Pearce & Turner Economics of Natural Resources and the Environment. (chs. 4-8) LL 496 P 100
Natural resources are inputs to production. They differ from other inputs, like labour and capital, in two important effects. Firstly, they are non-excludable. Meaning that it is very hard for someone to own the actual natural resource. Secondly, unlike capital and labour that are renewable, some of the natural resources are non-renewable. Once used up they will never be restored. Even the resources that are renewable take time to renew. Thus there is a maximum amount that can be extracted for a renewable natural resource to survive.
Now in general it is widely accepted among economists that free competitive market with no barriers and rational individuals leads to a Pareto efficient outcome that maximises the current welfare. Even when these conditions are not met, assuming no transaction costs (thus no bargaining problems of the sort Rubinstein describes) and well-defined property rights and perfect information, will lead to welfare optimisation. This is known as the Coase theorem. Government intervention is only needed when private system cannot maximise the welfare. There are two cases where government intervention is needed accordingly – when the conditions mentioned above are not satisfied for Natural Resources, and secondly, when these conditions are actually insufficient to maximise welfare. I will look at each of these cases in turn.
Main argument for government intervention to the NR management has been to prevent their overuse. For renewable resources overuse is easy to define – it occurs when the resource is used faster than it can reproduce (fish are fished quicker than they can grow back). Non-renewables usually exist in a variety of qualities (quality of oil). When they are relatively abundant their price is low and only the good quality, cheap resources are used. When it gets scarce and more expensive, then mediocre qualities become commercially feasible. However, non-renewables have number of alternative uses, some of which have substitutes, others that do not. Thus the overuse means that the resource is used at present for products that have substitutes, because it is so cheap. However, in the future, the bad quality resource is not enough for the products that have no substitutes. Most common example is the use of oil in both as fuel and as the raw material for pharmaceuticals.
MC with rental
value (social cost incl.)
MC with private costs
MC with rental
value (social cost incl.)
As seen, with private costs only accounted, the production is too big.
Secondly not all markets exist. Specifically the futures market and the insurance markets are not fully developed. If the futures market would exist they could have certain future income. However, if it does not, it can be shown that when the individuals are risk averse they prefer to have their returns now and thus extract too much of the renewable resource. And there might be ownership problems. It is not clearly defined who owns the air etc. Furthermore, sometimes it is more optimal to have things owned commonly (common property resources, CPR-s), I will extend that point further later. When the ownership is not defined not all exchanges can occur and allocation will be Pareto inefficient. In NR-s this will normally lead to overuse, as users assume no overhead costs.
However, as Mirrlees argues, there are also numerous factors that lead to under-use of NR-s. Mainly that most of the NR-s are managed by monopolies that restrict output, and the tax rate is such to make firms less willing to have unusually high profits from extraction. He argues that we are better off living in a world with many capital goods and no NR-s, than to live in a world with unused NR-s. Thus we should resort to empirical measures first of all to determine whether the overuse is really the case. Mirrlees analysis applies mainly to non-renewables, because it is quite clear that renewables can and are mostly overused.
Thus the government role in this case is to correct the market failure. It can provide the missing markets and, for example, establish the insurance schemes. It can reduce the uncertainty in the markets. For example, giving firms concessions to use the resource reduces their uncertainty and thus makes the allocation more efficient. However, the allocation will still be inefficient when there is a probability that with a change in government the concession agreement will end. This uncertainty will be reduced by more stable political system. Government can also calculate the total social costs and tax users of NR-s accordingly, as to make the result optimal. It can be thought of as the government assuming the ownership of the NR-s and thus manages them optimally. Furthermore, governments can force individuals to participate in transactions that are beneficial to the society but harmful to one of the parties. These transactions would not occur in the free market.
However, this analysis assumes that government has unlimited computing power (Hayek rejects that); that it is credible in a sense that the officials do not use the rights for NR-s to their personal advantage; that it can enforce its policies without them costing more than they benefit; and also that there is decent data to base the predictions on. Obviously none of these conditions is perfectly satisfied. However, research has shown that the errors are a lot smaller in small projects, where benefits can exceed costs, however, for bigger projects the imperfect information, adverse selection and moral hazard problems that the government policies face are usually higher than the potential benefits.
To bring some simple examples, McCay and Acheson (1988) have looked the natural resource management in the South-Indian villages. They had common farming land that tended to be overused. Privatisation was too expensive and would have left a large number of poor people. A council was set up to regulate the use of the land. Basically the animals were allowed to be private, there were auctions on the number of lams that each farmer kept and with that money village and the land was kept in order. This is an example how a small community can benefit from the government regulation that specifies ownership. Due to personal relations corruption was avoided.
However, Blaikie and Harriss reached a different conclusion for the NR management in Tamil Nadu, India. In there, they had a problem with watering the fields. Also, once a watering system was in use, people from other villages could free ride. Thus the state privatised some better lands. No attempt was made to exclude people from other villages. There was lots of bribery and bureaucracy. Final outcome was the marginalisation of most population who were forced to use the land left over from privatisation.
These examples show how government action can lead to two totally different outcomes. Oakerson has calculated conditions for the government intervention to succeed. Basically, it relies on many microeconomic features, like indivisibility and excludability of the particular NR in question.
Government interventions have often been justified on the grounds that the system was heading towards a collapse and intervention was the only reasonable solution. However, this assumes that societies always satisfy the Pareto conditions. In practice, they do not. People are not always selfish, there is a large deal of non-monetary judgement, like reputation. Also in many NR management systems people believe in God and thus are not rational in a Pareto sense. In these cases often customary management models according to social norms and culture are used. Also often the result has risen out of evolution (optimal foraging systems for example minimise the effort to get the results that are just acceptable, normally the results that their parents got). These societies are normally very dependent on natural resources and very vulnerable to shocks. However, the way to cure shocks is not necessary always the typical scientific way to transform the system to Pareto efficiency, sometimes it helps to counter the shock and restore the balance. For example A. Stocks has researched the resource management in an Amazon Varzea Lake Ecosystem. There was a shock to optimal foraging system by the population increase. However, a shock had been experienced by the system before by the growth of barbasco. Thus the system had rational parts, for example they did not allow commercial fishing. In this case the society showed self-regulation (as defined by Locke). Instead of collapsing with the increase in population, and depletion of fish, they started to use wood and sell it to cash markets. Birth control was also moderately being exercised. However, the system remained in optimal foraging and did not allow selling for commercial gain. This happened because of strong religious links among people. If commercial selling would have occurred (like predicted by free markets) the society would have depleted its resources very quickly. This shows a prime example of when government intervention is not needed.
As seen government intervention is not always necessary in Pareto inefficient situations. However, in the second part of this essay I like to discuss whether the intervention is necessary to maximise welfare even when the Pareto conditions are met. This means that Pareto conditions are not enough to maximise the welfare of the society. I will briefly look at two other issues with welfare where government intervention is often preferred, namely inequality and the sustainability of the NR-s to maintain the culture and the setup of the existing societies.
Pareto efficiency does not talk about inequality issues. It is Pareto equivalent when the King owns all N resources, and n-1 other citizens own 0, or when everyone owns N/n resources. However, the inequality issue is a very important one with NR-s. Most of the pro-market solutions increase inequality – which is true for privatising open-access resources, and preferring monopoly to other forms (as monopolies restrict output). Welfare of the nation can normally be enlarged when resources are divided more fairly. I am not going to go deep into this topic, except to note that it is a feature of the democratic society that everyone gets an equal vote, not depending on his or her finance. And when the state is more powerful than the individuals it can redistribute income. Thus in a society where the King owns everything, the nation could elect a parliament that redistributes his income. It is argued that this leads to greater welfare. Thus again, the maximisation condition is that government is independent, democratic and powerful. Then its actions are optimal to eliminate allocative inefficiencies.
Secondly for culture and sustainibility, it is sometimes argued that people value them more than the efficient allocation. In theory one could put monetary values on people’s cultural preferences etc. However, in practice this is not done due to the difficulty in judging the exact quantities. Still, mostly people prefer the traditional way, and thus, even when by calculations it is optimal to change the system by government intervention, it will not increase welfare due to intangible reasons.
Rental value is the opportunity cost for using the resource. It has been argued by Ricardo that because the land does not have any alternative uses its rental value will be zero in equilibrium. However, in practice it does not occur, because land does have competitive uses and when someone owns it, they are in a bargaining position to ask for part of the revenue the land brings.
Open Access means that there is non-excludability. Anyone can use the good, thus if there is a price to it, people will free ride. Competition ensures that profits will be driven to zero, and in this case the rental value of the renewable resource will be driven to the value of its direct private benefit. As anyone can use it now there is no point in investing to its future growth rates. When people base their decision to produce they will look at their private costs of production. When the immediate private benefits exceed that costs, renewable resource will be used. Thus open access makes the rental value in a competitive economy equal to the marginal costs of its use.
However, Coase theorem says that individuals can always reach a beneficial agreement. Thus in theory people should be able to agree to use the resource in a socially optimal way. However, as there is no way to exclude individuals, there will be free riders and an agreement like this is not feasible.
The only way the rental value of a resource can exceed its private value and be closer to its social long-term value, is when individuals are not completely rational in a Pareto sense. That is when they care about other people’s welfare and thus about the faith of the resource, or when they have reputation in the society that somehow makes them reluctant to use the resource (for example the religion prohibits).