11Economic ConceptsEconomic Conceptsand Applications to Climate Changeand Applications to Climate ChangeEconomic ConceptsEconomic Concepts••When markets work and when they donWhen markets work and when they don’’t workt workPolicy Interventions to correct market failuresPolicy Interventions to correct market failuresRecent research in Recent research in climateclimate changechange22Part 1: Economic ConceptsPart 1: Economic Concepts33First Theorem of Welfare EconomicsFirst Theorem of Welfare EconomicsPareto efficiencyPareto efficiency••No welfare enhancing trades can be madeNo welfare enhancing trades can be made••It is impossible to make somebody else better off without makingIt is impossible to make somebody else better off without makingsomebody else worse offsomebody else worse offFirst theorem of welfare economics: the equilibrium of aFirst theorem of welfare economics: the equilibrium of acompetitive market economy is Pareto efficient ifcompetitive market economy is Pareto efficient if••all goods are all goods are privateprivate••no difference between no difference between private and social costprivate and social costFormalizes Adam SmithFormalizes Adam Smith’’s concept of an invisible hands concept of an invisible hand44Invisible HandInvisible Hand““Every individual Every individual …… neither intends to promote the neither intends to promote thepublic interest, nor knows how much he is promoting it.public interest, nor knows how much he is promoting it.He intends only his own security, his own gain. And heHe intends only his own security, his own gain. And heis in this led by an invisible hand to promote an endis in this led by an invisible hand to promote an endwhich was no part of his intention. By pursuing his ownwhich was no part of his intention. By pursuing his owninterest he frequently promotes that of society moreinterest he frequently promotes that of society moreeffectively than when he really intends to promote it.effectively than when he really intends to promote it.””““It is not from the benevolence of the butcher, the brewer,It is not from the benevolence of the butcher, the brewer,or the baker that we expect our dinner, but from their regardor the baker that we expect our dinner, but from their regardto their own interest.to their own interest.””55Invisible HandInvisible HandIdea behind invisible handIdea behind invisible hand••Societal perspective:Societal perspective:A good should be produced if the A good should be produced if the ““utilityutility”” to the user exceeds the to the user exceeds thecost of producing itcost of producing it••Firm perspectiveFirm perspectiveCan make a profit if the Can make a profit if the ““utilityutility”” to the user (the maximum he/she to the user (the maximum he/sheis willing to pay) exceeds the cost of producing itis willing to pay) exceeds the cost of producing it••Ina well-functioning market, note how the incentiveIna well-functioning market, note how the incentiveof a firm align with that of societyof a firm align with that of society66Key Concepts I: Private / Public GoodKey Concepts I: Private / Public GoodPublic versus private goodsPublic versus private goods••Private goodPrivate goodRival: if I eat an apple, somebody else canRival: if I eat an apple, somebody else can’’t eat the samet eat the sameappleappleExcludable: I can keep other people from eating my appleExcludable: I can keep other people from eating my apple••Public goodPublic goodNon-rival: if I walk in a park, my neighbor can do so at theNon-rival: if I walk in a park, my neighbor can do so at thesame timesame timeNon-excludable: I canNon-excludable: I can’’t keep my neighbor from walking in thet keep my neighbor from walking in theparkparkProblem of free-riding: Incentive to let other people Problem of free-riding: Incentive to let other people ““provideprovide””a good without paying for it.a good without paying for it.77Key Concepts II: Private / Social CostKey Concepts II: Private / Social CostPrivate costs (benefits) of an actionPrivate costs (benefits) of an action••accruing to the actor onlyaccruing to the actor onlySocial costs (benefits)Social costs (benefits)••total costs of activity including those that accrue tototal costs of activity including those that accrue topeople other than the actorpeople other than the actorExample: driving a carExample: driving a car••Private costs: fuel, maintenancePrivate costs: fuel, maintenance••Social costs include pollution, road wearSocial costs include pollution, road wear88External EffectsExternal EffectsAny difference between private and social costsAny difference between private and social costsis referred to as an is referred to as an ““externalityexternality”” or or ““externalexternaleffecteffect””Recall how markets workRecall how markets work••in seeking profits firm produce a goodin seeking profits firm produce a goodIf If ““utilityutility”” to consumer (maximum willingness to pay) exceeds to consumer (maximum willingness to pay) exceedsthe cost of producing itthe cost of producing it••Problem: if private cost are different from social cost,Problem: if private cost are different from social cost,firm doesnfirm doesn’’t act in societies best interestt act in societies best interest990246810121416A BChoicesCostsPrivate-Social differencePrivateLeft - social cost 15, private 10Left - social cost 15, private 10Right - private & social cost of 12Right - private & social cost of 12Corporation will choose A as private cost is lower1010Examples of Private v. SocialExamples of Private v. SocialConserving tropical forestsConserving tropical forests••Private benefits: may be small for landownerPrivate benefits: may be small for landownersome sales of non-timber forest productssome sales of non-timber forest productsEco-tourismEco-tourism••Social benefits:Social benefits:carbon sequestrationcarbon sequestrationbiodiversity conservationbiodiversity conservationAvoided soil erosionAvoided soil erosion1111Market FailureMarket FailureSocial benefits > private benefitsSocial benefits > private benefits••Good is underprovidedGood is underprovided••Provider has too little
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