Economic Valuation of Ecosystem

Services

Market Allocation of Resources

Aseffa Seyoum (PhD), Natural Resources Economist

 Market Allocation of Resources

• A variety of institutional arrangements might be employed to

allocate resources, such as central planning and free markets.

• Central planning to achieve allocative efficiency it is necessary

that the central planner know all of the economy’s production
and utility functions.

• This is clearly infeasible, and is one of the reasons that attempts

to run economies in these ways have been unsuccessful.
 Market Allocation of Resources
 Free markets do not require that any institution or agent have
knowledge of all of the economy’s production and utility functions.

 Free markets are decentralized information-processing systems of

great power.

 The modern welfare economics that is the basis for environmental

and resource economics takes it that markets are the way
economies are mainly organized.

 The market economy is now the dominant mode of organizing

production and consumption in human societies.
 Market Allocation of Resources
 Free markets is an institutional arrangement that would
sustain an efficient allocation of resources, based on the
following assumptions:
o Markets exist for all goods and services produced and
consumed.
o All markets are perfectly competitive
o All transactors have perfect information
o Private property rights are fully assigned in all resources and
commodities.
o No externalities exist.
o All goods and services are private goods. i.e. there are no
public goods.
o All utility and production functions are ‘well behaved’
 Market Allocation of Resources
 Conditions required for a well-functioning competitive market
o Well-defined and enforceable property rights that characterize the
ownership of resources, goods, and services

o Market institution that is made up of the various rules governing

how buyers and sellers interact, particularly how price and other
terms of trade are set.

o Large numbers of buyers and sellers, each of which is small relative to

the overall market. Consequently, no individual buyer or seller has
market power

o Buyers and sellers are unable to collude and form organizations (e.g.,
cartels) that can affect market price by coordinating member firms’
collective purchase or sales quantities.
 Market Allocation of Resources
 Conditions Required for a Well-Functioning Competitive Market
o There are no positive or negative externalities
o There is the potential for low-cost entry by new sellers or buyers,
which further limits the potential for market power by incumbent
firms.
o Transaction costs, such as legal fees, taxes, or regulatory costs that
must be paid before an economic exchange is transacted, are
sufficiently low that they do not choke off mutually satisfactory
transactions.
o Information on characteristics such as the quality, availability,
pricing, and location of goods and services is available at low cost to
market participants.

 Market failure occurs when one or more of the above conditions

for a well-functioning competitive market are not met in a
substantial way.
Market Allocation of Resources

 Market Demand and Supply

 Market Demand
 A set of buyers known as consumers who are assumed to have the
objective of maximizing their overall level of satisfaction, or utility,
but are constrained in this endeavor by their budget and by market
prices.

 Each unit of each good or service provides the consumer with an

increment of utility known as marginal utility.

 Law of Diminishing Marginal Utility- when more than one unit of a

good is consumed in a reasonably short period, the marginal utility of
each successive unit consumed will decline.
Market Allocation of Resources
 Law of Demand- there is an inverse relationship between the
price of a good or service and the quantity demanded by
consumers

 Each point on this demand

curve represents the
maximum amount of
money the consumer is
willing to pay for the
indicated quantity of goods
and services
Market Allocation of Resources
 Market Supply

 Sellers are assumed to be firms that have the objective of

maximizing profit in neoclassical microeconomics.

 a supply curve is a graphical relationship between price and

quantity supplied.

 The Law of Diminishing Marginal Returns characterizes

production in the short run. This law states that as more and
more of a variable input is added to a fixed input, the marginal
productivity of each successive unit of variable input will
eventually become smaller.
Market Allocation of Resources
• Marginal cost is equal to the change in total cost caused by
an incremental change in output.

• Marginal cost tells us how much total cost increases when we

increase the quantity of output by one unit.

• a firm’s profit-maximizing output level occurs where price

equals marginal cost.
MC=P
• Under competitive market conditions where sellers are price
takers, firms supply along their marginal cost curve.
 Market Allocation of Resources
 When price rises, profit-maximizing firms respond by increasing
their output level.
 Higher prices are required to overcome rising marginal costs, which
in turn occur due to the Law of Diminishing Marginal Returns.

 A supply curve shows

the relationship
between price and
quantity supplied, the
firm’s supply curve is
its marginal cost curve
Short-Run Supply Curve
 Market Allocation of Resources
 Market equilibrium
 Market equilibrium occurs at a price where the quantity supplied (s)
by sellers equals the quantity demanded (D) by consumers.
 Quantity supplied equals quantity demanded, there is neither excess
supply nor excess demand.

 The price and the volume of trade

will stay the same over time until
some factor influencing buyer or
seller market behavior changes,
which will then necessitate a
period of adjustment as price
seeks its new equilibrium level.
 Market Allocation of Resources
 Efficient Allocation

 An ‘allocation of resources’, or just an ‘allocation’, describes

what goods are produced and in what quantities they are
produced by which firms, which combinations of resource
inputs are used in producing those goods, and how the those
goods are distributed between consumers.

 Efficiency in allocation requires that three efficiency conditions

are fulfilled:
 Consumption efficiency
 Production efficiency
 Product-Mix Efficiency
Market Allocation of Resources
 Consumption Efficiency
 Utilitarianism and Efficiency
 Utilitarianism also allows for the evaluation of efficiency.
What is a good general definition of efficiency?

 Minimization of waste.

 There are two different efficiency criteria commonly used by

economists for evaluating social policy – Pareto and Kaldor-
Hicks…
 Market Allocation of Resources
Pareto Efficiency
 Compares policy alternatives to the status quo.
 To be a Pareto improvement overt the status quo, a new policy
alternative must make some people better off (increase their
utility), perhaps leave some people unaffected, and make nobody
worse off (decrease their utility).
 An efficient allocation (Pareto efficient, optimal) is when it is not
possible to make one or more persons better off without making
at least one other person worse off. Conversely, an allocation is
inefficient if it is possible to improve someone’s position without
worsening the position of anyone else (Pareto Improvement).
 Market Allocation of Resources
Production Efficiency
KY
LXa LXb
LX X0

IX IY1
IY0
KYa a KXa

KYb b
KXb

Y0 LY
LYa LYb
KX
 Market Allocation of Resources
Social Welfare: Sum of Consumer and Producer Surplus

€
MB = Aggregate Marginal Benefit
MC = Aggregate Marginal Cost
CS = Consumer Surplus
MB PS = Producer Surplus
MC CS+PS = Social Welfare

CS
P*
PS

X
X*
 Market Allocation of Resources
 Social Welfare
 Consumer and Producer Surplus, MB=MC=P
€

MB
CS MC
P1

PS
P*
PS

X
X1 X*
 Market Allocation of Resources
 Pareto Efficiency
 Is it fair to say that the Pareto efficiency criterion is biased
toward maintaining the status quo? This presents ethical
problems when the status quo is widely held to be
unethical (e.g., slavery).
 Market Allocation of Resources
Kaldor-Hicks Efficiency
 Evaluates policy alternatives as well as the status quo.
 The Kaldor-Hicks efficient policy alternative (which may be the
status quo) generates the largest net social utility (or net social
benefit), even if some are made worse off.
 The Kaldor-Hicks efficiency criterion is sometimes referred to as
being potentially Pareto efficient because the potential exists for
those made better off to compensate those made worse off,
which would lead to Pareto efficiency by sharing net social
benefits with all members of society.
 Market Allocation of Resources
Efficient Resource Allocation
 The concept of efficient resource allocation refers to how we
measure the welfare of market participants.

 Buyers have a maximum price they are willing to pay for a given
quantity of the good, as represented by points along their
demand curve, and receive a gain from trade called consumer
surplus when their willingness-to-pay value is larger than the
price they had to pay.
 Market Allocation of Resources
Efficient Resource Allocation
 Since the market demand curve represents the willingness-to-
pay values of all the buyers in the market, total consumer
surplus is approximated by the area in this figure.

 Sellers receive a
symmetrical gain from
trade, called producer
surplus, when market
price exceeds those costs
that must be covered to
make a sale worthwhile
 Market Allocation of Resources
Efficient Resource Allocation
 Producer surplus is essentially profit to the producer before fixed
costs are taken into account.

 The sum of consumer and producer surplus is referred to as total

surplus, or the total gain from trade in this market.

 We measure the overall welfare of the market participants based

on total surplus.

 Resources are efficiency allocated when the welfare of the market

participants (as measured by total surplus) is maximized.
Market Allocation of Resources
Efficient Resource Allocation

 Resources are efficiently allocated when market participants

receive the maximum possible gains from trade.

 Resources are efficiently allocated at the equilibrium market

price because in a well-functioning competitive market there
is neither excess supply nor excess demand, and so there are
neither too many nor too few units of the good or service
produced.
 Market Allocation of Resources
Dynamically Efficient Nonrenewable Resource
Pricing

 Determining the optimal balancing of current

and future sales in a competitive natural
resource market.
 A resource market is dynamically efficient
when the sum of total surplus (in PV terms) is
maximized over the entire time horizon in
which the resource is allocated.
 The present discounted value (PV) of that
future payment (FP) is given by the following
formula:
PVFP = ($ future payment)/(1+r)i

 The rule for dynamic efficiency, called

Hotelling’s rule, requires that marginal profit
(P – MC) in year 0 must equal the PV of (P –
MC) in year 1 (and in any other future years).
 Market Allocation of Resources

Dynamically Efficient Nonrenewable Resource Pricing

 If there are more than just two periods, then Hotelling’s rule
requires that the PV of (P – MC) be equal across all time periods in
which the resource is to be allocated.

 When this condition holds, the sum of total surplus (in PV terms)
over all time periods in which the resource is to be allocated will be
maximized.
 Market Allocation of Resources
Hotelling’s rule:

 Hotelling’s rule simply formalizes our intuition that dynamic

equilibrium occurs when the marginal profit from selling a unit of
the resource is the same today as it is in a future period.

(P0-MC)/(1+r)0 = (P1–MC)/(1+r)1

Marginal profit, Marginal profit,

period 0 period 1
 Market Allocation of Resources
 When a nonrenewable resource is abundant, then consumption
today does not involve an opportunity cost of forgone marginal
profit in the future, since there is plenty available for both today
and the future.

 As the resource becomes increasingly scarce, however,

consumption today involves an increasingly high opportunity cost
of for- gone marginal profit in the future.

 Therefore the profit created by this form of resource scarcity is

called Hotelling rent (also known as resource rent or by the
Ricardian term scarcity rent).
 Market Allocation of Resources
 Hotelling rent is economic profit that can be earned and can
persist in certain natural resource cases due to the fixed supply of
the resource. Hotelling rent generated in year 0 by our dynamically
efficient solution is illustrated here.

 Due to fixed supply,

consumption of a resource
unit today has an
opportunity cost equal to
the present value of the
marginal profit from selling
the resource in the future.

Dynamically Efficient Solution, Year 0

 Market Allocation of Resources
 This opportunity cost limits current supply, which in turn
elevates current price above marginal cost, creating the rent.

 Likewise, marginal Hotelling

rent is defined to be the
marginal profit received from
a unit of the scarce resource,
(P – MC). As a resource
becomes increasingly scarce
relative to current and future
demand, this scarcity is
revealed in higher and higher
marginal Hotelling rent.

Dynamically Efficient Solution, Year 1

 Market Allocation of Resources
Allocating Recyclable Resources
 (E.g. metal, paper, plastic, etc.)
 The commodity market will have three supply curves—one for the
recycled source, one for the virgin source, and the market supply curve
that represents the horizontal sum of these two supply curves.
 Two different cases are explored. With low
commodity demand (D0), equilibrium price
P0 is everywhere below the minimum
price required to supply commodity from
recycled sources.
 In this case, firms (or recycling centers) cannot
afford to supply recycled material due to its
higher marginal cost, and the entire equilibrium
market quantity Q0 is generated from virgin
material.
 Under this unfortunate circumstance recycling
will only occur if the higher collection, sorting,
and shipping costs are subsidized.
 Market Allocation of Resources
 With high commodity demand (D1), equilibrium price P1 results in a total
equilibrium market quantity Q1, a portion of which (QR, as indicated by the arrow
is generated from recycled material.

 In this case higher market demand enables results in an equilibrium market price
that is sufficiently high as to support market-based recycling without subsidy.

 An interesting problem for metals cartels and monopolists is in setting production

levels and prices for primary resources, knowing that these prices and production
levels directly affect future competition from secondary (recycled) resources.

 Excessive current production of a durable resource or good will increase the

future used or recycled supplies that act as substitutes for future primary
production.
 In the case of metals, a higher level of current production assures a higher
secondary scrap market supply. As the stock of scrap grows, the supply of (new +
used) metal grows, driving down price.
 Market Allocation of Resources
Allocating Renewable Resources
 Unlike nonrenewable resources such as minerals, renewable resources
are a part of the self-regulating process of the living planet. Removing
some trees, fish, groundwater, forage, etc. will not result in permanent
destruction of the resource stock.
 Renewable resources can be depleted if use exceeds the maximum
sustainable yield over extended periods of time.
 Substantial work has been done on establishing maximum sustained yield
from various renewable resource stocks such as fisheries and forest
management.

 The notion underlying maximum sustained yield is to identify the

largest harvest rate (a “flow” variable) that can be sustained indefinitely
from the existing resource stock.
 Market Allocation of Resources
Allocating Common-Pool Resources

 Many natural resource systems are not partitioned by private property

rights. These resources may be held as state property or common
property (among a defined user group), or they may simply be open-
access.

 Certain resource stocks such as air, groundwater, or open-ocean fisheries

are fugitive resources that cannot effectively be partitioned and privately
owned.

 Gordon constructed a simple model of a commercially valuable common-

pool resource under open-access conditions to illustrate the problems
associated with appropriation externalities.
 Market Allocation of Resources
Allocating Common-Pool Resources
 In Gordon’s model, the problem is to find the optimal amount of effort
input E instead of the optimal quantity of output Q. Appropriation effort
refers to inputs such as capital and labor that are applied to harvesting
resource units from the CPR.
 Assume that the market price of the
resource being harvested is not affected
by the amount of effort applied to the
fishery.
 We assume that marginal effort cost
(MEC) and average effort cost (AEC) are
constant. MEC is the increase in total cost
from an additional unit of effort, while
AEC is total cost divided by the total
amount of effort applied to resource
harvest.
 For example, constant MEC and AEC imply that the cost of operating an oil well or a fishing
boat for an hour remains constant.
Market Allocation of Resources
Allocating Common-Pool Resources
 The economic benefits from effort are measured by revenue generation. As
with effort cost, there are two important revenue measures for effort—
marginal revenue product (MRP) and average revenue product (ARP).

 MRP is simply the change in total revenue caused by an additional unit of

effort, while average revenue product is total revenue divided by the total
amount of effort applied to resource harvest.

 The revenue generated by operating a fishing vessel for an additional hour

is MRP, while ARP is the average amount of revenue generated by an hour
of vessel operation.
 Low levels of total appropriation effort do not harm the productivity of the
resource stock, and so ARP and MRP are both high when total effort E is
low.
Market Allocation of Resources
Allocating Common-Pool Resources
 For example, if a fishery has not been fished very much, then a vessel can
catch many fish in an hour of effort. As total appropriation effort grows,
however, the resource stock de- clines, and so both MRP and ARP decline.

 MRP declines more sharply than ARP because MRP reflects revenue
generated by an additional unit of effort on an increasingly depleted
resource, while ARP reflects the average of revenue from both abundant
and depleted resource conditions.

 Declining MRP pulls ARP down, however, just as a bad set of semester
grades will pull down a student’s cumulative grade point average.
Market Allocation of Resources
Allocating Common-Pool Resources

 If MRP = MEC, then further effort will cause MRP < MEC, which will
cause profit to decline. The efficient level of appropriation effort leads
to maximum Hotelling rent to be shared by all the appropriators.

 The group-optimum (efficient) level of appropriation effort E* occurs

where MEC = MRP.

 The intuition is similar to the reasoning behind why a profit-maximizing

firm in a competitive market will supply a quantity of output where
market price equals marginal cost.

 Starting at zero effort, one can incrementally increase effort in one-unit

intervals and compare MRP to MEC. As long as MRP > MEC then an
additional unit of effort will increase profit.
Market Allocation of Resources
Allocating Common-Pool Resources
 The dilemma with CPRs is that, unlike the invisible hand of Adam
Smith’s competitive market, self-interested behavior in a CPR does not
yield the efficient outcome.

 The process of rent dissipation in CPRs is referred to as the tragedy of

the commons
 Localized CPR systems can be durable and sustainable in situations in
which open-access conditions are displaced by a common property
regime established and governed by the local people who depend on
the CPR.
 Institutions also specify the people who are allowed to use the CPR, the
methods and extent of appropriations from the CPR, the methods and
financing of monitoring systems, a system for resolving conflicts, and a
set of sanctions that are proportionate with the importance of the
transgression.