NATURAL RESOURCE ECONOMICS

Course Code: SFM 753

Credit Hour: 3
Lecture Hours: 60
Full Marks:75 (Theory: 60, Internal Assessment: 15)

Without natural resources life itself is impossible. From birth to death, natural resources, transformed
for human use, feed, clothe, shelter, and transport us. Upon them we depend for every material
necessity, comfort, convenience, and protection in our lives. Without abundant resources prosperity
is out of reach.
- Gifford Pinchot

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UNIT 1: INTRODUCTION (6)
How to define Economics?
 Adam Smith (1776 AD): Economics is a Science of Wealth. Malthus, Ricardo, JS Mill.
 Alfred Marshal (1890 AD): Science of material welfare. (W. Parato)
 L. Robbins (1932 AD): Science of Scarcity & Choice.
Major trend of Economic theory:
o J M Keyns (1930 AD): Macro Economics, deficit finance.
o Milton Friedman (1954 AD): Monetary theory.
o Michal P Todaro (1972 AD) : Contemporary Development Economics.
o The Earth Summit (1992 AD): Env. & Natural resource Economics.

1.1 Neo-classical economics

Concept of Neoclassical economics
 A Neoclassical economic theory says that a product or a services governed is valued above or
below the production cost, whilst it is a theory that considers the flow of various goods, services,
outputs, and income distribution through demand-supply theory which assumes unity of
customers in the economy and their main objective is to get satisfaction from the products or
services.
 Production cost – value - demand & supply – satisfaction.

Approach of Neoclassical economics

 Focus on the determination of goods, outputs and income distributions in markets through
supply and demand.
 An individual's rationality and his ability to maximize profit.

7 Assumptions of Neoclassical economics

 Rational Agents: rational behavior to choice & satisfaction.
 Marginal Utility: marginal analysis for decision.
 Relevant information: access & availability of information.
 Perceived Value: perceived value is more than input cost.
 Savings derives Investment : I = f(s) function determine.
 Market Equilibrium: Demand = Price = Supply
 Free markets: Minimum Government intervention.
o Decision on economic issues are always made rationally, based on full information on the
usefulness of the product or service.
o Consumers compare goods and then make the purchase decision based on the perceived
utility.
o The customer's main objective is to capitalize on the satisfaction afforded by the use of the
product.

Decision under managerial economics

The application of economic theory and methodology to decision making problems faced by both
public and private institutions.’
-J.R. Mcguigan & R.C. Moyer
For Profit Maximization
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π = TR – TC
= Qn×Px – [TFC + TVC] Hence M.E. discuss to manage Qn, Px, TFC & TVC.

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1.2 Meaning of natural resource economics
Economics is the study of how scarce resources, goods, and services are allocated among competing
uses. Basically, it deals with choice problem among scarce resources to minimize waste of resources
and maximize high valued use. Economic analysis helps to rank possible alternatives and select the
best among those alternatives. An allocation is good when it generates net benefits that exceed the
opportunity cost. Thus, at the most basic level, economics is about understanding opportunity costs.

Connecting Natural resource and Economics

The condition of scarcity implies that not all goals can be attained at the same time. While some aspects
of scarcity are social constructs, or are created or heightened by advertising, others are unavoidable
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aspects of life. Traditionally natural resource managers or environmental scientist had limited
knowledge of economics. Similarly, economist had limited understanding of natural resource
management. However, both of them interact in many ways in the real world thus both needs to work
together. Economic systems derive many valuable inputs (some commodified, some free) from the
ecological, hydrological, geological, atmospheric, and other systems and processes of Earth. For
example, nutrient cycling, soil formation, water regulation like ecosystem services have economic
value and methods have developed to estimate the value. Some of the economic activities has harmful
impact to the natural ecosystem that can be reduced or eliminated through careful public policy.
Environmentally harmful activity can be reduced (or environmentally benign activity can be
increased) by changing the incentives of people and businesses through the use of taxes, subsidies,
ecolabels, deposit/refund systems, and liability, or through the use of caps, bans, and technology
standards.
Markets for emission credits can be used in conjunction with emissions caps to reduce the cost of
compliance with environmental regulation. Natural resource economics address problems of
governing common-pool natural resources and helps to find optimal rate of renewable or non-
renewable resources. Further, it can raise questions on effectiveness of existing market and
institutional structures in allocating resources in adjudicating among the claims of present and future
generations. It focuses on the policy questions with respect to different types of natural resources
(forest, water, soil etc.). Basically it helps to identify and analyze the problems on allocation of these
resources. Further, resource economics helps to identify and analyze the alternative projects or
programs proposed as solutions. Cost and benefit analysis of these projects or programs is also possible
through natural resource economics. Specifically it helps to mainstream economics into natural
resource management.

1.3 Concept of externalities (market efficiency and market failure)

In economics, an externality is the cost or benefit that affects a third party who did not choose to incur
that cost or benefit. They can also occur from production or consumption. Externalities can either be
positive or negative.

i. Positive externalities: Positive externalities are the benefits to the third party from the consumption
and production activities of others. Positive externalities are also known as the external benefits.
Positive externalities are possible only when social benefits exceed private benefit. A positive
externality exists if the production and consumption of a good or service benefits a third party not
directly involved in the market transaction. For example, education directly benefits the individual and
also provides benefits to society as a whole through the provision of more informed and productive
citizens. Private markets will underproduce in the presence of such positive externalities because the
costs of production for the firm are overstated and the profits are understated.

ii. Negative externalities: Negative externalities are the cost imposed on third parties from the
consumption and production of the others. In other words, negative externalities are the cost borne by
third parties who are not involved in economic activities of others. Negative externalities are also
known as the external costs. A negative externality exists when the production or consumption of a
product results in a cost to a third party. Air and noise pollution are commonly cited examples of
negative externalities. When negative externalities are present, private markets will overproduce
because the costs of production for the firm are understated and profits are overstated.
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Market efficiency
Market efficiency refers to the degree to which market prices reflect all available, relevant information.
If markets are efficient, then all information is already incorporated into prices, and so there is no way
to "beat" the market because there are no undervalued or overvalued securities available. There are
three levels, or degrees or types, of the efficient market hypothesis: weak, semi-strong, and strong.
The weak form assumes that current stock prices reflect all available information, and that past price
performance has no relationship with the future.

Market failure
Market failure is defined as the situation of allocative inefficiency. It arises when the free market
forces of demand and supply fail to produce the quantities of goods and services people want at prices
which reflect their marginal utilities.
According to Dominick Salvatore, Market failures are the economic inefficiencies arising from the
existence of monopoly power in imperfectly competitive markets, from externalities and from the
existence of public goods."
Thus, it is clear that market failure is the failure of the market or market mechanism to give an efficient
allocation of resources. The major causes of market failure are existence of market power, public
goods, incomplete information and externalities.

Government response to market failure

Market Failure = Inefficiency of Competitive Market
I. Competitive Market fail due to:
 Market Power: When producer has monopoly power it chooses the output quantity at MC =
MR and sets price on the basis of AR which is higher than p.c. market.
 Incomplete Information: Consumers do not have accurate information about market price or
product quality, incentive & additional facilities, hence market system will not operate
efficiently.
 Effect of Externalities: Some time the consumption & production activities indirectly affect the
consumption or production of other goods Which is not directly reflected in market price is the
externalities. Caused by the acts of individual or institutions and that could be negative or
positive.
 Public goods: The goods is publicly available to many consumers but once it is provided to
some then very difficult to others from consuming it. hence the market fails to supply goods.
Non rival & non excludable are the character of public goods.

How externalities cause market failure?

Externalities cause market failure or inefficient use of resources. It means that there will be either
overproduction or under production of goods and services due to existence of externalities. The
significant cause of market failure is the existence of externalities in the production and consumption;
and the output is based on private cost and benefit. The socially optimum output is achieved where
marginal social cost (MSC) equal to the marginal social benefits (MSB).
1. Overproduction caused by Negative Externalities
2. Underproduction caused by Positive Externalities

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1.4 Management of the commons (Tragedy of commons, Prisoner’s dilemma and Ostrom’s
revolution)
A. Tragedy of commons:
The tragedy of the commons is a situation in a shared-resource system where individual users, acting
independently according to their own self-interest, behave contrary to the common good of all users
by depleting or spoiling the shared resource through their collective action.
Broadly speaking, our society has traditionally operated under the assumption that with a bit of
regulation, the human drive to act in our own self-interest will lead to healthy competition. But
when it comes to shared resources, this competition can lead to a depletion of common goods and
resources, resulting in a phenomenon known as the tragedy of the commons.
The tragedy of the commons is a term coined by British economist William Forster Lloyd in 1833.
In a pamphlet, Lloyd illustrated a hypothetical wherein a shared resource is gradually depleted by
human beings acting solely in their own interest. Lloyd used the example of a common property
(or “commons”) shared by local communities where herdsman led their cattle to graze. If each
herdsman acted in an economically rational way based solely on their own wellbeing, they wou ld
each allow more than their fair share of cattle to graze on the land, thus leading to overuse. Every
rational herdsman would be acting in their own best interest, but they would collectively be
destroying the grazing land they all relied on.
Tragedy of the commons theory rose in the popular consciousness in the 1960s when ecologist
Garrett Hardin, a professor at the University of California, Santa Barbara, delved into Lloyd’s
theory in a scholarly article. “Tragedy of the commons” As described by Hardin in 1968, in which
benefit maximizing rational individual intensively graze their own sheep in the common pasture,
harming it and leaving everyone worse off.

4 Examples of the Tragedy of the Commons

Examples of the tragedy of the commons can be seen throughout environmental science, especially
in discussions of the causes of climate change. The original example of the tragedy of the commons
had to do with overgrazing cattle on public land. Though this hypothetical is a bit dated, the
principle can be easily applied to a growing human population that is depleting the earth of its
natural resources. Some specific examples include:
 Deforestation: Overexploitation of the earth’s forest has had enormous consequences on the
environment. As a result of a lack of resource management, our forests have disappeared at a
rapid rate over the last century.
 Animal extinction: Overfishing and overhunting are examples of a common pool resource
being depleted by individuals acting in their own self-interest.
 Depletion of natural resources: When common resources are consumed with an eye towards
short-term gain, the result can be a tragedy of the commons. For instance, when water is drawn
from an aquifer faster than it refills, the immediate gains are undercut by the long-term danger
of drought.
 Climate change: Global warming is, on some level, a result of a tragedy of the commons, as
governments, corporations, and individuals fail to consider the cumulative effect their actions
have on our shared environment.

The ‘tragedy of the commons’ is real, but it is not inevitable. It is possible to create and operate thriving
commons, a third way besides private ownership and government control. In an age where we all
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depend on global commons such as the atmosphere or the oceans, we should be paying more attention
to commons management.

B. Prisoner’s dilemma:

The Oligopoly models

 Cournot’s duopoly model.
 Sweezy’s Kink demand curve model.
 Price Leadership Model.
o Price leadership by low cost firm.
o Price leadership by Dominant firm.
o Price leadership by Barometric firm.
 Collusive Model: The Cartel Management.
 Strategic Behavior & Game Theory in Oligopoly: -Pay off matrix, Nash Equilibrium &
Prisoner’s Dilemma.
 Prisoner's Dilemma for strategic decision making in Oligopoly.

Prisoner's dilemma is taken as an example to explain the fact about how firms reach to sub-optimal
situation by their maxi-min and mini-max behavior.
 In prisoner's dilemma, the behavior of two prisoners is taken as an example.
 In this theory, we study the uncertainty faced by the firms and the effect on their decision-making
process.
 Two criminals are arrested after committing a big bank robbery. However, the evidence is not
adequate to make the robbery charge stand unless one or both criminals confess. Each suspect is
interrogated in isolation from his companion so that no communication is possible between them.
The District Attorney promises no punishment for the suspect who confesses and a heavy
sentence of, say, twenty years' imprisonment for the other party.

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  If both suspects do not confess, both will go free. If both confess, they will get the sentence
prescribed by the law for the crime of robbery, for example ten years' imprisonment. Thus each
suspect has two strategies open to himself, to confess or not to confess, and is faced with the
dilemma: to confess (and go free if the other does not confess, or get the ten-year sentence) or
not to confess (and go free if the other does not confess, or get the heavy twenty-year sentence
if he is betrayed by the other suspect.

C. Ostrom’s revolution:
Assumption by Ostrom, 1971
 Rationality: All human are rational being preferring superior alternatives to inferior ones.
 Self interest: The politician, bureaucrats, citizens & state do something from a self interested
point of view by using their power & authority of the government.
 Benefit Maximizing: Bureaucrats & politician are only humans & they often face incentives/
motivation that pull them to decisions of inefficient outcomes.
 Uncertainty minimizing: Individuals adopt strategies to reduce the uncertainty of outcomes of
their choices.

Elinor Ostrom’s 8 rules for managing commons

1. Commons need to have clearly defined boundaries: In particular, who is entitled to access to
what? Unless there’s a specified community of benefit, it becomes a free for all, and that’s not how
commons work.
2. Rules should fit local circumstances: There is no one-size-fits-all approach to common resource
management. Rules should be dictated by local people and local ecological needs.
3. Participatory decision-making is vital: There are all kinds of ways to make it happen, but people
will be more likely to follow the rules if they had a hand in writing them. Involve as many people as
possible in decision-making.
4. Commons must be monitored: Once rules have been set, communities need a way of checking
that people are keeping them. Commons don’t run on good will, but on accountability.
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5. Sanctions for those who abuse the commons should be graduated: Ostrom observed that the
commons that worked best didn’t just ban people who broke the rules. That tended to create
resentment. Instead, they had systems of warnings and fines, as well as informal reputational
consequences in the community.
6. Conflict resolution should be easily accessible: When issues come up, resolving them should be
informal, cheap and straightforward. That means that anyone can take their problems for mediation,
and nobody is shut out. Problems are solved rather than ignoring them because nobody wants to pay
legal fees.
7. Commons need the right to organise: Your commons rules won’t count for anything if a higher
local authority doesn’t recognise them as legitimate.
8. Commons work best when nested within larger networks: Some things can be managed locally,
but some might need wider regional cooperation – for example an irrigation network might depend on
a river that others also draw on upstream.

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UNIT 2: ENVIRONMENTAL POLICY ANALYSIS (12)
Environmental policy analysis is the analysis of economic, scientific, and other data to provide
objective information on environmental issues. The end goals are to create policy recommendations,
promote solutions, and build public awareness. Environmental issues are growing in visibility in local,
national, and world arenas, as a myriad of human activities leads to increased impacts on the natural
world. Issues such as climate change, endangered species, wilderness protection, and energy use are
regularly on the front pages of newspapers. Governments at all levels are struggling with how to
address these issues. Environmental policy analysis is intended to present the environmental and social
impacts of policies, in the hope that better decisions will result when people have better information
on which to base those decisions. Conducting environmental policy analysis requires people who
understand what it is and how to do it.

2.1 Criteria for evaluating environmental policies

Policy evaluation is recently gaining momentum in environmental field. Initially, state government
assign audit and other legal bodies for policy evaluation focused on legitimacy of government
investments. Originally, policy evaluation was needed for administrative monitoring and economic
accountability later it focuses on reflection and learning. After the post war era, due to large scale
public investment program in US, economic based policy evaluation arose.
An evaluation is:
“…the process of determining the merit, worth or value of a process, or product of that process…”
(adapted from Schriven 1991:139, quoted in Mickwitz 2003: 420).

POLICY EVALUATION: WHY?

 To understand link between policymaking and environmental improvements
 To understand pros and cons of relying on different policy instruments
 To legitimize particular policies
 To improve policy processes and outcomes

POLICY EVALUATION: FOR WHOM AND BY WHOM?

Who is interested in policy evaluation?
 Decision-makers
 Those responsible to implement policy
 Those affected by policies
 Civil society and concerned citizens

Who carries out policy evaluations?

 Government evaluation agencies
 Professional evaluators, commissioned by government
 Other (third-party) evaluations

EVALUATING ENVIRONMENTAL POLICY: UNIQUE CHALLENGES

 Environmental cause and effect is complex.
 Long time frames / unknownability of effects.
 Insufficient knowledge about environmental tipping points, thresholds, carrying capacity.
 Diffuse sources of environmental harm with diffuse, often remote, environmental impacts.
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  Stakeholders with conflicting objectives and different belief systems (also regarding perceptions
of effectiveness).

ENVIRONMENTAL POLICY EVALUATION: AN EMERGING FIELD OF STUDY

 “Whereas the state of the art in program evaluation is in flux, the art of environmental program
evaluation has no state at all. It has only artists.” (Knapp and Kim 1998: 349, quoted in Mickwitz
2003).
 Is this pessimistic? Outdated? Is there a state-of-the-art in environmental policy evaluation now?

POLICY EVALUATION: WHEN?

 Ex-post evaluation: after policy has been implemented and there are measurable effects.
 Ex-ante evaluation: before policy introduced and/or implemented.
 Recently introduced policy instruments (RIPI) evaluation: soon after policy introduced, when
there are some (but not all) effects.

POLICY EVALUATION AT DIFFERENT TIMES: NEED AND RATIONALE

 Ex-post evaluation: essential for policy learning, adjustments, improving effectiveness.
 Ex-ante evaluation: useful if needs and goals not clear; if irreversible policy consequences.
 RIPI evaluation: useful to know half-way through if policy not delivering, to assess new
instruments before they become entrenched.

ENVIRONMENTAL POLICY EVALUATION: BROADER INTERPRETATIONS

 Effectiveness evaluation: evaluating if objectives of a policy intervention are met.
 Efficiency evaluation: evaluating the cost-effectiveness of meeting policy objectives.
 Side-effects evaluation: evaluating if the policy intervention produce side-effects.
 Process evaluation: evaluating the process of designing and implementing a policy.

GENERAL CRITERIA OF ENVIRONMENTAL POLICY EVALUATION

 Effectiveness and Efficiency
 Legitimacy and Acceptance
 Participation and Responsiveness
 Know how of scientific knowledge

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ECONOMIC CRITERIA OF EPE:
 Efficiency-Cost benefit analysis
 Are the benefits commensurate with costs
 Cost effectiveness-do the results justify the use of resources
 Can the results be achieved with the use of less resources
 Other criteria: Legitimacy, Transparency and Equity
 Efficiency:
o Net social benefits are maximized and net social costs are minimized.
o Efficient policy leads to a situation when marginal abatement costs are equal to the marginal
damages.
o Efficiency implies cost effectiveness but not vice versa.
o Pareto efficiency is often used-any change of resources can’t increase one’s utility without
decreasing others utility.

2.2 Institutional approaches to facilitate internalization of externalities (Liability rules, Property

rights approach)
Among many reasons behind market failure, external effects is one. Inefficiency resulting from
externalities is often avoidable. The socially optimal resource allocation can be achieved if decision
makers internalize, or feel themselves, the costs and benefits they bring to society. Government
interventions to repair market failures include taxes, subsidies, restraints, state production or state co-
ordination. Property rights approach and liability rules are the institutional approach to facilitate
internalization of externalities. If the costs to create institutions to assign property rights is lower than
the externality cost, allocating property rights is the best solution to internalize externality e.g. lakes,
grazing land, national parks.

PROPERTY RIGHT APPROACH

Based on the thought of property right theory originally coined in Coase work related to social cost
(Coase 1960)
Coase theorem:
 When rights are defined and transaction cost is zero, resource allocation is efficient and
independent of the pattern of ownership.
 It means all resource owner will eventually reduce the externalities in absence of transaction
cost. In real life it is almost impossible.
 When transaction cost is positive, it does matter how we have defined property rights and
attributed our property rights.
 For instance in landuse planning, either transaction cost should be minimized or interventions
are necessary in the initial property rights.
 Regulatory approach to land use planning is always not appropriate. It restricts people having
property right of a certain land to use as per their interest.
 If the theory of property right approach applies, the owner can use the land in their way if they
can reduce the negative external effects and convince people or compensate for the external
stakeholders who are affected by such use.
 Transaction cost of planned order is comparatively greater.
 Property rights are the initial entitlements.
 Entitlements in conflict-right to dump waste and right to have attractive river.
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  According to Ronald Coase 1960, when the affected parties are small, they can easily negotiate
each other and have efficient allocation.
 E.g, if the entitlement is with steel company, resort has to offer bribe and vice versa.

STRUCTURE OF PROPERTY RIGHTS

 Exclusivity: All the benefits and cost accrued to the owner and can sell others.
 Transferability: All property rights should be transferred from one to others voluntarily.
 Enforceability: Property rights should be secured from involuntary seizure or encroachment by
others.
 Eg. Two firms among which one is producing steel at upstream and resort at downstream. If
there are separate owners, efficient allocation is not possible as the steel firm dump waste as
much as possible into the river without considering the resort.

PROPERTY RIGHTS
Except private property regimes, other types of ownership are-
 State property regimes (Parks & forests)
 Common property regimes
 Resnullius regimes
Property should be allocated to those who value it the most, be they farmers, developers, or
conservation groups. Efficient transfers are impeded by incomplete information about ownership,
boundaries, and value, among other sources of transaction cost. Government can facilitate the transfer
of property rights by keeping accurate records of exactly what is owned by whom, how much was paid
for it, and for what use.Government also provides courts for the civilized resolution of boundary
disputes and other conflicts that arise.

TYPES OF PROPERTY RIGHTS

 Legal rights: rights to gain the land, means to have the end result of welfare
 Economics rights: rights to use the land to have income or welfare, end results
*Transaction costs can be defined as the costs associated with the transfer, capture and protection of
rights

PROPERTY RIGHTS-EXEMPLARY CASES

CASE 1
 Although the social cost of dumping sewage in lake is high than the private cost of septic system,
people continue to dump sewage in lake in absence of property rights
 If the property right of lake is given to the one who is dumping sewage, s/he realize the full social
cost of dumping. It can also belong to a neighbour who can monitor or incentivize for prohibiting
dumping.
CASE 2
 Poaching is a problem for a country who has not clearly assigned property rights.
CASE 3
 If each harvester owns a particular plant (or patch), the effects of harvest behavior are
internalized.
(Source : Anderson 2010)
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LIABILITY RULES
 When individual negotiation is not practical, court can adopt liability rules.
 E.g. steel company has to pay the resort for dumping waste into the river.
 Appropriately designed liability rules can correct inefficiency by forcing the one who cause
damage to pay for the damage.
 Liability for environmental harm is designed to compensate affected parties, with a particular
focus on restoring or replacing injured resources and/or providing compensation for lost value.
 Liability rules play a role of deterrent and compel to follow rules and regulations.
 It also helps to manage negative externality though it has not identified as illegal.

2.3 Command and control strategies

Command and control strategies are enviromental policy measures for managing externalities studied
under the welfare economics. Welfare economics may also be defined as that branch of economic
science which evaluates alternative patterns of resource allocations from the viewpoint of maximizing
economic welfare of the society as a whole. When externalities are significant and private solutions
are not found, government may attempt to solve the problem through . . .
o command-and-control policies (strategies)
o market-based policies (instrument)

 Command-and-control regulation requires or forbids certain behaviors with the goal of

addressing an externality.
 Command-and-control regulation can come in the form of government-imposed standards,
targets, process requirements, or outright bans.
 For example, the government may make it illegal for a company to dump certain chemicals in a
river. By doing so, the government hopes to protect the environment or other companies or
individuals that use the river that would otherwise suffer a negative impact.
 In practice, implementing regulation effectively is difficult.
 It requires the regulator to have in-depth knowledge of a certain industry or sphere of economic
activity. If done incorrectly, regulation can introduce inefficiency. For example, if the
government makes it illegal to dump in the river, the companies and their customers may suffer
because the products must be produced using less efficient methods.
 On the other hand, if the government allows too much to be dumped in the river, they have failed
to mitigate the negative externality.
 If the government is unsure of how to effectively regulate the market, it should seek other
methods of mitigating the externality.
 Advocates of market-based policies for reducing negative externalities point to the difficulty of
creating and enforcing effective regulation for reasons why the government should create
systems of incentives and disincentives instead of using the force of regulation.

2.4 Economic incentive (market based) instruments (Pivouvian tax, subsidy, Transferrable
emissions permit)
When externalities are significant and private solutions are not found, government may attempt to
solve the problem through . . .
o command-and-control policies (strategies)
o market-based policies (instruments)
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A. PIGOVIAN TAX
 A Pigovian (corrective) tax is a market-based policy option used by the government to address
negative externalities.
 Taxes increase the cost of producing goods or services generating the externality, thus
encouraging firms to produce less output.
 The tax should be set equal to the value of the negative externality, which is very difficult to do
in practice.
 Corrective taxes increase efficiency and provide the government with revenues as well.
 In the case of negative externalities, the social cost of an activity is greater than the private cost
of the activity.
 In such a case, the market outcome is not efficient and may lead to overproduction of the good.
 Taxes make it more expensive for firms to produce the good or service generating the externality,
thus providing an incentive to produce less of it. As the figure demonstrates, a tax shifts the
marginal private cost curve up.
 In response, producers change the output to the socially-optimum level.

BENEFITS OF CORRECTIVE TAX

 Take environmental pollution as an example. The private cost of pollution to a polluter is less
than its social cost.
 If the government levies a tax on pollution, it increases the polluter’s private cost. The polluter
now has an incentive to generate less pollution.
 The level of the corrective tax is intended to counterbalance the externality. In practice, however,
it is extremely difficult for the government to determine the appropriate level for the tax.
 Moreover, in determining the tax level, the government might come under pressure from various
interest groups that would benefit from a higher or lower taxation level.
 Nevertheless, by introducing corrective taxes in response to negative externalities the government
can not only increase efficiency, but raise revenues as well.

SOME SPECIFIC CONDITION

 Such taxes can cause liquidity problem for firms because taxes are high for the firm while their
corresponding environmental investment costs are highest.
 Two tiered approach can work in this situation meaning low tax or subsidy to some level then
increasing tax.
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 Another solution can be waiving tax to some period.
 In natural resource management, the counterpart to pigovian taxes is the levying of fees such as
mining royalties, stumpage fees, user fees and land taxes.
 Basically, policy making consists of correcting for externalities and other market failures as well
as imposing a scarcity rent when there is no effective owner who can claim such a rent.

B. SUBSIDY
A subsidy is a direct or indirect payment to individuals or firms, usually in the form of a cash payment
from the government or a targeted tax cut. In economic theory, subsidies can be used to offset market
failures and externalities in order to achieve greater economic efficiency. Government subsidies help
an industry by paying for part of the cost of the production of a good or service by offering tax credits
or reimbursements or by paying for part of the cost a consumer would pay to purchase a good or
service.

Direct vs Indirect Subsidies

Direct subsidies are those that involve an actual payment of funds toward a particular individual, group
or industry. Indirect subsidies are those that do not hold a predetermined monetary value or involve
actual cash outlays. They can include activities such as price reductions for required goods or services
that can be government-supported. This allows the needed items to be purchased below the
current market rate, resulting in a savings for those the subsidy is designed to help.

Examples of Subsidies
There are many forms of subsidies given out by the government. Two of the most common types of
individual subsidies are welfare payments and unemployment benefits. The objective of these types
of subsidies is to help people who are temporarily suffering economically. Other subsidies, such as
subsidized interest rates on student loans, are given to encourage people to further their education.

With the enactment of the Affordable Care Act, a number of U.S. families became eligible for health-
care subsidies, based on household income and size. These subsidies are designed to lower the out-of-
pocket costs for health insurance premiums. In these instances, the funds associated with the subsidies
are sent directly to the insurance company to which premiums are due, lowering the payment amount
required from the household.

Subsidies to businesses are given to support an industry that is struggling against international
competition that has lowered prices, such that the domestic business is not profitable without the
subsidy. Historically, the vast majority of subsidies in the United States have gone towards four
industries: agriculture, financial institutions, oil companies, and utilities companies.

C. TRANSFERRABLE EMISSIONS PERMIT (QUOTAS AND PERMIT)

Quota means a restriction on the import of something to a specific quantity. To address the problem
of negative externalities, governments may use a quota system to try and limit them. In a quota system,
the negative externality is capped at a certain amount. In the example of pollution, the government
may put a quota on the amount of pollution a factory can produce by issuing tradable permits. Tradable
permits are a market-based approach allowing the government to limit negative externalities produced
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by a group of firms. A permit is a right to produce a certain amount of a negative externality, such as
pollution. Permits are traded among firms. Firms that are able to cheaply reduce production of the
externality can sell permits to firms that are unable to make such reductions and are willing to pay for
the permits. Regardless of the initial allocation of permits, the market for permits achieves an outcome
that is more efficient for society.

When pursuing this approach the government sets a limit or cap on the amount of a pollutant that may
be emitted. It then allocates emissions permits up to the specified limit among firms. The permits
represent the right to emit or discharge a specific volume of a specified pollutant. Firms are required
to hold a number of permits equivalent to their emissions. Firms that need to increase their volume of
emissions must buy permits from firms that require fewer of them. This transfer is referred as a trade.
In effect, the buyer is paying a charge for polluting, while the seller is being rewarded for having
reduced emissions. The outcome achieved by the market for permits is more efficient, regardless of
the initial allocation of permits. The market for tradable permits creates incentives for firms to produce
less pollution. Firms that have a high cost of reducing emissions are willing to pay for the permits,
while those that can reduce emissions in the most cost-efficient manner will do so and sell their
permits. Tradable permits thus achieve a desired level of the externality by allowing the market to
determine which market actors can create the externality. There are several active trading programs
for air pollutants. For greenhouse gases the largest is the European Union Emission Trading Scheme.
In the United States there is a national market for sulfur dioxide emissions to reduce acid rain. Markets
for other pollutants tend to be smaller and more localized.

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Exemplary cases of policies applied for managing externalities in Nepal
 Tenth Five-Year Plan, 2002-2007
 Local Self Governance Act (LSGA), 1998
 Environment Protection Act, 2019 (2076) and Regulations, 2020 (2077)
 Climate Chnage Policy, 2019 (2076)
 Forest Act, 2019 (2076)
 Forest Regulations, 1995 (2051)
 Forestry Sector Strategy, (2015) 2072
 National Park and Wildlife Reserve Act, 1973 (2029) and Regulations, 1974 (2030)
 REDD Strategy, 2018
 Hydropower Development Policy, 2001

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UNIT 3: ENVIRONMENTAL ECONOMICS ANALYSIS (12)
3.1 Benefits-cost analysis (BCA or CBA)
 An economic tool to help make controversial public policy- decisions/ compares or evaluates
public policies,
 Process of ranking policy options from an economic point of views considering both the benefits
and costs of public policy/projects,
 BCA is about preferences not money,
 BCA can be informational or mandatory,
 First, the program must generate more benefits than implementation costs. These benefits must
affect the wellbeing of individual households.
Benefits > Costs, or Benefits/costs >1
 Second, the program should provide greater net benefits than any other alternative public
projects.
Net Benefits1 > Net Benefits2
(Net benefits = Benefits – cost )

STEPS TO BENEFIT- COST ANALYSIS

1. Specify clearly the project or program such as:
 Community forest management Rainwater harvesting
2. Determine quantitatively the inputs and outputs of the program,
 It is important to distinguish between transfers of resources due to substitution and the creation
of new resources,
 For example – job created by a CF management could be a transfer of resources. If project wasn’t
done , the works could have been used elsewhere.
3.Estimate the social costs and benefits of these inputs and outputs –
 As natural resource management produces benefits which are not traded in the conventional
market, requires to identify appropriate methods to estimate those benefits
4.Compare these costs and benefits

MAKING BENEFITS AND COSTS COMPARABLE

 Biodiversity conservation is not a single activities, and can’t produce benefits immediately-
which may have flow of inputs and outcomes over the period,
 an investment may be considered as an actual expenditure at today’s date (the costs) from which
one expects to earn future incomes (the benefits)
 To quantify investment of a project requires the choice of a temporal horizon wherein to set the
accounting of costs and benefits,
 requires discount rate to discount future values, so that costs and benefits can be compared,
 Present value of costs (PVcosts) vs Present value of benefits (PVbenefits).

DISCOUNTING
 The costs and benefits we've discussed often occur at different times. To compare them fairly, it
is important to discount costs and benefits that occur in the future.
 The idea is to compare a flow of benefits and costs into a single value.
 The present value of a future amount of money is the maximum amount you would be willing to
pay today for the right to receive that money in the future.
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PRESENT VALUE
Present value (PV) = Future value / (1+r)t
Where,
R = discount rate
t = time period
Net present value = PV of (Benefits-Cost)

PRESENT VALUE AND DISCOUNT RATE

 Present value accounts for the opportunity cost of not investing the money elsewhere.
 If your discount rate is greater than the interest rate, you will be willing to borrow money.
o A high discount rate says that current consumption is important to you.
 If your discount rate is lower than the interest rate, you will be willing to loan money.
o A low discount rate says that future consumption is important to you.
 Since, the market interest rate reflects an equilibrium of lenders and borrowers, we can use the
market interest rate as a measure of the discount rate.

WHY DISCOUNT RATE MATTERS?

 Discounting rate affects the value placed on future benefits and costs,
 Higher discount rates mean less importance on future returns,
 Important in the case of environmental programs/problems which are long-term,
 Lower discount rate – protect for future
 Higher discount rate – consume today

SOCIAL DISCOUNT RATE

 In a multifaceted economy with many investment instruments, with varying degree of risks, no
single discount rate exists,
 So, opportunity cost of foregone future consumption might different from opportunity cost
revealed in the market,
 In this case, it might make sense to use a social discount rate which is lower than the rates
observed in the marketplace.
 The social discount rate represents the willingness of society to trade-off present and future
consumption.

WHY MARKET RATES ARE NOT APPROPRIATE?

 Long term projects involve benefits and/or costs of future generations,
 Future generations are not represented in the market,
 People may be myopic and thus not save sufficiently,
 Other externalities that cause the market rate of return on investments to deviate from the social
discount rate, such as positive externalities from research and development.
 Uncertainty may be a concern
 Therefore, risk aversion may justify using a lower discount rate. However, uncertainty is not an
excuse to do nothing.

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COMPROMISE VIEW
 Use the market rate for the first 30 years of a project, and a lower social discount rate afterwards.
 The intuition is that, for the first 30 years or so, the market rate is a reasonable guide to individual
preferences. However, since the market rate may ignore future generations, a lower rate is used
for benefits and cost affecting future generations.

INTERNAL RATE OF RETURN (IRR)

 The discounted rate at which the PV of a projects’ expected cash inflows to the PV of the projects’
costs.
 This means the discounted rate which sets the NPV of all the cash flows from the project or
intervention equal zero.
 Helps to determine the yield on an investment.
 If the IRR of a new project exceeds a required rate of return, that project is desirable.
 The formula for IRR is:
NPV =0= P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . . +Pn/(1+IRR)n
where P0, P1, . . . Pn equals the cash flows in periods 1, 2, . . . n, respectively; and IRR equals the
project's IRR.

NET PRESENT VALUE (NPV) INTERNAL RATE OF RETURN (IRR)

It take interest as a known factor It take interest as a unknown factor

It calculates the exact amount of investment It calculates maximum rate of interest

SENSITIVITY ANALYSIS
A technique that determines how different values of an independent variable pact outcome under
certain specific conditions. It predicts the outcome if a situation turns out to be different compared to
the key prediction(s).

WHY SENSITIVITY ANALYSIS

 Uncertainty in various parameters since cash flows for long duration.
 Value of parameters can not be estimated precisely due to data availability or time constraints.
 Components to which results are sensitive, need more attention that other parts.

3.2 Concept of Total economic value

Economists are widely viewed by the general public as being committed to markets as a way of
allocating resources and consequently to the use of market prices as a reflection of social value. An
economist as someone who ‘‘knows the price of everything and the value of nothing.’’ Whereas
economists probably do as a group have more faith in markets than others, it certainly is not true that
we equate price with value. We recognize many goods and services for which there are no markets
(such as clean air, wildlife habitat, and fishing stocks) as having value.

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VALUE & VALUATION
 Value means monetary worth of something at marketable price.
o There are different techniques to estimate the value of non-market goods and services.
We may need to place a value on either a stock or a flow e.g. standing trees and harvest
of timber from forest. Value of service flow should be equal to the value of stock.
 Valuation means an act or procedure of estimating the value of something.
 Ecosystem produces an array of services.
 Not all services are equally important to each member of the community.
 The value of an ecosystem is viewed and expressed differently depending on the context in which
it is used.
 The value is not restricted to the utility derived from the direct use of ecosystem services; people
also derive utility from indirect and potential uses.
 Thus, the total economic value of an ecosystem is the sum of all service flows at the current time,
as well as those that may occur in the future.
 Economic valuation never refers to a stock, but only the change in a stock. If one speaks of the
economic value of biodiversity, then one always means the economic value of a change of
biodiversity not the true value of biodiversity.
 Economists thus stress that the valuation should focus on changes rather than levels of
biodiversity or ecosystem.
 However, economic-theoretical support for such a valuation approach is weak. The reasons are
that willingness to pay (WTP), or willingness to accept, are based on compensation or
equivalence variations of a change, and that change should be relatively small in comparison
with income levels.
 Economic values also depend on who is valuing them. For goods traded in world markets,
everyone buys or sells at the world price, and marginal values are consistent across people.
 However, for goods that are not traded, values depend on the people affected. For example, the
damage from air pollution in one country versus another will depend on the income of the
country.
 People in a poor country have many critical pressures on their scarce resources and so may be
unwilling to expend too many resources fighting this single risk. They may place a lower value
on air pollution abatement than people in richer countries.

VALUATION
Economic valuation is anthropocentric. Amenities are beneficial only to the extent that human beings
value them. This does not suggest improvements in ecosystem function or other nonhuman effects of
a policy have no value. Many people value open space, endangered species, and biodiversity and have
shown through their memberships in environmental advocacy groups, votes in local referenda, and
donations that they are willing to sacrifice much for these causes. However, the value of an
environmental amenity remains what people are willing to sacrifice for that amenity.

VALUATION TECHNIQUE
Valuation techniques can be applied to both valuing the damage caused by pollution and valuing the
services provided by the environment (negative & positive externality). For instance damage caused
by polluted air can effect on human health, loss recreation and damage vegetation, animals and
materials. The magnitude of this damage requires:
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  Identifying the affected categories
 Estimating the physical relationship between the pollutant emissions and the damage caused to
the affected categories
 Estimating responses by the affected parties towards averting or mitigating some portion of the
damage
 Placing a monetary value on the physical damages which is very difficult
It is necessary to estimate how much reduction in respiratory illness could be expected from a given
reduction in pollution.

 Active use value: direct use of the environmental resource e.g. fish harvest, timber harvest, water.
 Option value: willingness to preserve an option to use the environment in future even if one is
not currently using it.
 Existence value: WTP to keep a good in existence in a context where the individual expressing
the value has no actual or planned use for his/herself or for anyone else. Expressing a concern or
responsibility to resource.
 Bequest value: desire to preserve a potential for possible future use (children, grand children).

HOW TO VALUE NATURAL RESOURCES ?

 The values not captured by the market can be estimated by assessing changes in wellbeing,
 This can be done by measuring the net change in income that is equivalent to, or compensates,
for changes in the quality or quantity of environmental conditions,
 These changes are considered equivalent to changes in the welfare of the individual.
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AN EXEMPLARY CASE
 For some market-traded goods, we recognize that price is not a good measure of value due to the
presence of externalities; for example, with electricity produced from the burning of coal that
generates air pollution the price of electricity does not reflect the social cost imposed through
pollution.
 However, even when market price is inadequate, we find it useful to work with a ‘‘price-like’’
concept in dealing with allocation problems. This is partly because good decision making
requires a means of measuring the value of market and nonmarket goods in commensurate units.
For example, in deciding whether or not to allow an additional coal-fired plant, we need to
measure the cost of pollution in units comparable to the market value of energy. We refer to the
cost per unit of pollution as a ‘‘shadow price.’

3.3 Importance of the valuation of ecosystem services

Valuation can simply be defined “as an attempt to put monetary values to environmental goods and
services or natural resources”. It is a key exercise in economic analysis and its results provide
important information about values of environmental goods and services. This information can be used
to influence decisions about wise use and conservation of forests and other ecosystems. The basic aim
of valuation is to determine people’s preferences by gauging how much they are willing to pay (WTP)
for given benefits or certain environmental attributes e.g. keep a forest ecosystem intact. In other
words, valuation also tries to gauge how much worse off they would consider themselves to be as a
result of changes in the state of the environment such as degradation of a forest.

IMPORTANCE OF VALUATION OF NATURAL RESOURCES

 Environmental valuation techniques can provide useful evidence to support habitat conservation
policies by quantifying the economic value associated with the protection of biological resources.
 Measurement of the economic value of biodiversity is a fundamental step in conserving this
resource, since “the pressures to reduce biodiversity are so large that the chances that we will
introduce incentives [for the protection of biodiversity] without demonstrating the economic
value of biodiversity are much less than if we do engage in valuation.
 By assigning monetary values to biodiversity, the benefits associated with biodiversity can
directly be compared with the economic value of alternative resource use options it thus can and
should be applied in Cost Benefit Analyses of (larger) public and private projects.
 Environmental and natural resource economists have developed methods to estimate the benefits
of preserving environmental goods and services (and, conversely, the damages when such
resources are destroyed or depleted).
 If the benefits of environmental protection can be measured, they can be compared with costs.
 The economic benefit provided by an environmental good or service is the sum of what all
members of society would be willing to pay for it.
 For resources traded in markets such as oil, land, timber, and crops, the value of small quantities
of market goods can be measured by their observed price.
 In competitive markets, prices reflect both the marginal cost of producing the good to suppliers
and the marginal value to consumers.
 Prices are readily observed and constantly updated.

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POLICY RELEVANCE OF VALUATION
 Demonstrating the value: awareness raising;
 Land use decisions: for conservation or other uses;
 Setting priorities within a limited budget
 Limiting or banning;
 Assessing biodiversity impacts of non-biodiversity investments;
 Determining damages;
 Revising the national economic accounts;
 Choosing economic instruments for natural resources (e.g. taxes, subsidies).

3.4 Benefits estimation

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3.4.1 Market approach (Market price method, Production function, Replacement/Avoided
damage cost)
When a market of goods and services exists, it is relatively easy to apply market based approach to
measure value of these goods and services. There are many ecosystem goods such as fish, biomass,
medicinal plants that have market and normally market based approaches can be applied to measure
the value of these goods. We can derive the demand and supply curves of those goods which have
market.
Demand Curve: Other things remaining the same, the demand curve shows an inverse relationship
between the price of a commodity and its quantity demanded. (higher the price, lower the demand and
vice-versa).
Supply Curve: Other things remaining the same, the supply curves shows a positive relationship
between price of a commodity and its quantity supplied (higher the price, higher the supply and vice-
versa).

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Those ecosystem goods and services which do not have market can not be valued using market based
approach and it is not the subject matter of our study. Value means monetary worth of something at
marketable price. Valuation means act or procedure of estimating the value of something. Valuation
of ecosystem services refersto put monetary value to improvement or damage of the resource (kolstad,
2000). Valuation techniques can be applied to both valuing the damage caused by pollution and
valuing the services provided by the environment (negative & positive externality).

A. Market Price Method (Use data from actual market)

 The market price method uses the prices of goods and services that are bought and sold in
commercial markets to determine the value of an ecosystem service.
 This method values changes in either quantity or quality of a good or service.
 By measuring the change in producer and consumer surplus after the application of a change in
production or price, the value of environmental goods and services can be determined.
 Determine a producer and consumer surplus, a demand and supply function must be estimated.
 CS = WTP - AP (the area above the AP and below the demand curve)
Where,
WTP = Willingness to pay Price (the maximum amount that a buyer will pay for a good).
AP = The amount the buyer actually pays for a good.
 Producer Surplus = Market Price – Minimum Price to Sell.
 CS = ∆APB = (1/2) PB x PA (area of ∆)
 PS = ∆PBE = (1/2) PB x PE (area of ∆).
 This method is most often used to determine the value of provisioning services (use values and
marketed goods that have market prices) such as fish, biomass, grass, medicines, etc.

Valuation of ecosystem goods and services = change in consumer and producer surplus before and
after water pollution.
Problem
 Water pollution has reduced the commercial fishing in Phewa Lake, and the Association of
Fisherman wants to evaluate the benefits of cleanup.
 Use market price approach because primary resource affected is fish which has market.
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Advantages
 Data on price, quantity and cost can be easily obtained from actual market.
 Relatively easy and straight-forward to apply.

Disadvantages
 Does not reflect the true economic value of all the ecosystem goods & services because it values
only marketable ecosystem goods (the value of non-marketed goods and services are excluded).

B. Production Function Approach “Valuing the Environment as Input”

Production is the process in which inputs are converted into output. Production function shows the
functional relationship between inputs and output in the process of production.
Output(Q) = f(Inputs) = f(land, labor, capital, organization, ecosystem services)
The production function method is used to estimate the economic value of ecosystem goods and
services that contribute to the production of commercially marketed goods. This method assumes that
an environmental good or service essentially serves as a factor input into the production of a marketed
good. Thus, changes in the availability of the environmental good or service can affect the costs and
supply of the marketed good, the returns to other factor inputs, or both.
Example:
 Water quality affects the productivity of irrigated agricultural crops, or the costs of purifying
drinking water.
 The economic value of improved water quality can be measured by the increased revenues from
greater agricultural productivity, or the decreased costs of providing clean drinking water.

This method is most useful in cases where a resource is a perfect substitute for another input for
production and in cases where the producers are the only ones to benefit from changes in quantity or
quality of the resource, and consumers are not affected. Increased water quality in a reservoir means
that less chlorine is needed for treating the water. The benefits of increased water quality can be
directly measured by the decreased chlorination costs. To measure this contribution, the production
function for the commodity needs to be established, then the changes to the function must be observed
after a change in the ecosystem service, and the economic changes must be measured. If the only
difference between the goods or services is the ecosystem characteristic, then it is extrapolated that
the difference in the prices must be the value of that ecosystem characteristic or service.

 Application: Deforestation, wetland destruction, water pollution in agricultural production and

fisheries, etc.
 Collect data regarding how changes in the quantity or quality of the natural resource affect:
o costs of production for the final good
o supply and demand for the final good
o supply and demand for other factors of production
 Need to link the effects of changes in the quantity or quality of the resource to changes in
consumer surplus and/or producer surplus, and thus to estimate the economic benefits.

Output 1 = f(land, labor, capital, organization, polluted water)

Output 2 = f(land, labor, capital, organization, improved water)
In this case, the economic value of improved water is as much as increased in producer’s surplus.
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Advantages
 Straightforward
 Relatively inexpensive to apply because data are readily available.
Disadvantages
 The method is limited to valuing those resources that can be used as inputs in production of
marketed goods(those resources that are not used as inputs in the production of marketed goods
are excluded).

C. Replacement/Mitigation/Avoided damage cost

The cost analysis methods of ecosystem valuation are used to determine the value of an ecosystem
based upon the hypothetical scenarios where the ecosystem has been damaged or cannot properly
perform the environmental services. This method assumes that the costs of avoiding damages or costs
of replacing ecosystems or their services provide useful estimates of the value of these ecosystems or
services. This is based on the assumption that, if people incur costs to avoid damages caused by lost
ecosystem services, or to replace the services of ecosystems, then those services must be worth at least
what people paid to replace them.

a. Replacement Cost Method: The replacement cost method is used to determine the cost of replacing
ecosystem services. In this case, it is necessary to identify another method for providing the same
services and calculate the cost of construction for that project.This method would apply to the water
treatment example in NewYork because if these watersheds were lost it was determined that the cost
would be $6 billion dollars to construct a water treatment facility that would perform the same
environmental task. For example: Erosion protection services of a forest or wetland can be valued on
the basis of the cost of removing eroded sediment from downstream areas.

b. Damage Cost Avoidance Method: The Damage Cost Avoidance Method is used to determine how
many expenses are avoided by preserving an ecosystem and its services. Estimate potential damages,
then calculate either potential damage costs or the cost of avoiding a problem.
For example, a study by R.S. de Groot et al reports that the preservation of natural watersheds in
NewYork, avoided the construction of a $6 billion water treatment plant, so this implies that the
watershed is worth $6 billion.
Example 1: The improved water quality may be valued on the basis of the cost of building man-made
defenses for controlling effluent(run-off or waste) emissions of equal effectiveness.
Example 2: The flood protection service from a wetland ecosystem may be valued on the basis of the
cost of building man-made defenses for flood protection of equal effectiveness.

c. Mitigation cost method: This method is used to estimate the value of an ecosystem and its services
by measuring the cost of mitigating the effects of loss of these services. For example: grazing
ecosystem services might be lost due to mining activities in a wetland.
 Adverse impacts on welfare: loss of opportunities for grazing local livestock.
 Aversion: acquire livestock feed from market.
 Costs of acquiring livestock feed may be used as a proxy for the value of the grazing ecosystem
services.

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The are typically used in combination with each other because the research results would not be
thorough enough to make any policy decisions if only one of these methods were used since the
methods are some what sequential.

Advantages
 A useful technique in estimating indirect use benefits in the absence of ecological data.

Limitations
 Since this method is based on costs, they are usually not an accurate measure of benefits.
 Ignores social preferences for ecosystem services.

3.4.2 Revealed preference approach (Hedonic price method, Travel cost method)
 When a consumer purchases some commodities either because s/he likes them more than other,
o If there are two combinations of commodities : a and b
o Assume both are equally same cost and good
o If the consumer buys a than b, because s/he likes a over b
o Hence, revealed preference took place
 Estimates the value of ecosystem services based on the behavior of consumers in the market.

A. Travel cost method (TCM)

The costs and time that people incur during a trip to recreational sites can be used to infer the value of
that site. TCM estimates the economic (use) values associated with environmental goods and services
that are used for recreation. It estimates the economic benefits or costs resulting from:
 changes in access costs for a recreational site
 elimination of an existing recreational site
 addition of a new recreational site
 changes in environmental quality at a recreational site

The basic idea of the travel cost method is that the time and travel cost expenses that people incur to
visit a site represent the “price” of access to the site. Thus, peoples’ willingness to pay to visit the site
can be estimated based on the number of trips that they make at different travel costs.

Travel cost (TC) = Transportation cost + Time cost + Accommodation + food + other costs (entry fee,
guide, gift etc)
Value of site (V) = {(T × w) + (D × v) +a+f+ m)} × Va
Where,
T = travel time (in hours), w = average wage rate (£/hour), D = distance (in km), v = marginal vehicle
operating costs, a= accommodation, f= food, m= other expenses including entry fee, guide, gift etc,
Va = average number of visits per year.
Since, visitors get utility from recreational activities then the opportunity cost of travel time is usually
25 % of the actual wage rate.
Data needs
 Number of visits
 Demographic information about visitor
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 Round-trip mileage
 Travel costs per mile
 The value of time spent traveling, or the opportunity cost of travel time
 Expenses (entry fee, accommodation, fooding, gift, guide, bheti etc)

There are three variations of the travel cost method. These include:
i.Individual travel cost approach: Uses a more detailed survey of visitors.
ii.Zonal travel cost approach: Uses mostly secondary data, with some simple data collected from
visitors.
iii.Random utility approach: using survey and other data, and more complicated arppaoch.

i.Individual travel cost approach

 It uses survey data from individual visitors in the statistical analysia - involves collecting data on
the costs incurred by each individual travelling to the site.
 This ‘price’ paid by visitors is unique to each individual, and is calculated by summing the travel
costs from each individuals original location to the recreational site.
 By aggregating the observed travel costs associated with a number of individuals accessing the
site a demand curve can be estimated.
 The survey might ask for the following information:
o location of the visitor’s home
o how many times they visited the site in the past year or season
o the length of the trip
o the amount of time spent at the site
o travel expenses
o the person’s income or other information on the value of their time
o other socioeconomic characteristics of the visitor
o other locations visited during the same trip, and amount of time spent at each
o other reasons for the trip (is the trip only to visit the site, or for several purposes)
o perceptions of environmental quality at the site
o substitute sites that the person might visit instead of this site

ii.Zonal travel cost approach

 This method depends on secondary information from the recreational site
 It is applied by collecting information on the number of visits to the site from different distances.
 Because the travel and time costs will increase with distance, this information allows the
researcher to calculate the number of visits “purchased” at different “prices.”

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TCM-Advantages
 The method is based on actual behaviour-what people actually do-rather than stated willingness
to pay-what people say they would do in a hypothetical situation.
 The method is relatively inexpensive to apply.
 On-site surveys provide opportunities for large sample sizes, as visitors tend to be interested in
participating.
 The results are relatively easy to interpret and explain.
 The travel cost method assumes that people perceive and respond to changes in travel costs the
same way that they would respond to changes in admission price.

Limitations of TCM
 Difficulties in measuring the opportunity cost of time, when different visitors have different
wage rate. This problem is particularly in zonal approach.
 The estimation of WTP used in TCM is for entire site access rather than the specific features or
location within the site. If we wish to value the particular lake inside the national park then it
wouldn’t be possible.
 The exclusion of the marginal cost of other complementary goods such as trekking gears or tents.
Marginal cost of using such equipments should be included.
 Multi-purpose or multi-activity journeys – if the visit if part of the other activities or is a part of
the multiple site visit. Then, it may not provide actual estimations.
 Assumed responses to change in price – it assumes that visitors will react consistently to X$
increase in transportation cost as they would to X$ increase in other cost such as accommodation
or food or entry fee.

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B. Hedonic price method (HPM)
HPM is used to estimate the economic values of an environmental good that directly affect prices of
marketed goods. It is most commonly applied to variations in
property prices to estimate the value of local environmental goods. It can be used to estimate economic
benefits or costs associated with:
 environmental quality, including air pollution, water pollution, noise, soil quality, water quality,
erosion, drainage, proximity to waste sites
 environmental amenities, such as aesthetic views (sea, lake, forest) or proximity to recreational
sites (e.g. coast, open space)

HPM – Main assumption

 HPM is based on Lancaster’s characteristics theory of value (Lancaster, 1966). That is people
value the characteristics of a good, or the services it provides, rather than the good itself.
 Thus, property prices will reflect the value of a set of characteristics, including environmental
characteristics, that people consider important when purchasing a property.
 The price of a property is related to its characteristics, the characteristics of the neighbourhood
and community, and environmental characteristics.
 Thus, if non-environmental factors are controlled for, then any remaining differences in price can
be attributed to differences in environmental quality.
 For example, if all characteristics of properties and neighbourhoods throughout an area were the
same, except for the level of air pollution, then houses with better air quality would cost more.
This higher price reflects the value of cleaner air to people who purchase houses in the area.

HPM – Data requirement

To apply the hedonic pricing method, the following information must be collected:
 A measure or index of the environmental amenity of interest (e.g. for air pollution measurements
of SO2, SO3, H2S, H2SO4 etc. or for distance to hazardous waste sites distance in km).
 Cross-section and/or time-series data on property prices and property and household
characteristics for a well-defined market area that includes homes with different levels of
environmental quality, or different distances to an environmental amenity.

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  Regression analysis: A statistical process for fitting a line through a set of data points. It gives
the intercept and slope(s) of the “best fitting” line. Thus it tells how much one variable (the
dependent variable) will change when other variables (the independent, or explanatory,
variables) change.
 In the first stage of HPM, regression analysis is used to estimates the hedonic price function,
which relates the price of the property to its characteristics and the environmental
characteristic(s) of interest. Thus, the effects of different characteristics on price can be
estimated.
 The regression results indicate how much property values will change for a small change in each
characteristic, holding all other characteristics constant.
 That is differentiating the hedonic price function with respect to any one of the characteristics
yields the implicit price function (implicit because it is revealed to us indirectly through the
amounts people are prepared to pay for the whole property of which the particular characteristic
is only a part).
 In the second stage of HPM, the demand function (marginal WTP) is identified. To identify the
demand function information. There are two ways information on individuals’ demand (marginal
WTP) for a good at different prices
o either observe individuals’ demand for a good in one market when the price of the good
changes over time
o or observe individuals’ demand for a good in different markets where the good is traded
at different prices.

HPM- Advantages
 HPM is relatively straightforward and uncontroversial to apply, because it is based on actual
market prices and fairly easily measured data.
 Property markets are relatively efficient in responding to information, so can be good indications
of value.
 Property records are typically very reliable.
 Data on property sales and characteristics are generally readily available through many sources.
 If data are readily available, it can be relatively inexpensive to apply.

HPM- Limitations
 The scope of environmental benefits that can be measured is limited to environmental goods and
services that are related to property markets.
 The method will only capture people’s willingness to pay for perceived differences in
environmental attributes, and their direct consequences. If people aren’t aware of the linkages
between the environmental attribute and benefits to them or their property, the value will not be
reflected in property prices.
 The method assumes that people have the opportunity to select the combination of features they
prefer, given their income. However, the housing market may be affected by outside influences,
like taxes, interest rates, or other factors.
 Transaction costs in the property market are varied and not inconsiderable consisting of items
such as the time spent searching for properties, expenses on lawyers and surveyors, taxes and the
costs of moving possessions from one property to another. Given the prevailing market prices, a
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 household may want to live in a property with a different set of characteristics than their current
residence. However, if the transaction costs are sufficiently high, they may negate the benefits of
moving. The household will stay where it is and the housing market will remain out of
equilibrium.
 One of the fundamental assumptions of the HPM is that households have perfect information. If
households are not aware of the prices and characteristics of all the properties in the market then
it is likely that the prices that they pay for properties, and by definition the implicit price they pay
for different characteristics, will vary from sale to sale.
 The results depend heavily on model specification.
 Large amounts of data must be gathered and manipulated.
 The time and expense to carry out an application depends on the availability and accessibility of
data. If data must be gathered and compiled, the cost of an application can increase substantially.
 Only use values of environmental goods can be estimated by HPM. HPM cannot estimate non-
use values and hence the TEV of the environmental goods. Need to use other methods in addition
to HPM to estimate the non-use values in order to find out the TEV of an environmental good.

3.4.3 Stated Preference Approach (Contingent valuation, Choice experiment)

A. Contingent valuation method

One of the stated preference method. It estimates benefits asking people directly to state their
willingness-to-pay (WTP) for specific environmental services. It is called contingent because people
are asked to state their WTP, contingent on a specific hypothetical scenario. It can be used to estimate
economic value of all kinds of services and widely used method to estimate the monetary value of
non-use values of the environment.

Designing a CVM Study

When designing a CVM study consideration has to be given to the nature of the public good, payment
method, and the context of valuation.

Stages of conducting a CVM

a. Establishing/Setting up the hypothetical market
 Description of resource/ good
 Reason for payment
 Bid vehicle –property tax, income tax or entry fees.

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The good
The CV should explicitly define the following aspects of the good:
 its attributes
 Base line and new condition that results from the policy change (Environmental impacts, socio-
economic impacts)
 Sources of the changes
 the extent and timing of change

The payment method

 the payment vehicle – must be salient to the respondent –taxes, entry fees, rates. There is no point
talking about increasing local council rates with tourists.
 the decision-making unit for which the value is to be expressed: hunting trip is an individual
pursuit whereas a neighborhood air quality is more a household issue.
 the timing of payments.
 the relevant prices of other goods.

The context of valuation

 Participants are possibly influenced by who would benefit and who else would be offering their
valuation.
 Whether the measure of value will be WTP or WTAC.

How do you establish?

 Identify targeted population,
 Focus group discussion with the targeted population,
 Discussion with local experts – cross check whether feasible from policy perspective,

b. Obtaining bids
Obtaining bids could be achieved by:
 bidding game –higher and higher amounts are suggested to the respondents until their maximum
WTP is reached.
 payment card –respondents are presented with a range of values given income groups.
 Three types of questions
i. Open ended
ii. Iterative bidding
iii. Dichotomous choice

Open ended questions

 Open-ended questions –respondents are asked for their willingness to pay.
 No value being suggested to them.
 Respondents have found it relative difficult to answer such questions, especially where they have
no prior knowledge of trading with the commodity in question.
Example:
Q1. Suppose that the Kathmandu Metropolitan city was to increase the number of recreational parks
by double in the Kathmandu valley in the next five years. The Metropolitan city will charge additional

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tax for this for the next five year, which will add on your land tax. Are you ready to pay for this? --
Yes No
Q2. If yes, how much would you be willing to pay annually?
Q2. If no, why ? [ ]
i. I don’t have enough income
ii. It is government’s job
iii. I don’t believe this will happen
iv. I don’t trust the proposed program can improve the situation
v.Others (please specify)………….

Iterative bidding questions

 Suppose that the Kathmandu Metropolitan city was to increase the number of recreational parks
by double in the Kathmandu valley in the next five years. The Metropolitan city will charge
additional tax for this for the next five year, which will add on your land tax. How much would
you be willing to pay annually?
Answer: NRs. 500/year
Follow-up question:
If yes, would you be willing to pay NRs. 700/year,
 Kathmandu Metropolitan City is cleaning Bagmati river for the next five year. How much would
you pay annually as a Municipal fee if water quality of Bagmati river improved to fishing level
for the next five year?
Ans:
 How much would you pay annually if Bagamati water is safe for swimming for the next five year?
Ans:

Dichotomous choice questions

 Suppose that the Kathmandu Metropolitan city was to increase the number of recreational parks
by double in the Kathmandu valley in the next five years. The Metropolitan city will charge
additional tax for this for the next five year, which will add on your land tax. Would you be willing
to pay NRs. 500 annually? = Yes / No

Designing a cv questionnaire
Section One
 Designed to familiarize the respondent with the situation, and policy issues.
Section Two
 Ascertain those who knew resources and visited the area, extent of usage.
Section Three
 Background information -explanatory information, maps, photo, etc.
Section Four
 Ask the respondent for their willingness to pay; with management intervention and possible
outcomes.
 Payment vehicle -respondents must be presented with a believable payment vehicle and affected
by.
Section Five
 Collect socio-economic data
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c. Estimating mean WTP and/or WTA
 If open-ended, bidding game or payment card approach have been used, then the calculation of
sample mean and/or median WTP or WTAC is straightforward.
 It is usual in CVM to find that mean WTP exceeds median WTP, since the former is influenced
by a relatively small number of relatively high bids (this is, the distribution of sample WTP is
skewed).
 When dichotomous choice method has been used, then the calculation of average WTP is more
difficult. The distribution of bids becomes binomial and depends of the shape of individual utility
functions.

d. Aggregating the data

 Aggregation refers to the process whereby the mean bid or bids are converted to a population total
value figure.
 Also called Total WTP/WTA or Social benefits
 Total WTP/WTA = mean WTP/WTA × population × proportion of respondents having WTP

e. Estimating bid curves

Consider - Biases
There are three types of bias which may distort the results of a CV analysis:
i. Design Bias: The way in which the information about the problem is put across can be a powerful
effect on the respondents.

Example of design bias:-

The government has discovered a threat of a major outbreak of a new aids virus that is expected to kill
600 thousand people. Two programs have been proposed.
If program A is adopted, 200 thousand people will be saved.
or,
If program A is adopted there is a 1/3 probability that 600 thousand people will be saved, and 2/3
probability that no one will be saved.

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ii. Strategic Bias: respondents may think that they can influence the course of real events by the shape
of their answers, and bias them accordingly.

iii. Starting point bias: comes from the researcher suggesting starting bids

Advantages of CVM
 Flexible in its application,
 Can obtain use and nonuse values,
o Market approach or revealed preference estimate use values only,
 Places values on services that are not related to any market processes,

Decision rule
The way of decision is the responses from majority interviewees. The policy will be implemented if
majority of the respondents (at least 50%) are willing to pay. Out of the total respondents who are
willing to pay, their majority will choose the payment vehicle.

B. Choice experiment
CE founded on neo-classical microeconomic consumer theory – consumers optimize utility by
selecting the best option among the available alternatives. In general, consumer makes a decision by
evaluating the costs and benefits of available alternatives. Alternatives are hypothetical outcomes of
the proposed policy/programs and one is the current situation. Therefore, it is expected that consumers
evaluate the available alternatives based on the current situation.
Alternatives are comprised of attributes and distinguished by the levels of these attributes. Attributes
are the characteristics of alternatives. Levels are the measure of a change in attributes, which could be
either qualitative of quantitative. A change in the attributes affect the respondents wellbeing. It is based
on the Lancaster’s characteristics theory of value – individual derives utility from the characteristics
of goods rather than the goods per se. The individuals make trade-offs between attributes in the
different alternatives in a choice set (Albizar et al. 2001). Choices are the function of the attributes in

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the given alternatives, which are relevant to the problem being investigated. A monetary value is
usually an attribute that reflects the cost of the individual given in the particular alternative, which is
the basis of WTP/WTA estimation. There is no obligation that all characteristics included in the choice
set should have a positive association with utility. Choices made in CEs are analyzed by using random
utility theory. The indirect utility function (U) is split into two components: a deterministic component
(V) and error term (ε). ε captures the effects of the unobservable factors in individuals’ utility functions
(Hensher et al., 2005). A random model with a utility function that states that individual (i) is
associated with alternative (j) models the consumer choice behaviour as:
Uijt = V(xijt)+ ε (ijt)
where individual i obtains utility (U) from alternative j in each of the choice sets t presented to them.
x is attributes.

Benefits of CE
 allows testing for internal consistency – multiple choice sets
 Offers benefits transfer
 Reduces framing bias
 Can elicit more information from each respondents than CVM
 Acknowledged for credible estimation

Steps
i.Selection of attributes and their levels – focus groups and experts consultation
ii.Choice experiment design – using Ngene or stata
iii.Survey administration
iv.Choice response analysis

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CE Design
 All effects are not equally interesting (Louviere et al. 2000),
 In CE, goal is to generate statistically significant design rather than focusing on orthogonality
(Hensher et al. 2005),
 The D-efficiency design strategies produce significantly improved results, in a sense of relative
efficiency (Roe et al. 2008),
 Hence, Ngene 1.0.2 software was used for an efficient design,
 24 profiles were blocked in six versions,
 Households were selected systematically ( interviewed every 10th household),

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MWTP(NRs.)

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Methodological issues
 Focus group discussions are key to ensure the success of CE surveys in developing economies
(Bennet & Birol 2010),
 Number of attributes and choice sets in a block are likely to influence the choice task in a low-
literate community,
 Visual aids can improve choice by reducing task complexity (Jae & Delvecchio 2004),
 Local enumerators are effective to ensure villagers that their commitments are not binding,
 Conventional way of eliciting WTP increases the number of free riders in agrarian community
(Alam 2006),

3.4.4 Valuation of timberland

Timberland means privately owned land, or land acquired for state forest purposes, which is devoted
to and used for growing and harvesting timber. In some countries forests are state or community owned
and there is no market for forest land. However, in many countries timber land can be privately owned
and thus there exists an active market for it. Since property transactions in general require valuations,
the need for timberland valuations is high in these countries. There are several timberland valuation
approaches discussed and analyzed in timberland valuation literature. Three of the most prominent
approaches are:
a. the income approach
b. the sales comparison approach
c. the cost approach

Need of Timberland Valuation

The need for timberland valuations is high and is mostly driven by the changes in private timberland
ownership. Additionally, timberland valuations might be needed for financial reporting, asset
monitoring, loan collateral, insurance, taxation, etc.

Income Approach
The income approach is based on the net present value (NPV) calculation (Straka & Bullard, 1996).
The main income approach used in forestry and timberland investment is called the land expectation
value (LEV) method. LEV is used to assess the value of bare forest land, but also to choose from
various forest management alternatives as well as to determine the rotation age of a certain forest.
LEV uses the NPV of the incomes and costs related to the timber production. LEV is not an ordinary
discounted cash flow analysis, because the timber is growing to perpetuity, not just for a fixed number
of years or one rotation. LEV assumes that at the start there is only bareland, therefore it is sometimes
said to be bareland value or soil expectation value.

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Assumptions
 Income and costs are the same for all the rotations.
 All incomes and costs are converted to the end of the rotation and regarded as a single value at
the end of each rotation.
 There are an infinite number of rotations.
 Each rotation will start with regeneration costs.
 Land value is not an input in a calculation.

Valuing Timberland With Even-aged Trees

 The first step is to determine all the cash flows associated with one rotation. These cash flows
comprise initial costs (planting, site preparation, etc.), subsequent costs (thinning costs,
disinfestation, property tax, etc.) as well as revenues during the rotation (thinning incomes, final
harvest income, etc.).
 The second step is to calculate the future values of these cashflows at the end of the rotation and
then add them together to get the net future value with the formula shown on Equation.
 The third step is to use the perpetual periodic series present value formula shown on Equation to
calculate the LEV.

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 The calculated value is for the bareland, meaning that it doesnot take into account the existing
timber (i.e.merchantable timber, premerchantable timber and logging debris).

Valuing Immature Timber

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UNIT 4: ENVIRONMENT AND SUSTAINABLE DEVELOPMENT (10)
All the physical surroundings on the earth are called the environment. The environment includes
everything living and everything nonliving. Sustainable development is development that meets the
needs of the present without compromising the ability of future generations to meet their own needs.
The Environment and Sustainable Development (ESD) Programme focuses on the integration of
economic, social and environmental aspects towards a balanced holistic concept of sustainable
development. The ESD Programme is one of two programme areas of the United Nations University
(UNU) system.
4.1 Concept of sustainability: Weak and strong sustainability
Sustainability concept firstly discussed as a solution to transform conflicting objectives into
complementary aspects of a common goal in United Nations Conference on Human Development in
1972. An activity with an unlimited time horizon is sustainable. It can be applied to everything from
production and consumption to the flows of natural, physical, and human capital. Due to the failure of
conventional economic development practices, the concept of sustainable development first emerged
in Brundtland Commission in 1987. According to Bruntland Commission, sustainable development is
“development that meets the needs of the present without compromising the ability of the future to
meet their own.” The Brundtland Commission identified seven strategic imperatives for sustainable
development:
 Reviving growth.
 Changing the quality of growth.
 Meeting essential needs for jobs, food, energy, water, and sanitation.
 Ensuring a sustainable level of population.
 Conserving and enhancing the resource base.
 Reorienting technology and managing risk.
 Merging environment and economics in decision making.
Later, the concept was further discussed and refined in United Nations Conference on Environment
and Development (UNCED) in 1992 which is more commonly known as the Earth Summit, produced
an international charter known as Agenda 21, a program of action for sustainable development
worldwide. The Earth Summit also produced the Rio Declaration on Environment and Development,
also known as the Earth Charter. One of the most important products of the Earth Charter is the list of
guiding principles for sustainable development and recognizes the importance of economics for
sustainable development. Based on the several themes of earth charter, sustainability is “a
community’s control and prudent use of all forms of capital—nature’s capital, human capital, human-
created capital, social capital, and cultural capital—to ensure, to the degree possible, that present and
future generations can attain a high degree of economic security and achieve democracy while
maintaining the integrity of the ecological systems upon which all life and production depends.”

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SUSTAINABLE ECONOMIC DEVELOPMENT
“Sustainability” and “Sustainable development” are often used interchangeably. As a prescription for
the allocation of scarce resources, sustainable development is closely tied to the world of economics.
The criterion for Hicksian sustainability, named after economist John R. Hicks (1975), is maintenance
of consumption levels defined as gross output less investment. Capital provides for production, which
fuels consumption and in turn provides welfare. Thus, economists often treat a criterion of
nondeclining capital and the Hicksian’s maintenance of consumption as being operationally equivalent
to the criterion of non-declining welfare. A nondeclining capital stock should provide intergenerational
equity in terms of opportunities for production, consumption, and happiness, and the capital stock is
far easier to measure than subjective levels of happiness.

SUSTAINABILITY: WEAK VS. STRONG

The meaning of sustainability is the subject of intense debate among environmental (and resource)
economists. Perhaps no other issue separates the traditional economic view of the natural world from
the views of most natural scientists. The debate currently focuses on the substitutability between the
economy and the environment — or economic goods and services, or “natural capital” and
“manufactured capital” —, a debate captured in terms of “weak” vs. “strong” sustainability.

WEAK SUSTAINABILITY
 Focus on uncertainties about the preferences, incomes, and technology of future generations
 The simplification of the economic model is useful for the sake of practicality, and this focus on
the availability of capital provides a functional, if imperfect, guide for resource allocation
 Based on the work of Nobel Laureate Robert Solow and John Harwick, human capital can
substitute natural capital.
 Neoclassical economists believe that decreases in natural capital over time will not be problematic
if balanced by increases in physical capital
 At the heart of the controversy is the substitutability of natural capital (fossil fuels, biomass, the
ozone layer, and so on) and physical capital (man-made capital as in machines, buildings, and
roads).

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 Advocates of weak sustainability argue that physical and natural capital are substitutes, making
the relevant question: Is our accumulation of physical capital sufficient to make up for our loss of
natural capital?

 With no population growth and no depreciation of physical capital, consumption levels can
remain constant from one generation to the next.
 The stipulation is that exhaustible natural resources are never consumed, but rather are turned into
physical capital.
 The total stock of productive capital is thus sustained because the current generation converts
natural capital into physical capital and “lives off” the output of physical and human capital.
 David Pearce and Giles Atkinson (1995) present an index of weak sustainability
 They begin with the assumption that human capital will not depreciate because it has public-good
aspects and can be passed from one generation to another.
 Fitting with the assumptions of weak sustainability, they also assume that savings are invested in
physical capital, which is a perfect substitute for natural capital. The maintenance of the total
capital stock, then, depends on a national savings rate that is at least as great as the combined
depreciation rate of natural and physical capital.
 The condition for sustainability is thus:
Z=Savings/GDP-(Depreciation of natural capital + Depreciation of physical capital)/GDP

STRONG SUSTAINABILITY
 Introduced by ecological economist championed by Harman Daly
 Focus on maintenance of natural capital
 Natural and physical capital play complementary role but not substitute
 Natural capital is essential for production, consumption and welfare
 Due to uncertainty, its dangerous to perceive physical capital can substitutes natural capital as
biodiversity and life sustaining cycles of oxygen, carbon, nitrogen and water
 Says neoclassical economist gave inadequate attention to environmental degradation and
pollution that can curtail social welfare regardless of the maintenance of total capital levels.
 Some of the economist has emphasized net domestic product as a indicator of sustainability.

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 The strong sustainability version of the Pearce–Atkinson sustainability rule is,
Natural Capital Depreciation/GDP=0
 This requires natural capital depreciation to be zero, or negative, which would mean an
appreciation in natural capital.

 Advocates of strong sustainability prefer not to rely on uncertain technological innovations. They
see natural and physical capital as complements, and expect limited amounts of natural capital to
form the binding constraint on future welfare. The strong sustainability criterion is the
maintenance of sustainable levels of natural capital.
 If our current levels of resource use and welfare are not sustainable, we will have to make
sacrifices up front in order to reach the highest sustainable level of welfare. Delays in this
correction may lead to decreases in the highest level that can be sustained.
 As indicated by the red line that starts upward and then falls to the horizontal axis, some
economists believe that continued consumption at current levels could cause severe
environmental losses and bring welfare far below the survivable level in the future.

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 If the goal is a sustainable level of welfare as indicated by the horizontal dark blue line, ecological
economists advise a gradual adjustment of our resource use toward a sustainable level starting
now, as illustrated by the green line.
 If we continue to deplete natural resources at current rates, they say, we could sustain or improve
welfare in the short run as shown by the red line, but cause irreversible environmental damage
and a corresponding loss of welfare later on.
 Strong sustainability requires the maintenance of aggregate levels of natural capital.
 It does not stipulate the sustenance of specific components of natural capital or specific physical
flows of resources.
 The harvest of every fishery and forest at a sustainable rate would be a sufficient but unnecessary
condition for strong sustainability.
 Depletable resources like fossil fuels can be used if they are replaced by renewable resources like
ethanol so that the total stock of natural capital is maintained.
 Sustainable practices are a deliberate attempt to improve intergenerational equity.
 If this interest in equity across time carried over to equity across individuals, policymakers would
allocate the sustainability burden by placing constraints on rich nations, while allowing poor
nations to improve their conditions.
 In practice, any actual decrease in resource use would most likely occur in developed countries;
developing nations have relatively little to sacrifice.

4.2 Sustainability rules: Hartwick approach, London School approach, safe minimum
standard approach, Harman Daly’s operational principles
A. Hartwick-Solow approach
 Based on the principle of strong substitution assumptions between natural and human capital.
 A non-declining consumption through time is possible to obtain, even in the case of using non-
renewable resources (such as oil).
 As long as the stock of capital did not decline over time, non-declining consumption is possible.
 If the stock of oil (a type of natural capital) is depleted, the stock of man-made oil is built up as a
replacement.

Criticism of the Hartwick-Solow approach (rule)

 First, individuals derive diverse utility from Nature which is not confined to an input resource for
production. Thus, non-declining consumption is not equivalent to non declining welfare over
time.
 Second, it depends specifically on the Cobb-Douglas form that says the elasticity of substitution
between natural resources and man-made capital is greater than one, which means that the limited
supply of the natural resources is actually irrelevant.
 Third, natural resources and man-made capital are not truly substitutes to each other. Natural
capital can be exploited by man, but cannot be created by man.

B. London School approach

 Some level of substitution is possible between certain elements of Kn and Km though natural
capital provides numerous non substitutable services to human beings. Many of them should be
preserved for future.

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 The important strategic question here is: how much of Kn should be preserved? Possible options
are:
o all of them at the existing level,
o the level consistent to the maintaining of the critical elements of Kn, or
o some amount in between these two.
 The crucial problem of this approach is that we must assume that we can measure the value of Kn
at any point in time. In practice, it is difficult to measure different elements of Kn in terms of
quantity or monetary terms.
 Another challenge is to identity an area to preserve the natural capital.
 Difficult to measure human interference against the natural rate of change due to several factors.

C. Safe minimum standard approach

 Very closely linked to the non-declining natural capital stock approach.
 Originates from decision making in uncertainty that means societies are unaware of future costs
of current environmental degradation.
 In environmental policies, two types of actions can be taken:
o conserve environmental resources (such as wilderness areas) or
o not to conserve them.
 prevent all reductions in natural capital stock below the safe minimum standard identified for
each component of this stock unless social opportunity costs of doing so are ‘unacceptably’ high.
 deciding to conserve today is shown to be the risk-minimizing way to proceed.

Ignorance:
 Current generations are unaware of the future preferences thus conservation is needed to address
uncertainty.
 Second is the uncertainty about the possible threshold of the ecological processes and rate of
resource depletion as well as the risk taking behavior of decision makers.
 Thirdly, there is an ignorance of the intrinsic value of species and natural phenomena.

Issues:
 difficulties in identifying critical SMS levels and
 problems in defining ‘unacceptable large’ opportunity costs of preservation.

D. Harman Daly’s steady-state (operational principles)

 In 1990, Herman E. Daly identified ‘operational principles’ of SD. If these principles were
followed, nations would move towards SD (Daly 1990, 1992).
 OP1: Set renewable resources harvest levels (fish, forest, game) at less than or equal to the
population growth rate.
 OP2: Establish for degradable pollutants assimilative capacities of the receiving ecosystems and
maintain waste discharges below these levels. The discharge of cumulative pollutants should be
set adequately close to zero.
 OP3: Divide the financial receipts from non-renewable extraction into an income stream and
investment stream. The latter part should be invested in renewable substitutes (for example
biomass for oil) as an substitute of non renewable resources.

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 OP4: Minimize matter and energy throughput in societies. In the economy there must be some
controls on macroeconomic scale. These controls must be quantitative and exercised for
population and resource use.

Most neoclassical economists assume that technological advance will outpace resource scarcity over
the long run and that ecological services can also be replaced by new technologies. Ecological
economists, on the other hand, assume that resource and ecological limits are critically important and
are much less confident that technological advances will arise in response to higher prices generated
by scarcities. This difference in worldview, however, does not prevent neoclassical and ecological
economists from sharing the same pattern of reasoning. (Costanza et al., 1997: 69).

4.3 Sustainable accounting (Green accounting): Integrated Environmental and Economic

Accounting (IEEA)
The Sustainability Accounting Standards Board (SASB) states that “sustainability accounting reflects
the management of a corporation's environmental and social impacts arising from production of goods
and services, as well as the management of the environmental and social capitals necessary to create
long-term value.” A new system of sustainable accounting known as green accounting has emerged.
It permits the computation of income for a nation by taking into account the economic damage and
depletion in the natural resource base of an economy.

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4.4 Concept of green economy
The green economy is defined as economy that aims at making issues of reducing environmental risks
and ecological scarcities, and that aims for sustainable development without degrading the
environment. It is closely related with ecological economics, but has a more politically applied focus.
The aim of the Green Economy is to establish a sustainable economy that uses natural resources
efficiently and has a lower environmental impact. The aim is to develop new, sustainable patterns of
production and consumption to ensure prosperity and a high quality of life for generations to come.
For example: The Republic of Korea has adopted a national strategy and a five-year plan for green
growth for the period 2009–2013, allocating 2 per cent of its gross domestic product to investment in
several green sectors such as renewable energy, energy efficiency, clean technology and water.

In 1987 Our common future (Bruntlandreport) popularize the term Sustainable Development.
Relying on the idea of sustainable development and also on the theory, the methods and the policy
options provided by the environmental and natural resource economics-Government of the UK by a
group of leading environmental economists, Pearce, Markandyaand Barbier, 1989 -First coined
"Green Economy" Blueprint for a Green Economy. In 1991 and 1994 the authors released;
1. Blueprint
2. Greening the world economy and Blueprint
3. Measuring Sustainable Development

During the 1990s and most of the 2000s the concept of Green Economy was not widely used. There
were more narrow interpretations of a Green Economy which can include proper pricing, also called
Environmental Externalities. Negative externalities is the term for the costs which society has to bear
because of degradation of ecosystems and environmental pollution. Concept of Polluter Pays
Principle. Others call for financial investments in renewable energy, energy efficiency which help
to both generate jobs and reduce greenhouse gas emissions. Environmental economists were aware
that any form of economic activity not only generate benefits but also costs.
Natural resource economics is another school of thought that has helped to frame or develop the Green
Economy concept. This school of economics deals basically with the supply, demand, and
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distribution of renewable and depletable resources. A key objective for natural resource economics
is to find ways to manage resource efficiently and sustainably so that they are available to future
generations. In principle, a Green Economy should guarantee the capacity of natural capital that
provides resources and environmental services in the long run.
Green economy is a concept further developed -by the UN in response to the current global financial
and economic crisis in 2008 and 2009. A new edition of the book was released in 2013. There the term
Green Economy is anchored to three key areas -accounting for the environment, valuing the
environment, and policies for environmental protection. Energy economics, particularly the area that
focuses on renewable energy and energy efficiency, can also be said to be contributing to or shaping
the term Green Economy. So investment in low-carbon technologies and climate mitigation strategies
have been quickly portrayed as key components for the transition into a Green Economy.
And sometimes similar concepts like the Low-Carbon Economy and the Clean Energy Economy are
also used to refer to a Green Economy. There is a growing body of evidence that shows the rapid loss
of ecosystem services and this situation has encouraged investment in and conservation of natural
capital, which is also a critical aspect for the modern interpretation of the term Green Economy.
Building upon other schools of economics ecological economies have also advocatedfor the economic
value of ecosystem services and resources.

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How Green Economy can be Achieved?
 Reversing the process of unsustainable development
 Environmental valuation and accounting for natural capital depreciation must be fully
integrated into economic development policy and strategy;
 The role of policy in controlling excessive environmental degradation requires action based
on effective and appropriate information, incentives, institutions, investments and infrastructure;
 Increasing collaboration between environmental scientists, ecologists and economists is
required to assess and monitor the environmental and welfare impacts of ongoing natural resource
depletion, pollution and ecological scarcity.
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4.5 Maximum sustained yield
Renewable resources are those for which the stock can be continually replenished. In this case, market
would ultimately make a smooth transition from depletable to renewable resources. However some
renewal resources like plants and animals are also exhaustible if not managed effectively. If a
population is drawn down beyond a critical threshold, the species can become extinct. Biological
populations of a renewable resource depend on biological consideration and actions taken by society.
The population determine the resources available for future. Human activity determines the flow of
these resources over time. Thus optimum rate of use across time and across generations is very crucial.
What is the efficient rate of use of the renewable resources? In early 1970s Lester Brown (1974) caught
the world’s attention by reporting that the world’s fish catch had started to decline and reflect on the
resource scarcity. Decline in total catch turned out to be temporary problem during the 1970s as the
number of catches increased after it. Total catch figure masks this problem as the number of catches
were increasing however the rare species of fishes were extinct.
GROWTH & POPULATION
 Understanding sources of decline is important to know the problem of managing common
property resources.
 Efficient allocations:
o Characterization of the fishery originally rests on a biological model proposed by Schaefer
(1957).
o It shows a particular relationship between the growth of the fish population and the size of
the fish population.
o However other influencing factors were not considered while establishing the relationship
that will be balanced in a long duration.

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Maximum sustained yield (MSY) is theoretically the largest yield (or catch) that can be taken from
a species' stock over an indefinite period. Fundamental to the notion of sustainable harvest, MSY aims
to maintain the population size at the point of maximum growth rate by harvesting the individuals that
would normally be added to the population, allowing the population to continue to be productive
indefinitely. The maximum sustainable yield is usually higher than the optimum sustainable yield and
maximum economic yield.

Optimum sustained yield: The level of effort (LOE) that maximizes the difference between TR and
TC. Or, where MR = MC. This level of effort maximizes the economic profit or rent of the resource
being utilized. It usually corresponds to an effort level lower than that of maximum sustainable yield.
In environmental science, optimum sustainable yield is the largest economical yield of a renewable
resource achievable over a long time period without decreasing the ability of the population or its
environment to support the continuation of this level of yield.

Maximum economic yield: Relating to MSY, the maximum economic yield (MEY) is the level of
catch that provides the maximum net economic benefits or profits to society. Like optimum sustainable
yield, MEY is usually less than MSY.

APPLICATION OF MAXIMUM SUSTAINED YIELD

 MSY has been especially influential in the management of renewable biological resources such
as commercially important fish and wildlife.
 In fisheries terms, maximum sustainable yield (MSY) is the largest average catch that can be
captured from a stock under existing environmental conditions.

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 MSY aims to balance between too much and too little harvest to keep the population at some
intermediate abundance with a maximum replacement rate.

LIMITATIONS OF MSY (Based on Larkin 1977):

 Kept populations at too much risk.
 Did not account for spatial variability in productivity.
 Did not account for species other than fishes.
 Considered only the benefits, not the costs of fishing and
 Sensitive to political pressure.

ASSUMPTIONS
 Natural resources grow and replace themselves that’s why they are renewable resources.
 When the harvesting rate is lower than the growth rate, survivability rate and regeneration rate,
there will be surplus resources to harvest.
 Organism do not grow indefinitely.
 There is always equilibrium point where the rate of growth is maximum and starts to fall down
after it.
 Equilibrium population size is called carrying capacity.

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RESOURCES AVAILABILITY
 Resource scarcity is high despite of having high growth rate.
 There are few resources that is growing. In addition, mortality rate of some species is also high.
 Considering both condition, growth rate of resources is high at the mid of logistic growth
equation or half of the carrying capacity

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The formula for maximum sustained harvest (H) is one-fourth the maximum population or carrying
capacity (K) times the intrinsic rate of growth (r ) i.e. H=Kr/4.

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UNIT 5: SUSTAINABLE FINANCING OF BIODIVERSITY CONSERVATION (8)
5.1 Introduction of conservation finance

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5.2 Biodiversity finance (BIOFIN) initiatives
Designing comprehensive financing plans to assure long-term and steady financial flows to
conservation.

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5.3 Solutions for biodiversity finance: Payment for ecosystem services, Wetland banking,
Nutrient trading, Biosafety fee, Voluntary climate financing, Dept-for-nature swaps, Disaster
risk insurance, Ecological fiscal transfers’

1. Payment for ecosystem services

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2. Wetland Banking

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3. Nutrient trading
Nutrient trading is a relatively new and untested technique for pollutant reductions in waterbodies that
makes assumptions regarding short and long term effects.

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4. Biosafety fee
Biosafety means measures to be taken to avoid or minimize of risk to human health and causes any
harm or loss, the Act provides for recovering the cost of.

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5. Voluntary climate (carbon) financing

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6. Dept-for-nature swaps

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7. Disaster risk insurance

8. Ecological fiscal transfers

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UNIT 6: INSTITUTIONAL ECONOMICS FOR NRM (8)
Spangenberg (2002) has identified institutions as a fourth dimension of the sustainability apart from
social, economic and environmental aspect. Institutional economists have distinguished between
economic and non-economic factors as well as economic and social processes. Economics is
concerned with “the study of structure and functioning of the evolving field of human relations which
is concerned with the provision of material goods and services for the satisfaction of human wants it
is the study of the changing patterns of cultural relations which deals with the creation and disposal of
scarce material goods and services by individuals and groups.” (Gruchy, 1947, pp. 550-552).

6.1 Evolution process of institutional economics: concepts, features, development and

effectiveness
Economist knows the price of everything but not the values. Neoclassical economics doesn’t consider
non-market goods and services. Sustainable development more specifically sustainable forest
management involve not only priced goods and services but also values far beyond the reach of market
mechanisms. The neoclassical weighing premise, based on prices, has to be replaced by a hierarchical
approach based on values.

Some ultimate values that cannot be substituted and which therefore can neither be protected nor
managed through market mechanisms. Management decisions around such values should not be based
on an aggregation of individual preferences for them. The starting point for sustainable forest
management (and sustainability) has to be the value society places on forest (and all other natural)
resources. In this context, markets and market prices can constitute one of the many institutional
arrangements to support and strengthen a broader set of institutions for sustainable forest management.

Difficult to estimate the legacy of resources, technologies and aesthetics each generation has to pass
on for the next generation. Sustainability concept recommend that legacy passed on should be adequate
or acceptable. Decisions made considering future includes tradeoffs e.g. species conservation with
forgone human consumption. The physical and social sciences, especially of economics, distinguishes
the items/values which are beyond trade-offs i.e. ultimate value or “merit-goods” and trade-offs among
the goods which can be substituted for each other.

Merit goods” are beyond the boundaries of markets, and other institutions must play the key role in
the decisions involving these goods or attributes of natural resources. Among the substitutable goods,
some may not influence by market transactions due to the absence of market for them. Their valuation
and hence decisions regarding their tradeoffs with marketable goods and services will also require the
support of some other institutions. Markets are useful in establishing appropriate rates of trade-off
among the goods, those which can be effectively traded in the market. Knowledge of appropriate
market function and instruments to make it better is important.

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Features of Institutional economics
 Institutions order relationship among individuals in a society.
 Includes laws, constitutions (laws about making laws), traditions, generally accepted moral and
ethical precepts and customary and accepted ways of doing things.”
 The market idealized by economic theorists or as implemented in the practice of commerce is
itself an institution.Institutions of any kind direct, control, restrain or at least influence almost
every activity or interpersonal relationship in a complex modern society.
 Institutions restrict individual freedom by limiting the harm an individual can impose on others
and vice versa.
 Institutions define rules of the game that helps to define the structure of incentives for individuals
involved into it.
 Change in resource scarcity, technology, demand, people’s preference and other relevant aspects
is unavoidable. Institutions play a great role to manage all these changes.
 Neo-classical economic theory, when applied to natural resources, is generally focused on
technological developments but ignored the institutional structure that shapes the interactions
between policy makers, resource managers and resource users.
 Institutions varies from rules, norms, codes etc., whether formal or informal, which define the
rights, privileges and obligations of various groups under a regime.
 Organizations are physical manifestations of institutions, designed to achieve certain objectives.

Market as an Institution
 Markets are a social construct and operate in the context of a set of institutions, which greatly
affect how well the market mechanisms serve human needs.
 Markets should be carefully designed rather than automatically appear in their optimal form.
Perfectly competitive market are the most socially efficient market.

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 Invisible hands which supports a good functioning of market is usually invisible but usually under
attack of many visible hands. The role of the state and the institutions it supports or constrains is
thus important to good market functioning.
 Public policy helps relatively better to function market well.

Institution vs Organization
 An organization is a systematic collection of people, who work together for achieving the desired
end, under a common identity. Conversely, an institution is an establishment, that is dedicated
to promoting a specific cause that can be educational, professional, social, etc.
 North (1990) who defines institutions as:“the humanly devised constraints that structure political,
economic and social interaction”. Contrary to sociological concepts of institutions,
 North (1993) distinguishes his definition clearly from the concept of organizations: “Institutions
are the rules of the game….Organizations are the players…”.
 Property right rules may be considered a subset within the broader category of economic concepts
of institutions.

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New Institutional economics
 Economic development used to focus on inputs, production process and outputs without
considering institutions to empower and constrain the individuals to incentivize or disincentives'
them.
 The firm was placed as a black box in micro and macro economics.
 Later role of institutions in modern development of capitalism was focused.
 Williamson coined the term “new institutional economics” in 1975. The adjective was chosen
deliberately to distance the newer approach from the old institutionalism.
 Approach of focusing on decision making process within a organization is institutional economics
and cost incurred for it is transaction cost.
 The new institutional economics (NIE) is an interdisciplinary enterprise combining economics,
law, organization theory, political science, sociology and anthropology to understand the
institutions of social, political and commercial life.
 Its goal is to explain what institutions are, how they arise, what purposes they serve, how they
change and how - if at all they should be reformed.

6.2 Concept and analysis of transaction and transformation cost

Transaction cost economics(TCE), understood as the study of the economic consequences of “costly
exchange”, existed a long time before becoming a research program within the framework of
economics. The term transaction cost was coined very late and the economics related to it during 1960.
Transaction costs are costs incurred that don’t accrue to any participant of the transaction. They are
sunk costs resulting from economic trade in a market. In economics, the theory of transaction costs is
based on the assumption that people are influenced by competitive self-interest.
At the highest level, only markets exist, and people in the economy are free to enter into contractual
agreements with each other. Under such a viewpoint, the company exerts full control over the contract,
which led economists to believe that contracts would be violated by different parties when they find
an opportunity to do so. The aim of the transaction cost was to limit the authority of contractual
relationships.
Transaction costs in economies aim to clarify why some markets are able to accommodate many
organizations while others are dominated only by a few, which are known as hierarchies. It is
dominated by hierarchies as it is a more efficient way to build relationships. Four elements of
transaction cost economics:
 uncertainty and unpredictability in the world.
 With bargaining and asset specificity, organizations that enter into transactions find it expensive
to leave them.
 Economic transactions are not based on pure rationality but on bounded rationality.
 The inherent opportunistic behavior of individuals in an economy makes it harder for contractual
agreements to be enforced after a long period of time.
Entrepreneurs of large hierarchical organizations don’t need contractual agreements because they use
organizational policies such as coercion, monitoring, and incentives to maintain control. The TCE
theory states that a hierarchy can allocate resources more effectively, or efficiently, than a market due
to imperfect information and bounded rationality.

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Transformation cost
 In the changing context, given set of institutions is not sufficient, transaction cost can increase.
 Transformation is necessary.
 Transformation cost-the cost incurred for the transformation of property rights from one to others
to regulate the natural resources more effectively.
 Transfer of property rights helps to regulate social cost incurred due to individual behavior. e.g
steel company and resort in a river bank

6.3 Conflict and cooperation in Natural resource management (NRM)

Differences in key actors interests, institutions and other essential elements set for a common resource
management lead to conflict. Collective efforts to manage such resources help to manage those
resources effectively and efficiently. Institutions play a great role for those collective efforts of diverse
actors. Number of ecosystem services can be derived from a natural resource at a single time that
creates a possibility of having conflict among relevant stakeholders. Food security crisis, international
land grabs, emergence of new markets for ecosystem services highlighted the conflicts over natural
resources. Local disputes over land, water, forest, fisheries can contribute to broader social conflicts.
Civil conflict also reduce the rate of development.

Management of natural resources can also be a focus of cooperation that helps to build resilient
institutions to moderate or reduce the impact of conflicts or post conflict recovery. Competition over
natural resources causes not only conflict but also acts as a measure of cooperation to build social and
ecological resilience. Conflict: cover a continuum of patterns of interaction among stakeholder groups.
Existing structure of natural resource management institutions affect the scope for collective action
and conflict management. Understanding the factors that influence collective action is key for any
purposive effort to promote cooperative natural resource management, conflict transformation, and
resilience.

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Priority area for policy and legal reforms
 engage community institutions to establish clarity in resource tenure,
 enable collective action among small-scale producers,
 strengthen both statutory and traditional conflict resolution mechanisms, and
 proactively address inequalities in natural resource access and management authority.

Conflict Resolution
 Efforts at legal and judicial reform and capacity strengthening for local institutions often focus
separately on statutory versus customary mechanisms for conflict resolution and justice,
sometimes ignoring one side of the spectrum altogether.
 In most cases, however, legal, customary, and informal mechanisms are highly complementary.
 Failure to recognize and legitimize this legal pluralism is at the root of many resource tenure
conflicts
 Statutory law and judicial institutions have significant benefits that helps to collaborate disparate
social groups within a society.
 Advantages of customary conflict resolution mechanism:
o Accessibility
o Social cohesion
o Adaptation

Compiled by: ROSHAN SINGH THAGUNNA (M.Sc Watershed Management, 2076-78) 101 |
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 Please Revise once...
ALL THE BEST !!!

Compiled by: ROSHAN SINGH THAGUNNA (M.Sc Watershed Management, 2076-78) 102 |
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