1 becomes smaller than that extracted in period
t. Therefore, the figure shows that, under the Hotelling’s rule, the miner should take
the optimal mining path to extract a smaller level of resources for the next period (t
+ 1) relative to the previous one (t).
Having learned that the optimal extraction path under the Hotelling’s rule is to
decrease the amount of extraction over time, let us determine the optimal price
for this rule. For simplicity, I assume that the cost is constant over the periods in
5.1 Economics and Non-renewable Resources 119

Cost, benefit Cost, benefit

Extraction Extraction
level level

(a) Extraction level for period t (b) Extraction level for period t+1

Fig. 5.3 Extraction path of a miner based on the Hotelling’s rule

Extraction level Price

Time Time

(a) Optimal extraction path (b) Optimal price path

Fig. 5.4 Optimal extraction and price paths of a non-renewable resource

Eq. (5.4), such that MC(qt ) = MC(qt+1 ) = 0. Then, because MNBt = pt and
MNBt+1 = pt+1 , Eq. (5.6) can be expressed as Eq. (5.7):

pt+1 = (1 + r ) pt = (1 + r )2 pt−1 = (1 + r )t p0 (5.7)

where p0 is the initial price when the extraction started.

Let T and pT denote the terminal extraction period and its price, respectively.
Then, in the optimal extraction path, Eq. (5.7) shows that the price continues to rise
with the interest rate until it reaches pT . This price is called the choke price because
it represents the point at which all the resources are depleted and the price ceases to
rise.2 Figure 5.4 depicts the extraction and price paths of a non-renewable resource
until this terminal extraction period.

2Choke price is defined as the lower bound of price when the supply is zero. However, in the case
of non-renewable resources, it represents the upper bound when the production stops owing to an
exhaustion of the resource.
120 5 Economics and Non-renewable/Renewable Resources

Extraction level Price

Time Time

(a) Optimal extraction path (b) Optimal price path

Fig. 5.5 Optimal extraction and price paths after an increase in the resource reserve

The subsequent paragraph explains how these extraction and price paths change
under various conditions. First, let us examine a case illustrating a change in the non-
renewable resource reserve. Figure 5.5a shows that the discovery of a new resource
will increase the initial level of resources held by the miner. The shift from q0 to q0
in the figure shows this increase in the resource reserve. Because an increase in the
initial reserve shifts the extraction path upward, the volume of extraction for each
period will increase and the length of the extraction period will be extended from
T to T  . Meanwhile, the price path will shift downward owing to an increase in the
initial resource stock and resources extracted for each period (see Fig. 5.5b).
Second, let us examine the change in the marginal extraction cost. Assume that
there is a positive marginal extraction cost c where c = MC(qt ) = MC(qt+1 ), c > 0.
Consider a case when c increases to c . If the extraction is maintained at the same
level, then an increase in the marginal cost will lead to a decline in the net benefit
from mining. Hence, to sustain the net benefit at the same level as that before an
increase in the marginal cost, it will be crucial for the miner to lower its extraction
volume. Thus, as shown in Fig. 5.6a, an increase in the extraction cost will lower
the initial extraction level from q0 to q0 , and thereby lengthen the extraction period
from T to T  . Because an increase in the marginal cost increases the resource price
in each period, the optimal price path will shift upward to the gray line in Fig. 5.6b.
However, if the marginal extraction cost falls from c to c , for instance, owing to

Extraction level Price

Time Time

(a) Optimal extraction path (b) Optimal price path

Fig. 5.6 Optimal extraction and price paths after a change in the marginal cost of extraction
5.1 Economics and Non-renewable Resources 121

technological innovation, the marginal net benefit will increase by the amount of
the decrease in the marginal extraction cost if the extraction level is maintained at
the same level. Assuming that the net benefit is kept at the same level as the case
before the cost reduction, a decline in the marginal cost will increase the extraction
level from q0 to q0 and shorten the extraction period to T  . The price of the resource
for each period will become smaller and its path will shift down to the dotted line
presented in Fig. 5.6b, owing to the cost reduction for each period.
In the previous examples, we assumed that the miner was a competitive firm that
determined the resource price based on the principles of a competitive market. As a
third variation, let us consider how the extraction and price paths change in the case
of a monopoly market. As we learned in Sect. 2.1.2 of Chap. 2, a monopolistic firm’s
production level becomes lower than that of a competitive firm, and the monopolistic
firm seeks to sell the product at a price higher than that set by the competitive firm.
Figure 5.7 illustrates the levels of prices and quantities for the monopolistic and
competitive miners. PM and PC and Q M and Q C are the optimal prices and production
levels for the monopolistic and competitive miners, respectively. The monopolistic
miner extracts the resource at a level where the marginal revenue equals the marginal
cost, and the competitive miner sets its extraction level at the point where the demand
and supply curves intersect. Hence, Q M < Q C and PM > PC . Thus, as depicted in
Fig. 5.7b, the price path for the monopolistic miner will start at a higher point than that
of the competitive miner, and the length of extraction will become longer (T M > T C ).
Finally, let us address the question of whether the depletion of non-renewable
resources adversely impacts extraction. Nordhaus, one of the recipients of the 2018
Nobel Prize for Economics, pointed out that non-renewable resources such as crude
oil are unlikely to reach an endpoint where they are fully exploited, given that these
resources will be replaced by alternative resources based on new technologies such
as solar photovoltaics (PV) and other infinite renewable energy sources (Nordhaus,
1973). The new technology, called the backstop technology, produces a close substi-
tute to exhaustible resources using an alternative source called the backstop resource.
The word backstop literally refers to a barrier that is placed at the rear of something,
like a backstop net used in baseball. Here, it is used to refer to a technology that

Price Price

Quantity Time

(a) Price and production levels (b) Optimal price paths

Fig. 5.7 A comparison of monopoly and competitive markets and their optimal price paths
122 5 Economics and Non-renewable/Renewable Resources

Price Price

Time Time

(a) Price paths of natural gas and PV (b) Price path of the energy

Fig. 5.8 Backstop resource and the price path of energy

prevents the exhaustion of non-renewable resources by replacing them with new

alternative resources.
Figure 5.8 demonstrates an example of how the backstop technology can save
the conventional resources from complete exhaustion. In the figure, natural gas is
depicted as an example of a non-renewable resource, and the photovoltaic (PV)
system is taken as the backstop resource for natural gas. p gas and p PV are the prices
of natural gas and PV, respectively. The natural gas price follows the price path based
gas
on the Hotelling’s rule, starting at its initial price of p0 and increasing at the rate
gas
of interest until reaching pT —its choke price at the terminal point. The PV price
is assumed to be constant at p PV . Figure 5.8a shows that, after time T B , the price
of natural gas will become higher than that of PV ( p PV ). Thus, after T B , the PV
will become a major energy source, thus replacing natural gas. Therefore, as seen
in Fig. 5.8b, the energy price will not exceed p PV ; the PV will become the backstop
resource, preventing natural gas from reaching its final extraction period T.

5.2 Economics and Renewable Resources

A renewable resource is a natural resource that replenishes itself faster than it is

consumed, and hence, does not become exhausted. Recall that the amount of the
resource in period t + 1 is expressed as the following Eq. (5.1) introduced at the
beginning of Sect. 5.1:

Rt+1 = Rt − Q t + R. (5.1)

For the renewable resource to remain renewable, R > 0 and R ≥ Q t must

hold. If R < Q t , the level of the natural resource will decline in period t + 1,
and a continuation of this trend will exhaust the resource. Therefore, as shown in
Fig. 5.9, while the stock of non-renewable resources decreases with consumption,
5.2 Economics and Renewable Resources 123

Stock level Stock level

Accumulated Accumulate
consumption d

(a) Non-renewable resource (b) Renewable resource

Fig. 5.9 Stock of resources and accumulated consumption

the stock of renewable resources can increase or decrease depending on the volume
of resources recovered and consumed.
Renewable resources often exist on common property, such as common forests or
fishing grounds. In this context, it must be noted that the unsustainable use of shared
renewable resources can expose them to the risk of the tragedy of the commons.
Renewable resources are susceptible not only to overexploitation but also to factors
such as climate change and natural disasters. Therefore, how the level of these
resources changes is uncertain. Taking forest and fishery resources as representa-
tives of renewable resources, in this section, we will explore economically viable
and environmentally sustainable ways of managing these resources.

5.2.1 Economics and Forest Resources

Forests account for one-third of the global land area. In Japan, two-thirds of the land
area is covered with forests, which is about 25 million hectares. Figure 5.10 shows the
various functions of forests. Forests provide private goods such as timber and food.
They also play an important role as public goods by conserving the biodiversity,
protecting the environment, preventing landslides and natural disasters, providing
environmental amenities, and supporting our health and recreation.
In this section, I will introduce three economic models—maximum sustainable
yield (MSY), single rotation model (SRM), and Faustmann rotation model (FRM)—
explaining how the forest resources should be managed and used in an economically
optimal and sustainable manner. Before elaborating on these three models, let us
examine some basic concepts required to understand these models.
First, because the forest economics model examines the optimal harvest period,
it is necessary to understand the relationship between the timber age and the volume
that can be harvested from the forest at that age. Timber age refers to the age of
forest trees planted for harvesting wood when they reach maturity. The relationship
between the timber age and its volume at that age forms the growth function used
124 5 Economics and Non-renewable/Renewable Resources

Private good
Public good functions functions

Preserving Landslide Health and Cultural Productive

Biodiversity Groundwater Environmental
global and soil amenity
conservation recharge recreation function function
environment preservation

Surface Preserving
Mitigating scenery and Timber
erosion Flood
global prevention Supporting elegance
mitigation Controlling
Genetic warming health
temperature Food
recovery
Educational
Preventing support
surface Fertilizer
collapse Water
Absorbing
resource A place for
CO2
storage work
experience Feed
Preventing
Air Recuperation
Species other landslide
purification support Chemical and
disasters A place to get industrial
in touch with materials
Alternative Water volume nature
energy Preventing control
Greening
sediment run- materials
off A place for art
and religion
Ornamental
Stabilizing the Amenity plants
Ecosystem Water Recreation
global climate creation Preserving
Soil purification traditional culture
system preservation and regional Craft materials
diversity

Fig. 5.10 Functions of forests

for the analyses in the forest economics models. Given this, I introduce the growth
function of a timber stand.
Suppose that a logger is planning to plant trees on empty land. Let the time the
logger starts planting trees be t = 0, and let Q(t) denote the volume of wood that can
be harvested from the forest at period t. Then, the growth function of timber stands
can be expressed as follows:

Q = Q(t) (5.8)

The equation varies by the type of timber. However, it is often expressed as a

cubic function such as Q(t) = at + bt 2 − ct 3 where a, b, and c are constants, and as
an exponential function such as Q(t) = ea−b/t where b > a > 0. In the subsequent
part of this section, let us use this growth function to examine the MSY, SRM, and
FRM.
The Maximum Sustainable Yield (MSY) Model
The MSY model determines the maximum sustainable yield of a logger based on the
level of the growth of timber stands. The maximum sustainable yield is the maximum
amount of production that can be sustainably obtained without diminishing the forest
resources. In this book, it will be expressed as MSY taken from its acronym.
The MSY model has the following assumptions. First, it assumes that the logger
considers replanting the forest after the timbers are cut for harvesting. Second, the
logger seeks to maximize the average timber production. This average production
from the timber is called the mean annual increment (MAI); under this assumption,
the logger aims to maximize MAI to maximize the profit obtained from the timber
5.2 Economics and Renewable Resources 125

production. This goal can be expressed as Eq. (5.9) below, where t and Q(t) denote
the harvest cycle of timber stands and the total volume of the stands, respectively:

Q(t)
MAI = . (5.9)
t
Finally, this model also assumes that the logger maximizes the profit only from
the growth rate of timber, without considering the price of timber or the discounted
value of the investment when the timber is harvested, sold, and converted to cash.
Under these conditions, the profit maximization problem of the MSY model can
be stated as follows:
Q(t)
Max MAI = (5.10)
t t
where Max means to maximize the value with respect to t. Assuming that a timber
t
growth function is a cubic form as shown in Fig. 5.11a, the first-order condition
(FOC) of the MSY model can be expressed as Eq. (5.11):

dMAI Q  (t)t − Q(t) Q(t)

= =0⇔ = Q  (t). (5.11)
dt t2 t
Hence, the condition of the optimal harvest period for the logger’s MSY model
can be stated as Eq. (5.12)

Q(tMSY )
= MAI = Q  (tMSY ) (5.12)
tMSY

where tMSY denotes the optimal harvest period in the MSY model.
Equation (5.12) indicates that when the logger harvests the timber under the
MSY model, the optimal harvest period is determined at a point where the MAI
of the timber or the average timber growth equals the marginal growth rate of the

A line whose slope is

(a) Timber growth function (b) Optimal harvest period in the MSY

Fig. 5.11 Timber growth function and its optimal harvest period (tMSY ) in the MSY
126 5 Economics and Non-renewable/Renewable Resources

timber. This condition is illustrated in Fig. 5.11b. In Fig. 5.11a, b, tMax and Q Max
represent the harvest period and the production level of timber, respectively, when
the timber growth function reaches its maximum. However, they are not the optimal
harvest period and production level for the MSY model. The optimal harvest period
for the MSY becomes the point where the slope of a line connecting the origin and a
MSY )
point lying on the timber growth function ( Q(ttMSY ) equals the marginal growth rate

Q (tMSY ). Therefore, in the MSY model, the optimal harvest period comes before
the time when the timber growth reaches its maximum (tMax > tMSY ).
In practice, loggers’ harvest does not end in just one period; they reforest the
timber stands to continue the business, making the most of their land. Figure 5.12
presents a case when the logger’s harvest cycle continues multiple times under the
MSY model. t ∗ is the time taken for the timber to grow and reach the optimal harvest
period (tMSY ) in the model. Based on the assumption that the logger harvests its
timber based on the MSY, the second cycle will also take t ∗ to reach its harvest
period. Given this, the harvest cycle for the MSY becomes t ∗ , which represents the
length of time from planting a sapling to harvesting. Thus, the second and third
harvest periods become 2t ∗ , 3t ∗ , respectively, and so on.
Finally, I introduce the following numerical example to show how the optimal
harvest period can be determined using the MSY model.

A numerical example for the MSY model A logger’s production function

is denoted as Q(t) = e10−64/t where Q(t) is the timber volume, and t is the
monthly harvest period. Solve the optimal harvest period for this logger when
the logger’s decision to cut the timber relies on the MSY model.

First, the profit maximization problem of this example is Max Q(t)/t. Given that
t
the optimal condition in the MSY model is to equalize the average timber growth
(MAI) with the marginal growth rate (MGR) of timber, the optimal condition can be
stated as Eq. (5.13).

First cycle Second cycle Third cycle

Fig. 5.12 Logger’s harvest cycle in the MSY model

5.2 Economics and Renewable Resources 127

Q(t) Q  (t)
MAI = MGR ⇔ = Q  (t) ⇔ = 1/t (5.13)
t Q(t)

Applying Q(t) = e10−64/t and Q  (t) = 64/t 2 · e10−64/t to this equation gives

Q  (t) 64/t 2 · e10−64/t

= = 64/t 2 = 1/t. (5.14)
Q(t) e10−64/t

Solving for t in Eq. (5.14), t MSY = 64. Hence, the optimal harvest period can be
estimated as 5 years and 4 months, given t in this example is measured in months.
The Single Rotation Model (SRM)
In the third assumption of the MSY model, the loggers harvest timbers without
considering the investment value of the sold timber. In the single rotation model
(SRM), the loggers consider the forest resources as financial assets, and they aim to
maximize profits by investing the earnings obtained from harvesting their timbers in
a bank. The SRM also assumes that the logger does not plan to reforest timberland
but intends to maximize the profit from a single harvest. The term “single” in SRM
is also based on the assumption that the timber stands are harvested only once.
Under these assumptions, the profit maximization in the SRM can be denoted as
Eq. (5.15):

Max π = p Q(t)e−r t (5.15)

t

where π is the logger’s profit, p is the per-unit timber price, Q(t) is the timber
production volume, and r is the interest rate. The main difference between the SRM
and MSY models is that the SRM considers the investment value of the revenue
generated from the use of forest resources and that the price and interest rate affect
the logger’s decision to cut down the timber stands.
In Eq. (5.15), p Q(t) is the revenue obtained by selling the timber; however, in
the SRM, given that the logger’s decision is influenced by the future value of this
revenue when deposited in a bank, the revenue should be evaluated at its present
value (PV). Thus, in the SRM, when the interest is assumed to be a continuously
compounded one, the PV of the revenue from the timber is expressed as p Q(t)e−r t .
The reason for multiplying e−r t with the revenue is based on the fact that because the
revenue is deposited in a bank with a continuously compounded interest, the future
value (FV) of the timber revenue can be expressed as FV = PVer t . Multiplying e−r t
with both sides of this equation gives FVe−r t = PV, and hence, the future value of
the timber revenue is converted to PV, as seen in Eq. (5.15).
From Eq. (5.15), the FOC of the logger’s profit maximization problem is stated
as follows:
dπ
= p Q  (t)e−r t + p Q(t)(−r )e−r t = 0 (5.16)
dt
128 5 Economics and Non-renewable/Renewable Resources

By rearranging Eq. (5.16), we obtain:

p Q  (t) = r p Q(t). (5.17)

Equation (5.17) represents the optimal condition of harvesting for SRM, which
determines the optimal harvesting period.
To understand more about this condition, it is important to examine Fig. 5.13. In
the figure, p Q  (t) represents the marginal benefit of delaying the harvest because
it is the additional benefit obtained from the additional timber growth. Q  (t) is the
marginal growth rate of timber; hence, it represents the additional growth in the
timber volume when the time moves forward by one unit. By multiplying the timber
price to this marginal growth rate, we obtain the additional value gained from the
marginal change in the timber growth. Figure 5.11a shows that the timber growth
rate declines with time (Q  (t) < 0); hence, the p Q  (t) curve has a downward trend,
as depicted in Fig. 5.13. However, the right-hand side of Eq. (5.17) r p Q(t) denotes
the marginal cost of delaying the harvest. Given that p Q(t) is the profit earned from
selling the timber in period t, r p Q(t) represents the interest that could have been
earned if this profit were deposited in a bank. It is the foregone gain from the interest
that could have been earned if the harvest were conducted, and thus, r p Q(t) can
be viewed as the opportunity cost of delaying the harvest. Because Q(t) increases
with a change in time, r p Q(t) becomes an ascending curve on the right, as shown
in Fig. 5.13.
Therefore, the condition stated in Eq. (5.17) implies that the optimal harvest period
in the SRM is determined as the point where the marginal benefit and cost of delaying
∗
the harvest are equal. Confirming this in Fig. 5.13, we can see that, at time tSR , where
the marginal benefit curve (MB) and the marginal cost curve (MC) intersect, the total
welfare obtained from the forest resource is maximized.
∗
The equilibrium point tSR has another implication. To illustrate this, let us examine
Eq. (5.18), which can be derived by rearranging Eq. (5.17).

Q  (t)
=r (5.18)
Q(t)

Fig. 5.13 Optimal harvest Benefit, cost

period in the SRM
MB MC
5.2 Economics and Renewable Resources 129

Q  (t)
Q(t)
in this equation is the growth rate per unit of timber. Hence, this equation
indicates that, at the optimal harvest period, the growth rate per unit of timber matches
the interest rate. This leads to the question of what the logger should do if the growth
rate per unit of timber is not the same as the interest rate.
To answer this issue, we must understand the relationship between the interest
rate and the growth rate of timber. When the interest rate is high, it is more profitable
to cut and sell the timber in exchange for money that can be deposited in a bank in
order to earn this high interest. However, when the interest rate is low, it is more
profitable to delay the harvest because it is more profitable to let the timber grow and
wait until the interest rate becomes high.

(t)
Hence, when the interest rate is greater than the growth rate of timber ( QQ(t) < r ),
it is more profitable to cut down the timber and gain the money for investment.

(t)
However, when the interest rate is lower than the growth rate of timber ( QQ(t) > r ), it
is more profitable to delay the harvest and let the timber grow until the interest rate
becomes sufficiently high.
Finally, I explain how the optimal harvest period is determined in the SRM using
the following numerical example.

A numerical example for the SRM A logger’s production function is denoted

as Q(t) = e10−64/t where Q(t) is the timber volume, and t is the monthly
harvest period. Assume that the logger intends to sell each unit of timber for
USD 500 and that the continuously compounded interest rate in the bank is 4%.
When the logger is not planning to reforest timberland, find out the optimal
harvest period for this logger.

First, the profit maximization problem for this logger can be stated as
Max 500Q(t)e−r t .
t
Q  (t)
Thus, the FOC of this problem becomes 500 · Q  (t) = r · 500 · Q(t) ⇔ Q(t)
= r.
10− 64
Applying Q(t) = e10−64/t to this condition, 64/t10−·e 64
2
= 0.04 ⇔ 64 = 0.04.
t

e t t2
∗
Solving for t gives tSR = 40. Hence, the optimal harvest period in this SRM becomes
3 years and 4 months.
The Faustmann Rotation Model (FRM)
In the FRM, like the SRM, it is also assumed that the logger aims to maximize the
profit obtained from timber harvesting while considering the interest that could be
earned if the revenue from the forest resource is deposited in a bank. The main differ-
ence between the FRM and SRM is that the logger plans to reforest the timberland
after harvesting the timber stands and that the logger maximizes the profit when the
forest resource is managed over multiple periods, with the cycle of growing timber,
harvesting, and reforesting. The name Faustmann rotation model comes from the
130 5 Economics and Non-renewable/Renewable Resources

German forester, Martin Faustmann, who first derived this model in 1849 (Faustmann,
1968).
The profit maximization problem of a logger in the FRM is expressed as Eq. (5.19):
∞

Max π = p Q(t) e−r t , (5.19)
t
t=1

where the profit earned by the logger is π , the price per unit of timber is
p, the timber
production volume is Q(t), and the discount rate is r. Because Q(t) ∞ t=1 e
−r t
=
−r t
p Q(t) 1−e−r t = er t −1 , this equation can be rearranged as:
e p Q(t)

p Q(t)
Max π = (5.20)
t er t − 1

From Eq. (5.20), the FOC for profit maximization in the FRM becomes the
following:

dπ p Q  (t) p Q(t)r er t  p Q(t)r er t r · p Q(t)

= rt − rt = 0 ⇔ p Q (t) = = . (5.21)
dt e −1 (e − 1) 2 ert − 1 1 − e−r t

Transforming Eq. (5.21),

 
p Q  (t) 1 − e−r t = r · p Q(t) ⇔ p Q  (t) = r · p Q(t) + p Q  (t)e−r t . (5.22)
rt rt
Because Eq. (5.21) suggests p Q  (t) = p Q(t)r
er t −1
e
, p Q  (t) · e−r t = p Q(t)r
er t −1
e
· e−r t =
p Q(t)r  −r t
er t −1
p Q(t)
, we apply π = er t −1 from Eq. (5.20), p Q (t)e p Q(t)r
= er t −1 = πr . Applying
this term to Eq. (5.22), the optimal condition of harvesting timber under the FRM
can be stated as:

p Q  (t) = r p Q(t) + πr. (5.23)

Comparing this with Eq. (5.17), which gives the condition for optimal harvesting
in SRM, the only difference between Eqs. (5.17) and (5.23) is the π r part on the right-
hand side. As already explained, p Q  (t) on the left-hand side of Eq. (5.23) is the
marginal benefit (MB) gained by delaying the harvest, and r p Q(t) on the right-hand
side is the marginal cost (MC) of delaying the harvest. The additional component πr
represents the investment value of the timber when the timber is harvested multiple
times. In other words, π r represents the marginal opportunity cost of losing the future
benefits that could have been obtained if the harvest had been conducted. Thus, the
∗
optimal harvesting period for the FRM, tFR , is determined when the total marginal
cost of delaying the harvest, including this opportunity cost, equals the marginal
benefit of delaying it.
We graphically understood the meaning of the optimal harvest condition for the
SRM. Similarly, I would like to explain the optimal harvest condition of the FRM
5.2 Economics and Renewable Resources 131

using a figure. In Fig. 5.14, let MCFR and MCSR be the marginal cost curves for the
FRM and SRM, respectively. MCSR denotes r p Q(t), and MB is the marginal benefit
∗ ∗
of delaying the harvest denoting p Q  (t). tFR and tSR are the optimal harvest period
for the SRM and FRM, respectively. Because MCFR = MCSR + πr , the marginal
cost curve for the FRM is a curve that shifts the MCSR curve upward by πr . This
shift occurs because, in the FRM, there is a marginal opportunity cost π r, as shown
in Eq. (5.23), in addition to the normal marginal cost of delaying the harvest r p Q(t).
As shown in Fig. 5.14, this shift shortens the optimal harvest period for the FRM
∗ ∗
much more than that of the SRM (tFR < tSR ). Hence, in the FRM, the additional
opportunity cost of delaying the harvest incentivizes the logger to harvest the timber
stands earlier than they would in the case of SRM.
Finally, I would like to introduce a numerical example for the FRM and understand
how the optimal harvest period can be estimated for this case.

A numerical example for the FRM A logger’s production function is denoted

as Q(t) = e10−64/t where Q(t) is the timber volume and t is the monthly harvest
period. Assume that the logger intends to sell each unit of timber for USD 500
and that the continuously compounded interest rate in the bank is 4%. When
the logger is planning to reforest the timberland and cycles one’s harvest, find
out the optimal harvest period for this logger.

Stating r and p as the interest rate and price of timber, this maximization problem
 r p Q(t) Q  (t)
becomes Max eprQ(t) t −1 . From Eq. (5.21), p Q (t) = 1−e−r t , Q(t) = 1−e−r t . The produc-
r
t
tion function in this problem is the same as that in the example of SRM, and thus,
Q  (t) t2
Q(t)
= 64
t2
. Applying these conditions yields 64t2
= 1−e0.04−0.04t ⇔ 1−e−0.04t − 1600 = 0.

The optimal harvest period for FRM is obtained when t satisfies this equation.

Fig. 5.14 Optimal harvest Benefit, cost

period in the FRM

t
132 5 Economics and Non-renewable/Renewable Resources

Table 5.2 Per-unit timber

MSY SRM FRM
growth rate for the MSY,
Q  (tMSY ) Q  (tSR ) Q  (tFR )
SRM, and FRM Q(tMSY ) = 1
tMSY Q(tSR ) =r Q(tFR ) = r
1−e−r tFR

Because solving for t is difficult manually, I used the Solver Add-in in Microsoft
∗ ∼
Excel to solve this equation. Using Solver, tFR = 34.64. Thus, the optimal harvest
period for the FRM comes to around 2 years and 10 months, which confirms that
when the logger faces the same production function, the optimal harvest period for
the FRM is shorter than that for the SRM.
A Comparison of the Three Forestry Economics Models
Here, let us compare the MSY, SRM, and FRM and explain why the optimal harvest
period differs in these models. Let r be the rate of interest obtained when the timber
is converted into cash and deposited in a bank. Then, the per-unit timber growth rate
in the three forestry economics models can be summarized as in Table 5.2.
In this table, the per-unit growth rate for the MSY model can be obtained by
rearranging Eq. (5.11), where Q(t) t
= Q  (t). The growth rate for the SRM can
be derived from Eq. (5.18), and that for the FRM can be derived by transforming
p Q  (t) = r1−e
p Q(t)
−r t in Eq. (5.21).

Given that the average annual interest rate of managing financial assets can gener-
ally be more than 2%, and the average harvesting period of timber stands is more  than
1
50 years, tMSY < r . Furthermore, 1−er−r tFR > r because 1−er−r tFR − r = r er tFR1 −1 > 0.
  
Thus, QQ(t(tMSY
MSY )
)
< QQ(t(tSR
SR )
)
< QQ(t(tFR
FR )
)
, which indicates that tMSY > tSR > tFR .
The reason that the optimal harvest period for the MSY is the longest and that
for the FRM is the shortest is that the harvest period tends to become shorter as
the interest rate becomes higher. An increase in the interest rate implies an increase
in the opportunity cost of delaying the harvest. This is based on the fact that when
the interest rate is high, the amount of interest the logger can obtain from the cash
earned by selling the timber becomes high. Therefore, when the interest rate is high,
a profit-maximizing logger has the incentive to cut the timber stands. However, when
the interest rate is low, the opportunity cost of holding the forest is small, and hence
the logger will delay the harvest hoping for an increase in the interest rate in the
future.
Assuming the opportunity costs of delaying the harvest for the case of MSY,
SRM, and FRM as OCMSY , OCSRM , and OCFRM , respectively, the relationship
between these opportunity costs is OCMSY < OCSRM < OCFRM . The reason
tMSY > tSR > tFR sustains among the three forest economics models can be attributed
to this relationship between the opportunity costs of delaying the harvest.
5.2 Economics and Renewable Resources 133

Fig. 5.15 Logistic function

5.2.2 Economics and Fisheries Resources

This section focuses on the two fisheries economics models. The first model is the
open-access fisheries model where there is no property right in fishing. The other
model is the private property fisheries model with a property right in fishing and only
those with the property right can fish.
To understand these models, let us first understand the basic concepts such as the
growth function for the fisheries resources, production function, total revenue, and
the total cost for the fisheries. Subsequently, this section will introduce the fisheries
economics models for the open-access and private property fisheries and explore
their differences. Finally, it will focus on the management of the fisheries resources
and introduce some examples of Japanese fisheries management.
Growth Function for the Fisheries Resources
Fisheries’ growth function is a function expressing the changes in the volume of fish
stock in a certain marine area at a certain period. Specifically, if the level of the fish
stock (biomass) at period t and the rate of change in the fish stock are denoted as
X (t) and Ẋ (t), respectively, the growth function of the fish stock, F(X (t)), can be
stated as Eq. (5.24):

dX (t)
Ẋ (t) = = F(X (t)). (5.24)
dt
We assume that fish stock grows based on the logistic function, given that several
studies have shown that the population of living organisms usually follows the logistic
function.3 The logistic function has the shape shown in Fig. 5.15, where k is the
carrying capacity of the fish. The carrying capacity is the maximum population of
a species allowed in a particular habitat. When the growth rate of the intrinsic fish
population is r, the logistic function for the fish population can be expressed as

3The logistic function was developed by Verhulst (1845) and popularized by the study of Pearl and
Reed (1920).
134 5 Economics and Non-renewable/Renewable Resources

follows:
k
X (t) = (5.25)
1 + ce−r t

where c is a constant depending on the type of species.

0−k·(−r ce−r t ) r ·ce−r t ·k
We differentiate Eq. (5.25) by t, dX
dt
= (1+ce −r t )2 = (1+ce−r t )2
. From Eq. (5.25),
r ·ce ·k−r t r · X ·k
k−X
r (k−X )· k
because ce−r t = k−X
,
applying this yields (1+ce −r t )2 = 2 =
X
=
X
  { 1+( k−X
X )} ( )
k 2
X
r (k − X ) · X
k
= r X 1 − Xk . As a result, the growth function of the fish stock
becomes:

F(X (t)) = r X (1 − X/k). (5.26)

Figure 5.16 represents the relationship between the logistic function and the
growth function of fish stock.
A condition where the level of fish stock does not change with respect to changes
in time is called the steady state. There are two steady states in the growth function
of the fish stock. Let us examine them by referring to Fig. 5.17. The first steady state
occurs when there is no fish in the habitat such that X = 0. If 0 > X > k, then
Ẋ (t) > 0, and the growth rate of the fish stock reaches its maximum. This maximum
point is called the maximum sustainable yield, and this point is denoted as X MSY in
the figure. The fish stock continues to increase until it reaches its carrying capacity

Fig. 5.16 Logistic function

and growth function

X(t)
0
k

X(t)=

t
5.2 Economics and Renewable Resources 135

Fig. 5.17 Growth function of fish stock

point, X = k. This point where the stock level becomes equal to its carrying capacity
(X = k) is the second steady state. This point is a stable equilibrium, given that when
the stock level is on the left side of k, the stock level will increase until it reaches k,
and when the stock level exceeds k, the level will decrease and return to k. Therefore,
when the level of the fish stock is in the vicinity of this point, it converges to X = k.
To further understand the characteristics of the growth function, let us consider
a case when the fish stock is affected by the fishing activities. We will introduce
a more general fishery production function later. For simplicity, at this point, let
us assume that the catch function denoting the level of harvest by the fishery is a
constant, H = h(h > 0). Then, the relationship between the catch and fish stock
can be summarized as Fig. 5.18a, b on the basis of the level of catch by the fishery.
First, when the level of the fish harvest is H1 = h 1 in Fig. 5.18a, the fish stock
depletes. This is because when H1 > F(X ), the catch level is higher than the MSY—
significantly higher than the growth rate of the fish stock. Second, when H2 = h 2 in
Fig. 5.18a, the harvest level becomes equal to the level of fish stock at MSY such

F(X), H F(X), H

k k
0 X 0 X

(a) (b)

Fig. 5.18 Growth function of fish stock and fishery production function
136 5 Economics and Non-renewable/Renewable Resources

that H2 = F(X MSY ). In this case, both the fish harvest and the growth of fish stock
are maximized, and the catch continues at equilibrium. Finally, when the catch level
is 0 < H3 < F(X MSY ), there will be two equilibriums. As shown in Fig. 5.18b,
when H3 = F(X 1 ), any point to the left or right of the equilibrium H3 = F(X 1 ) will
deviate from the equilibrium. If the level of the growth rate of fish stock is to the left
of X 1 , the stock will continue to decline because H > F(X ). If the growth rate is to
the right of X 1 , the stock will increase because H < F(X ). Thus, this equilibrium is
considered unstable. However, when H3 = F(X 2 ) in Fig. 5.18b, any point left to the
equilibrium will move toward the equilibrium because H < F(X ), and points right
to the equilibrium will also converge toward the equilibrium because H > F(X ).
Therefore, a deviation from X 2 will lead to a movement toward the equilibrium point,
making the equilibrium stable.
Production, Revenue, and Cost Functions for the Fisheries
This section explains the fishery’s production function. As a premise, first, I will intro-
duce the harvest function of the fishery in general. In the harvest function explained
in Fig. 5.18, the level of the harvest was assumed to be a constant. However, now,
I introduce a harvest function comprising three elements—the levels of effort, fish
stock, and catchability. The effort is a variable reflecting the level of capital and
labor inputs, such as the number of fishing vessels, the number of days operated, the
size of the net, and the number of fishing gears used for catching fish. The fish stock
variable represents the level of fish stock in the habitat or fish ground, which has been
explained previously. The catchability variable represents the catch efficiency, which
refers to the probability of catching fish in the fishing jurisdiction. We assume this
variable to be a constant, though it can vary depending on the type of fish, fisheries,
and fishing grounds, among others. Under these assumptions, if the fishing effort, fish
stock, and catchability are denoted as E, X, and A, respectively, the harvest function
of the fishery can be expressed as follows:

H = Q(E, X ) = AE X. (5.27)

Using this equation, let us first examine the relationship between the fishing effort
and fish stock. Assuming that the harvest level is a constant H , the harvest function
can be written as Q(E, X ) = H = AE X . Then, the relationship between E and
X can be presented graphically as the one shown in Fig. 5.19. It is observable from
the figure that an increase in the fishing effort leads to a decline in the fish stock
level. This relationship is quite obvious because fishing effort (e.g., fishing vessels,
days operated, the size of the net, and the number of fishing gears) represents the
amount of capital and labor invested into fishing. Therefore, an increase in the capital
and labor invested into fish harvesting will increase the catch and, in turn, lead to a
decline in the fish stock in the fishing ground. Another interpretation of this graph is
that high fish stock levels in the fishing ground eliminates the need for the producers
to make high labor or capital investments into fishing. However, low fish stock levels
would require producers to expend more efforts into catching fish.
5.2 Economics and Renewable Resources 137

Fig. 5.19 Fishing effort and X

fish stock

Next, we would like to consider the relationship between the fishing effort and
harvest level. In Fig. 5.20, we assume that E 1 > E MSY > E 2 , where E is the slope of
the harvest function. The harvest function is depicted as the gray line in the figure.
It is discernible from the figure that the slope of this line shifts to the left with an
increase in the effort levels. We can see that the level of fish stock (X) decreases with
an increase in the fishing effort (E). In terms of the relationship between the fishing
effort and harvest level, it is observable that when HMSY = F(X MSY ) > F(X 2 ) = H2
(X < X MSY < k), an increase in the effort leads to an increase in the harvest.
However, when H1 = F(X 1 ) < F(X MSY ) = HMSY (0 < X < X MSY ), we can
see that the increase in the effort causes a decline in the harvest level. Therefore,
when the harvest function intersects the growth function (F(X )) on the right side of
X MSY , the fish harvest can be increased with an increase in fishing efforts. However,
when the harvest function intersects the growth function on the left side of X MSY ,

F(X), H

0 k X

Fig. 5.20 Fishing effort (E) and harvest level (H)

138 5 Economics and Non-renewable/Renewable Resources

the effort will not further increase, but rather decrease the fish harvest. The reason
for this relationship is that, when moving along the growth function from the right
to the left, the growth rate of the fish stock starts diminishing when the level of the
stock falls below X MSY . At this stage, an increase in the rate of a catch will exceed
the growth rate of the fish stock.
Finally, I derive a fishery’s production function when the harvest function is stated
as AE X . In the presence of fishery, because the changes in the fish stock level will
be reduced by the amount of the fish harvest, the changes in the fish stock stated in
Eq. (5.24) can be stated as follows:

dX (t)
Ẋ (t) = = F(X (t)) − Q(E, X (t)) (5.28)
dt
where Q(E, X (t)) denotes the harvest function.
Here, the catch is determined at the intersection between the harvest and growth
functions. At this point, the level of fish stock would be in a steady state, which
means that there would be no change in the fish stock such that Ẋ (t) = 0. Thus, the
following equation can be obtained:

Ẋ (t) = F(X (t)) − Q(E, X (t)) = 0 ⇔ F(X (t)) = Q(E, X (t)) (5.29)

Applying F(X ) = r X (1 − X/k) and Q(E, X ) = AE X provided in Eqs. (5.26)

and (5.27), this equation can be written as

r X (1 − X/k) = AE X. (5.30)
 
Solving Eq. (5.30) for X gives X = k 1 − AE
r
; applying this to Q(E, X ) =
AE X , the following equation can be derived:
 
AE
Q = Ak E 1 − . (5.31)
r

This equation represents the relationship between the harvest level (catch level)
and the fishing effort, which is the production function for the fishery. Figure 5.21
illustrates this production function.
Now, let P be the price of the fishery product. Then, based on this fishery’s
production function, the total revenue curve of the fishery can be expressed as
Eq. (5.32):
 
AE
TR = P Q(E) = P · Ak E 1 − . (5.32)
r

The total revenue curve can be illustrated by shifting the production function
upward by the amount of price multiplied by the production level, and hence it can
be presented as Fig. 5.22a.
5.2 Economics and Renewable Resources 139

Fig. 5.21 Production

function for the fishery

0 E

E
0 0 E

(a) Total revenue curve (b) Total cost curve

Fig. 5.22 Total revenue and cost curves for the fishery

Finally, assuming c as the per-unit cost of putting the fishing effort, the total cost
curve can be written as Eq. (5.33)

TC = cE. (5.33)

The total cost curve becomes the line depicted in Fig. 5.22b.
In the subsequent section, I introduce the fisheries models for the cases of open
access and private property and explain the optimal behavior for the fisheries in these
models.
An Open-Access Fishery Model
An open-access (hereafter, OA) fishery is a fishery where anyone can freely access
the marine resources in the fishing grounds. In other words, on such grounds, all
fishermen have the right to access (use) the resources. New fishermen enter these
fishing grounds to exploit the profit-making opportunities. These grounds continue
to attract new fishermen until the total revenue equals the total cost, and there is no
opportunity to gain profit. Thus, Eq. (5.34) holds in the long-run equilibrium of an
OA fishery.
140 5 Economics and Non-renewable/Renewable Resources

Fig. 5.23 Fishing effort at TR,TC

the equilibrium for the OA
fishery

0 E

TR = TC (5.34)

where TR and TC are the total revenue and cost, respectively, for the fishery.
Applying therelationship
 presented in Eqs. (5.32) and (5.33), Eq. (5.34) can be
stated as P Ak E 1 − AE
r
= cE. Solving this equation for E yields:

∗ r c
E OA = 1− (5.35)
A P Ak
∗
where E OA is the optimal fishing effort for the OA fishery in the equilibrium.
Figure 5.23 illustrates this equilibrium, given the total revenue and cost curves stated
in Eqs. (5.32) and (5.33).
Next, using Fig. 5.24, we will examine how the production levels of the OA fishery
change with a price change. Subsequently, we will discuss the shape of the supply
curve for the OA fishery. From Eq. (5.32), Fig. 5.24a depicts the total revenue curve
when the price of a fishery product is 1. Given that P Q = Q when P = 1, this curve
is the same as the fishery’s production function demonstrated in Fig. 5.21. Therefore,
the production levels in Fig. 5.24b–d at the equilibrium point are determined at the
point where the fishing efforts identified from the intersection of the total revenue
and cost curves in each figure are stretched vertically and meet the production curve
illustrated in the black curves. The equilibrium point in Fig. 5.24b–d shows how the
production levels at the equilibrium change with a price change.
Figure 5.24b graphically demonstrates that when the price is 0.5, the equilibrium
fishing effort E 1 is smaller than E MSY . Figure 5.24c, d depict the graphs when
the prices are 1.5 and 2, respectively. In these cases, both equilibriums E 2 and E 3
are larger than the E MSY . Comparing the production levels for Fig. 5.24b–d, it is
observable that Q 1 > Q 2 < Q 3 . In a general supply curve, production volume
increases with a rise in price. However, in this figure, the production volume does
not increase according to the rise in price. The production levels do not increase
continuously with an increase in price in the supply curve of the OA fishery because
when the effort level exceeds the maximum sustainable yield (E MSY ), the production
does not increase with additional efforts. This stagnation in the production with an
increase in effort is related to the decline in stock resulting from increased fishing
5.2 Economics and Renewable Resources 141

(a) (b)

(c) (d)

Fig. 5.24 Effects of the price change on the production level in the OA fishery

efforts beyond E MSY . As seen in Fig. 5.24c, d, when the fishing effort exceeds E MSY ,
the production level has a declining trend relative to the price increase. Therefore,
the OA supply curve has a form where the production level continues to increase
with a price increase until it reaches the production volume of the MSY, but it begins
to decrease with the price when it exceeds the MSY.
Using a numerical example, the supply curve for the OA fishery can be illustrated,
as in Fig. 5.25. The curve depicts a case when the intrinsic fish population r = 0.5,
fish catchability coefficient A = 0.001, per-unit cost of effort c = 5, and carrying
capacity of the fish k = 100. As seen in the figure, the supply curve for the OA has a
backward bending shape, which, as mentioned earlier, has a normal upward trend with
a price increase until the production level reaches the MSY (Q MSY ). However, the
supply curve starts to have a downward slope when the production continues beyond
142 5 Economics and Non-renewable/Renewable Resources

The supply curve is downward sloping

because the fish stock is declining owing
to overfishing from increased effort.

The supply curve has the

normal upward trend
where more efforts are
added when the price
increases, and this increase
in the effort level increases
the production.

Fig. 5.25 Supply curve for the OA fishery

the level where too much fishing effort is invested; this overfishing leads to a decline
in the fish stock. When the fishing effort exceeds E MSY , the harvest level exceeds the
growth rate of the fish stock. Hence, although the fishery adds effort to increase its
production when the price increases, it fails to increase the production owing to the
scarcity in the fish stock. Therefore, in its price and production relationship, the OA
supply curve reflects the effects of resource scarcity owing to overfishing.
Finally, let us examine
 the
 OA supply curve using an equation.
 Given that
∗
Q = AE X = Ak E 1 − AE from Eq. (5.31), applying E = r
1 − c
from
r    OAc  A  P Ak c 
Eq. (5.35) yields Q OA = Ak · A 1 − P Ak · 1 − r · A 1 − P Ak = kr 1 − P Ak ·
S r c A r
 
c
P Ak
= Pr cA 1 − P cAk . Thus, the OA supply curve can be expressed as Eq. (5.36).

rc  c
Q SOA = 1− (5.36)
PA P Ak

A Private Property Fishery Model

In the private property (PP) fishery, only producers with fishing rights can catch
fish from the fishing grounds. This fishery imposes restrictions on the number of
producers that can enter the fishing ground or the volume of catch; the producers
can gain positive profit from the fishery. Thus, the producers in this fishery face the
same profit maximization problem as an ordinary producer in microeconomics such
that its profit maximization problem can be stated as Max π (E) = TR(E) − TC(E).
E
The FOC for this problem is dπ/dE = 0 ⇔ dTR(E) dE
− dTC(E)
dE
= 0. Therefore, the
condition of the long-run equilibrium in the PP can be expressed as follows:

MR = MC, (5.37)
5.2 Economics and Renewable Resources 143

where MR and MC are the marginal revenue and cost of the fishery, respectively.
When assuming
 the same production function as that of the OA fishery,
 because
TR = Pak E 1 − AE r
from Eq. (5.32), MR = dTR
dE
= P Ak 1 − 2 AE
r
. Similarly,
because TC = cE from Eq. (5.31), dTC = c. Applying these results into Eq. (5.37),
  dE
P Ak 1 − r = c. By solving for E, the optimal fishing effort for the PP fishery
2 AE

becomes
∗ r  c
E PP = 1− (5.38)
2A P Ak
∗
where E PP denotes the optimal fishing effort for the PP fishery.
Figure 5.26 illustrates the equilibrium fishing effort for the PP fishery. The figure
also demonstrates the equilibrium effort for the OA fishery. It is discernible from
the figure that the level of effort at the equilibrium for the OA fishery is higher than
that for the PP fishery. This becomes
 evident by
 comparing
 Eqs. (5.35) and (5.38),
∗ ∗
given that E OA = Ar 1 − P cAk > E PP = 2rA 1 − P cAk . The OA fishery invests a
higher fishing effort than that of the PP fishery, at the equilibrium, because the OA
fishery does not have any entry barriers. This aspect makes the competition among
the fishermen of the OA fishery more intense than that among the fishermen of the
PP fishery. Thus, in order to gain an advantage over other fishermen, the producers
put more fishing efforts in the OA fishery, which causes the fish stock in the fishing
ground of the OA fishery to become smaller than that in the PP fishery (X OA < X PP ).
Next, I describe the supply curve for the PP fishery. To understand how the changes
in the fish price affect the production level for the PP fishery, let us examine Fig. 5.27.
Similar to Fig. 5.25a, Fig. 5.27a shows the total revenue curve when the fish price is
1, which is equivalent to the fishery’s production function, given that when P = 1,
P Q = Q. The production levels at the equilibrium in Fig. 5.27b–d (Q 1 to Q 3 ) are
determined by stretching the effort levels at the equilibrium (E 1 to E 3 ) vertically until
they intersect with this production function drawn using black lines. Figure 5.27b–d
show that an increase in the price from 1 to 2, leads to a continuous increase in the

Fig. 5.26 Comparison of TR

the optimal fishing effort for
the OA and PP fisheries

0
144 5 Economics and Non-renewable/Renewable Resources

(a) (b)

(c) (d)

Fig. 5.27 Effects of the price change on the production level in the PP fishery

equilibrium fishing efforts. It is also observable that an increase in these efforts with
price leads to an increase in the production levels at the equilibrium. In the PP fishery,
this positive relationship between the production level and price continues until it
reaches E MSY , the effort level at the maximum sustainable yield. Thus, the supply
curve for the PP fishery is situated upward to the right, similar to the general supply
curve in economics where an increase in the price leads to increased production.
To draw an example of the supply curve for the PP fishery, consider a case where
r = 0.5, A = 0.001, c = 5, and k = 100. These numbers are the same as those
for the OA supply curve shown in Fig. 5.25. Using these figure, the PP supply curve
can be expressed as Fig. 5.28. Unlike the OA supply curve, it is apparent that the
positive relationship between the price and production levels continues for the PP
supply curve.
5.2 Economics and Renewable Resources 145

200
180
Production increases with price,
160 and this relationship continues
140 until it approaches the maximum
sustainable yield .
120
100
80
60
40
0 2 4 6 8 10 12 14

Fig. 5.28 Supply curve for the PP fishery

Finally, let us derive the equation for the PP supply curve. From Eqs.
 (5.31)

∗
and (5.38), Q = AE X = Ak E 1 − AE r
and E PP = 2rA 1 − P cAk .
∗
Applying the optimal
 effort
 level E PP into the production
  function
 gives

Q PP = Ak · 2 A 1 − P Ak · 1 − r · 2 A 1 − P cAk = kr2 1 − P cAk · 21 1 + P cAk =
S r c a r
 2
kr
4
1 − P cAk where Q SPP denotes the production level for the PP fishery.
Therefore, the supply curve for the PP fishery can be expressed as follows:
  c 
kr 2
Q SPP = 1− (5.39)
4 P Ak

Fisheries Management
Fisheries regulations can be broadly classified into three categories as shown in
Table 5.3. The first type is input control where the regulations are enforced to the
entry side of the fisheries. For example, there are regulations for controlling the
size and number of vessels used for capturing marine resources. The second type of
regulation deals with controlling the technical aspects, such as setting limitations for
the size of nets, types, and sizes of fish, and restricting the fishing periods. Finally,
the third type of control is the output control focusing on the exit side of fisheries,
such as limiting the volume of landings. All of these efforts limit the amount of
fishing effort (E), fish harvesting levels (X), and the efficiency of the catch (A),
which are the factors that determine the production levels of the fishery we studied
in the fisheries economics model. Because the amount of fish harvested mostly relies
on these factors, these regulations can be used to control the levels of catch in the
fishing ground.
146 5 Economics and Non-renewable/Renewable Resources

Table 5.3 Types of regulations for controlling the fish stock

Types of controls Contents Examples
Input control Regulations influencing the Controlling the number of vessels,
preharvest stage of fisheries, such as vessel size, fishing days, and fishing
limitations on the number of vessels gears, among others
deployed (entrance regulations)
Technical control Regulations influencing the harvest Controlling the type and size of fish,
stage of fisheries, such as limitations fishing season, and fishing gears,
on the size and type of fish that can among others
be caught
Output control Regulations influencing the Controlling the daily landings,
post-harvest stage of fisheries, such enforcing seasonal, and areal
as limitations on the number of fish limitations
landings (exit regulations)

Next, I show how the regulations are implemented in fisheries management.

The types of fisheries management may vary depending on whether the regulatory
authority, such as the government or the local community, involved with fishery,
takes the initiative of managing the fishery. As shown in Table 5.4, under top-down
management, regulations are enforced by the top government authorities, whereas,
under bottom-up management, the rules are created and implemented voluntarily
by the local community. In this type of management, the rule is often based on the
customs established by the local fisheries in the region. The third type of management
is comanagement involving a hybrid of top-down and bottom-up approaches—both

Table 5.4 Basic forms of fishery management

Types of management Contents Examples
Top-down management Fisheries management where Total allowable catch (TAC),
the management rules are individual quota (IQ),
determined and applied by the individual transferable quota
top regulatory authorities such (ITQ), and TAE (total
as the central or local allowable effort)
governments
Comanagement Fisheries management where Community-based fisheries
both the regulatory authority management (CBFM)
and the local community are
involved in determining and
applying the management
rules. It involves a hybrid
approach of top-down and
bottom-up management
Bottom-up management Fisheries management where Territorial use rights in
(autonomous management) the management rules are fisheries (TURFs)
determined and applied
voluntarily by the local
community
5.2 Economics and Renewable Resources 147

the top authority and the local community collaboratively establish and enforce the
rules.
A typical example of the top-down approach is the total allowable catch (TAC)
system. Under this, a maximum allowable catch is set for different types of fish
species in the fishing ground. In Japan, TACs are currently set for eight species:
horse mackerel, mackerel, Japanese anchovy, saury, pollock, snow crab, Japanese
flying squid, and bluefin tuna. The TAC system is effective in that it ensures that the
total catch is kept below the regulator’s target level. However, this system drives the
producers to catch the fish as quickly as possible before the total quota is reached,
which leads to a race to fish first. This is why the TAC system is also ironically called
the derby system or the Olympic system because the system only intensifies the
competition to fish fast. To overcome this shortcoming of the TAC system, several
countries have implemented the individual quota (IQ) and individual transferable
quota (ITQ) systems. The IQ system allocates quotas to fishermen based on the
TACs, and thereby eliminates the race to fish first. The ITQ system advances the IQ
system in that it allows the producers to exchange the quotas. It often allows producers
unwilling to continue the fishing business to sell their entire quota to anyone who
wants to enter the fishery.
Such a market system has not yet been applied to Japanese fisheries. Traditionally,
Japanese fisheries have mostly implemented the bottom-up approach. The reason the
top-down approach has not achieved popularity in Japan is that each local region has
its own rules regarding fishing gear, no-fishing zones, and landing regulations, and
the government has never seen the need to impose new rules to intervene with the
already established local rules. However, owing to the recent trend of aging of people
engaged in fisheries and the depopulation of the local fishing communities, it has
become difficult for communities to manage their fisheries by themselves.
In this regard, the top-down approach can be advantageous in that it can facilitate
consistency in the rules applied for all fishermen, making it easier to achieve the
regulator’s goal of recovering the fish stock. However, it may create problems; for
example, monitoring the implementation of rules can increase regulatory costs and
severe regulations can put pressure on the livelihood of fishermen. Although the
ITQ system is economically efficient, it can cause institutions with a large capital to
monopolize the fishing quotas. It is important to implement effective rules to regulate
monopolization in order to conserve local fisheries operating under the ITQ. The
bottom-up approach of controlling the marine resources has also been disrupted by
an aging population and the depopulation of the local community. Given that both
the top-down and bottom-up approaches suffer from issues, the Japanese Fisheries
Agency suggests using the comanagement method combining the advantages of
both, the top-down and bottom-up approaches. This method can contribute toward
the effective management of the Japanese fisheries (Fisheries Agency, 2010).

Exercise 5.1
Suppose that the price of a certain resource in the first period is p1 and the amount
of resource extracted by a mining firm in this period is q1 . If the total cost curve TC
in period 1 is shown by the following equation, answer the following questions:
148 5 Economics and Non-renewable/Renewable Resources

TC = 2q12 + 4

It is assumed that the amount of resource extracted by the firm is equivalent to

the firm’s production level.
a. Solve the firm’s net marginal benefit in the first period.
b. Let p1 = 20, q1 = 2.5 and let the interest rate r be r = 0.1. If the firm extracts
the resource based on the Hotelling’s rule, solve the firm’s net marginal benefit
in the second period.
c. Say P R denotes the price of renewable energy that can become a substitute for
the resource in this exercise and suppose P R = 14. Solve the period when the
resource will be replaced by this renewable energy.

Exercise 5.2
Let Q(t), P, c, and r be the growth function of timber, timber price, replanting cost
of timberland, and interest rate, respectively. Answer the following questions:
a. State the logger’s economic problems for the case of single rotation and
Faustmann rotation models. Then derive the optimal conditions in these models.
b. Explain how the cost of planting a timber forest affects the harvest period in the
Faustmann rotation model.

Exercise 5.3
Suppose that the level of timber growth of a forest can be expressed as Q(t) =
200t + 5t 2 − 0.04t 3 . Answer the following questions:
a. Plot the timber growth function from t = 0 to t = 150 using MS Excel.
b. Use the MS Excel Solver Add-in to find the optimal harvest period for the case
of maximum sustainable yield, tMSY .
c. When the interest rates are r1 = 0.04 and r2 = 0.02, use the MS Excel Solver
Add-in to find the optimal harvest period for the SRM and FRM. Explain the
reason for the difference between the harvest periods when the interest rate
increases from 0.02 to 0.04.

Exercise 5.4
When the growth function of the fishery resource, the production function of the
fishery, and the cost function of the fishery are given as F(X ) = 0.4X (1 − X/200),
Q(E, X ) = 0.001E X , and T (E) = 10E, solve the following questions. It is
assumed that X and E are the amounts of fish resource and fishing effort, and the
price per unit of fish resource is P.
a. Find the supply function when there are no fishing rights in the fishing ground
of an open-access fishery.
b. Find the supply function for the case where fishing rights exist in the private
property fishery.
5.2 Economics and Renewable Resources 149

c. If P = 100, compare the production levels between the open-access and private
property fisheries and explain the reason for the variance in the production levels.

References

Conrad, J. M. (2010). Resource economics (2nd ed.). Cambridge University Press.

Faustmann, M. (1968). Calculation of the value which forest land and immature stands possess for
forestry. In M. Gane (Ed.), Allgemeine Forst- und Jagdzeitung, 15 Dezember 1849 (W. Linnard,
Trans.) (pp. 27–554).
Fisheries Agency (2010). 2010 white paper on fisheries (in Japanese). Retrieved November 8, 2021,
from https://www.jfa.maff.go.jp/j/kikaku/wpaper/h22
Hotelling, H. (1931). The economics of exhaustible resources. Journal of Political Economy, 39,
137–175.
Nordhaus, W. D. (1973). The allocation of energy resources. Brookings Papers on Economic Activity,
3, 529–570.
Pearl, R., & Reed, L. J. (1920). On the rate of growth of the population of the United States since
1790 and its mathematical representation. Proceedings of the National Academy of Sciences of
the United States of America, 6, 275–288.
Verhulst, P.-F. (1845). Recherches mathematiques sur la loi d’accroissement de la population.
Nouveaux Mémoires de L’Académie Royale des Sciences et Belles-Lettres de Bruxelles, 18, 1–38.
Appendix
Solutions to Exercises

Chapter 2

Exercise 2.1

a. Price: 4, quantity: 6
The producer’s total cost curve can be derived from the average cost curve:
TC = AC· Q = 21 Q 2 −2Q. Thus, the marginal cost curve is C = ∂TC ∂Q
= Q −2.
The optimal quantity in a perfect competition market is the intersection of this
marginal curve and the demand curve. The demand curve is given as Q = 10−P,
P = 10 − Q. Thus, by solving 10 − Q = MC = Q − 2, the optimal quantity
is Q C = 6. Applying this to the demand curve, the optimal price is PC = 4.

© The Editor(s) (if applicable) and The Author(s), under exclusive license 179
to Springer Nature Switzerland AG 2022
K. Aruga, Environmental and Natural Resource Economics,
https://doi.org/10.1007/978-3-030-95077-4
180 Appendix: Solutions to Exercises

b. Price: 6, quantity: 4
The condition of profit maximization for a monopoly market is marginal revenue
(MR) equals marginal cost (MC). Since the total profit TR can be calculated
as TR = P Q = (10 − Q)Q, MR = ∂TR ∂Q
= 10 − 2Q; hence, by solving
MR = 10 − 2Q = MC = Q − 2, the optimal quantity is Q M = 4, and the
optimal price is PM = 10 − 4 = 6.
c. Deadweight loss: 4
The deadweight loss (DWL) from a monopoly is the area of triangle ABC.
Hence, DWL = P M − 2 · 22 = 4.

Exercise 2.2

a. Social damage: 16/3

The private marginal cost (MPC) can be derived from the private cost function
MPC = ∂PC ∂Q
= Q + 1. Since the external cost is given as 4Q, the social cost Cs
becomes Cs = CP + 4Q = 21 Q 2 + 5Q. Thus, the marginal social cost (MCS)
is MSC = ∂SC∂Q
= Q + 5.
Plotting the MPC and MSC with the demand curve, social damage (SD) will
be the areaof triangle
 1 ABC in the figure above. By calculating this area, SD =
(11 − 7) · 6 − 10 3
· 2
= 16
3
.
b. 10/3
To internalize the externality, social damage needs to be diminished. For this
purpose, the regulator needs to restrict the production level from point A to
point C. The production level of C can be obtained by solving the intersection
of the marginal social curve and the demand curve. Hence, the regulator should
reduce the production level to 10/3.
Appendix: Solutions to Exercises 181

c. T =4
To reduce the level of product from point A to point C by a Pigouvian tax, the
marginal private cost (MPC) curve needs to shift to the marginal social cost
(MSC) curve. Hence, the tax level is the difference in the intercept between the
MSC and MPC, which is T = 5 − 1 = 4.
d. 40/3
In this problem, all the tax revenue will be used to diminish environmental
pollution. Since T is a per-unit tax, and the production level is 10/3, the tax
value is 4 · 10
3
= 40
3
.

Exercise 2.3

a. E A = 24, E B = 36
Based on the equimarginal principle

3 A 2
MAC A = MAC B ⇔ E = EB (1)
5 5
Since the total allowable emissions are restricted to 60,

E A + E B = 60 (2)

Solving Eqs. (1) and (2), E A = 24, E B = 36.

b. Factory A will buy 16 units of emissions credit from factory B.
Factory A’s actual emissions are 40, which is larger than the emissions credit
obtained.
Since A’s emissions credit is 24 from the result of problem a, factory A needs
to buy 16 credits from factory B.
182 Appendix: Solutions to Exercises

c. A’s benefit: 384/5; B’s benefit: 256/5

From the figure, the benefits obtained by the emissions trading for factories A
and B correspond to the areas of acd and abc.
Hence, acd = ( 5 ) = 384 , and abc = ( 5 )
24− 72 ·(40−24) 72
−8 ·(36−20)
2 5 2
= 256 .5

Chapter 3

Exercise 3.1
a. WTP = 30.
Let F, F  denote the areas in which the areas of forest restored are 4 ha and
10 ha, respectively.
Based on the definition of WTP, the utility before the change should be equal
to the utility after the change when the WTP is subtracted from the amount of
money initially possessed. Thus, the following equation holds:
 
U (F, M) = U F  , M − WTP .
1 1 1 1
Insert the provided numbers into this equation, 4 2 50 2 = 10 2 (50 − WTP) 2 .
Hence, WTP = 30.
b. WTA = 75
The WTA will be the amount received to maintain the level of utility when the
forest restoration project is not canceled. Thus, the utility when the project is
executed equals the level of utility when
 theWTA is added to the initial money
possessed, which can be stated as U F  , M = U (F, M + WTA).
1 1 1 1
Insert the provided numbers into this equation, 10 2 50 2 = 4 2 (50 + WTA) 2 .
Hence, WTA = 75.
c. If Andie’s preference is affected by loss aversion, the WTA becomes higher
than the WTP, because more money is required to accept the loss of utility from
the cancelation of the forest restoration project than the money willing to be
paid for restoring the forest. If Andie thinks that the forest cannot be perfectly
restored by money, then the forest and money are not perfect substitutes. Thus,
the WTA tends to be higher than the WTP.
Appendix: Solutions to Exercises 183

Exercise 3.2

a. 122.5
The value of the wetland corresponds to the sum of the gray triangle and shaded
area.
Thus, it can be calculated by
(75 − 40) · 27 = 122.5.
b. 82.5
The economic loss from this project corresponds to the shaded area, which can
be obtained by subtracting the gray triangle area from the area estimated in
problem a: 122.5 − (60 − 40) · 24 = 82.5.

Exercise 3.3
184 Appendix: Solutions to Exercises

a. d=3
Insert
 the hedonic price into the utility function, u = d · (66 − 3 p) =
d 66 − 2d 2 − 12 = 54d − 2d 3 .
du
Since the first-order condition of utility maximization is dd = 0,

du
= 54 − 6d 2 = 0
dd
as d is assumed to be positive, d = 3.
b. 28
When the diversity level doubled, d = 6. Thus, the land price of the forest is
p = 23 · 36 + 4 = 28.
c. 12
When d = 3, p = 23 · 32 + 4 = 10. Thus, u( p, d) = u(10, 3) = 3 · (66 − 30) =
108.
If d = 6, since u = 108 = 6(66 − 3 p), p = 16. Therefore, the amount of land
price overestimated is 28 − 16 = 12.
d. 4
The land price of the forest was 10 when d = 3 and 16 when d = 6. Hence, the
individual’s willingness to pay for doubling the diversity level is 16 − 10 = 6.

Exercise 3.4

a. 57.5
The median WTP is the WTP when the acceptance rate is 0.5. Using the simi-
larity between triangles ABC and EDC, 0.6 − 0.2: 0.5 − 0.2 = 80 − 50: DC ⇔
4: 3 = 30: DC.
Appendix: Solutions to Exercises 185

Thus, DC = 22.5, B D = 30 − 22.5 = 7.5, and the median WTP = 50 + 7.5 =

57.5.
b. 52
The average WTP corresponds to the areas of gray and shaded trapezoids. The
area of the gray trapezoid is (1.0 + 0.6) · 50
2
= 40. The area for the shaded
(80−50)
trapezoid is (0.6 + 0.2)· 2 = 12. Thus, the average WTP = 40+12 = 52.

Exercise 3.5
a. Q = 41
The optimal output level of the project is the output that maximizes the social
net benefit of the project. Because the social net benefit of the project (NB)
is NB = B(Q) − C(Q) = Q 2 − 2Q 2 , the first-order condition is ∂NB
1

∂Q
=
1 − 21
2
Q − 4Q = 0.
Thus, the optimal out level Q = 41 .
b. NB = 38
1
Substituting Q = 41 into NB = Q 2 − 2Q 2 , NB = 38 .

Chapter 4

Exercise 4.1
a. E =3
The condition for the socially optimal emissions is MAC = MD.
20 − 5E = E 2 − 4 ⇔ E 2 + 5E − 24 = (E + 8)(E − 3) = 0. Since E > 0,
E = 3.
b. 29/6 3
The total social cost is (4 − 3) · 5 · 21 + 2 (E 2 − 4)dE = 29
6
.

Exercise 4.2
a. P ∗ = 4, Q ∗ = 12
The equilibrium price and quota can be obtained by applying Q S = Q D .
Solving 2P + 4 = − 21 P + 14, the equilibrium price P ∗ = 4. The equilibrium
quantity Q ∗ = 12.
b. PPES = 12, Q PES = 8, the amount of payment required was 10.
As the quantity is controlled at 8, the new quantity Q PES at equilibrium will be
8.
Applying the demand curve gives a new price PPES = 12. The amount of shift
in the demand curve corresponds to line AB in the figure below. The amount of
payment was 12 − 2 = 10.
186 Appendix: Solutions to Exercises

Chapter 5

Exercise 5.1
a. p1 − 4q1
Denoting the firm’s net benefit in the first period as π1 , π1 = p1 q1 − 2q12 − 4,
Hence, the marginal net benefit for the first period MNB1 = ∂π ∂q1
1
= p1 − 4q1 .
b. 11
Based on Hotelling’s rule, MNB2 = (1 + r )MNB1 . Because p1 = 20, q1 = 2.5,
and r = 0.1, MNB2 = 1.1 · ( p1 − 4q1 ) = 1.1 · (20 − 10) = 11.
c. 5th period
In this problem, the marginal net benefit is equal to the price of the resource.
Thus, using Hotelling’s rule, the price of a resource in the third period MNB3 =
1.1 · MNB2 = 12.1.
Similarly, the prices in the 4th and 5th periods can be obtained as
MNB4 = 1.1 · MNB3 = 13.31 and MNB5 = 1.1 · MNB4 = 14.641.
Therefore, it is in the 5th period when the price of the resource exceeds the price
of the renewable energy P R = 14.

Exercise 5.2
a. (i) SRM
In the SRM, no reforestation cost is incurred after the harvest. Therefore, the
revenue in this model is p Q(t), and the maximization problem becomes the
following:

max π = p Q(t)e−r t
t

Solving for the FOC, dπ/dt = p Q  (t)e−r t + p Q(t)(−r )e−r t = 0.

Appendix: Solutions to Exercises 187

Hence, the optimal condition is p Q  (t) = r p Q(t) ⇔ Q  (t)/Q(t) = r .

(ii) FRM
Because the logger will replant the timberland in the FRM, the revenue in this
model becomes p Q(t) − c. The maximization problem for the FRM can be
expressed as follows:

max π = ( p Q(t) − c)e−r t + ( p Q(t) − c)e−2r t + · · ·

t
∞  
p Q(t) − c p Q(t) − c
= ( p Q(t) − c) e−r ti = = e −r t
· .
i=1
er t − 1 1 − e−r t

p Q  (t)
Solving for the FOC, dπ/dt = er t −1
− r er t · p Q(t)−c
(er t −1)2
= 0 ⇔ p Q  (t) =
r· p Q(t)−c
1−e−r t
.
Hence, the optimal condition is

p Q  (t) = r ( p Q(t) − c) + p Q  (t) · e−r t = r ( p Q(t) − c) + r π.

b. From the result of the FRM, p Q  (t) = r ( p Q(t) − c) + r π . Thus, it is evident

that the larger the replanting cost (c), the smaller is the marginal cost of delaying
the harvest. When the replanting cost increases, the opportunity cost of holding
the forest becomes smaller. This means that it is more profitable to hold the
forest and grow the timber than to harvest it for cash. Thus, the replanting cost
gives the logger an incentive to delay the harvest, relative to a case where there
is no such cost.

Exercise 5.3
a.
Q(t)

0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160

b. Creating a table like below, tMSY ∼

= 62.5.
188 Appendix: Solutions to Exercises

Q
MSY Q(t) Q  (t) Q − 1/t
1 204.960 209.880 0.024
62.5 22,265.6 356.2 0.0

1 2
c. tSR and tSR in the table below denote the optimal harvest periods for the SRM
when the interest rates are r1 = 0.04 and r2 = 0.02. Similarly, tFR
1 2
and tFR are
the optimal harvest periods for the FRM when the interest rates are r1 = 0.04
and r2 = 0.02.

SRM FRM
Q Q Q r1 Q r2
1
tSR Q − r1 2
tSR Q − r2 1
tFR Q − 1−e−r1 t
2
tFR Q − 1−e−r2 t

1 0.984 1 1.004 1 0.004 1 0.014

31.2 0.0 54.8 0.0 4.9 0.0 23.0 0.0

As seen from the table when r1 = 0.04, the optimal harvest periods in the SRM
1 ∼ 1 ∼
and FRM are tSR = 31.2 and tFR = 4.9, respectively, while those for the case of
2 ∼ 2 ∼
r1 = 0.02 are tSR = 54.8 and tFR = 23.0. These results indicate that, in both SRM
and FRM, the harvest period comes earlier when the interest rate is higher.
The reason for this is that an increase in the interest rate leads to an increase in
the opportunity cost of delaying the harvest, providing an incentive to the logger to
harvest the forest and obtain cash to deposit in the bank to earn interest.

Exercise 5.4
4
a. E OA = 400 − 2 10P
Because

104
TR = P · 0.001E X = TC = 10E, X = . (i)
P

In a steady state, given that Ẋ = F(X ) − Q(E, X ) = 0, 0.4X (1 − X/200) −

0.001E X = 0.
Thus,

E = 400 − 2X. (ii)

4
Applying Eq. (i) into (ii), E OA = 400 − 2 10P .
S
Therefore, denoting the production level in the open-access fishery as Q OA ,
   
−3 104 104 4000 50
S
Q OA = 0.001E X = 10 · 400 − 2 · = 1−
P P P P
Appendix: Solutions to Exercises 189

4
b. S
Q PP = 20 − 5·10
P2
Because
 X = 200 − 0.5E from Eq. (ii) of problem a, TR = P · 0.001E X =
P · 0.2E − 0.5 · 10−3 E 2 . Thus, MR = P · (0.2 − 0.001E) = MC = 10.
4
Solving this equation gives E PP = 200 − 10P .
S
Therefore, denoting the production level in the open-access fishery as Q PP ,
 
−3 104
S
Q PP = 0.001E X = 10 200 − (200 − 0.5E)
P
   
−3 104 104 5 · 104
= 10 200 − 200 − 0.5 200 − = 20 −
P P P2

c. Applying P = 100 into the supply functions derived in problems a and b,

  4
S
Q OA = 4000
P
1 − 50P
= 40 · 21 = 20, and Q PP
S
= 20 − 5·10
P2
= 20 − 5 = 15.
Thus, Q OA > Q PP . The production level in the OA fishery is larger than that
S S

in the PP fishery because the OA fishery has no entry barrier for fishermen.
This aspect makes the competition more intense among the producers of the
OA fishery than that among the producers of the PP fishery. Hence, the level
of the total catch in the OA fishery tends to become higher than that of the PP
fishery.

Chapter 6

Exercise 6.1

a. The volume of the recycled plastic bottle: 4. The volume of the virgin plastic
bottle: 20.
190 Appendix: Solutions to Exercises

Because the price of virgin plastic bottles is 2, the volume of recycled plastic
bottles supplied in this market can be calculated by applying this price to the
recycled plastic bottle supply curve: Q R = 2 + 2 = 4.
The volume of virgin plastic bottles produced can be obtained by calculating the
plastic bottle demand when PV = 2. Thus, the volume of virgin plastic bottles
produced is Q V = −4 · 2 + 32 = 24. However, at the left of Q R = 4, the
price of a virgin bottle will be higher than the recycled bottle. When Q < 4, the
recycled bottle will be used. Hence, the total volume of virgin bottles supplied
in the market will be 24 − 4 = 20.
1
b. 6
The recycling rate can be calculated by QQVR = 244
= 16 .
c. The recycling rate will be reduced to 38 after the regulation.
When PV = 4, Q R = 4 + 2 = 6, Q V = −4 · 4 + 32 = 16.
Q
Hence, the recycling rate Q R = 38 .
V