Chapter 4

Economics of Natural Resources

Natural Resources:
Specific attributes of the environment that are valued or have proven
useful to humans [or have the potential to do so]* --G. Johnston
Aspects of nature that can be used by humans to satisfy human
wants--Hite & Mulkey
key to human use: technology, time, accessibility, application,
perception; conflicts often related to culture
Economics: the study of the production, processing, distribution,
consumption of goods/services in an exchange system.
Natural Resource Economics
application of economics to manage naturally occurring resources
for human needs/wants with efficiency as the primary goal.
efficiency may be defined in market or nonmarket terms, focused
on the short or long run, relative to current or future generations,
local or global in scope.
Contd.
decision choices include maintaining the status quo, altering the
status quo, or doing nothing with focus on relevant institutions.
evaluation always includes the costs & benefits of a decision & to
whom those costs & benefits accrue.
Environmental Economics vs. Natural Resources Economics
Environmental Economics: economic basis for pollution problems &
policy alternatives
Natural Resources Economics: problems of managing common-pool
natural resources, determining optimal rates of extraction, &
understanding resource markets
common-pool natural resources: difficult to exclude access, but once
extracted is no longer available to others (groundwater, rivers, fisheries,
public forests)
Scarcity, Opportunity cost, economic rationality
 Why Study Natural Resource Economics?
Natural Sciences lack commonly accepted decision process
Economics may “assume” the problem away
Irreversibility
Market failure
Joint importance of economic and ecological systems
Physical-Natural-Economic System Links
•Improves efficient functioning of system
•Improves understanding about the world we live in
Summary: Improved management of natural resources,
whether for private, public or natural gain
Classification of Natural Resources
Contd.
1. Flow Resources (non- depletable)
a. Non-storable (sometimes called “environmental resources”)
Often indivisible
Inexhaustible (in human span of time)
Time & management relevant only to consumption, not
supply
Contd.
1. Flow Resources (cont)
b. Storable (by nature, as in living matter; by humans with
technology)
 May be divisible
 Time & management relevant to both to consumption &
supply
 The services are what are significant for humans
Storable Flow Resources
Contd.
2. Fund Resources (stock or depletable resources)
a. Exhaustible & Renewable
Regenerative within human use time frame
Assumes use within minimum & maximum thresholds
Contd.
Contd.
2. Fund Resources (cont)
b. Exhaustible & Nonrenewable
Relatively fixed stocks/fund within human use time frame
(1) Nonrecyclable--Examples: fossil-fuel energy resources
(oil, natural gas, coal, peat, many “renewable” resources when
thresholds violated)
(2) Recyclable--Examples: some minerals (iron, aluminum,
gold, silver)
 Framing Natural Resource Issues
Quantity & Quality of: Land, Water, Air, Energy
Public vs. Private Management Question
Trend of Magnitude of Problem:
•Persistent, Chronic, Cyclical, Declining, Growing?
Irreversibility
Geographic scope
Whose problem & who decides (ethics)?
Property rights
Time (short vs. long run; current vs. future generations)
Optimism vs. Concern for Environment & Natural Resources
Concerns
•Global warming & climate impacts
•Over-population & biodiversity
•Soil/water quality/Mineral/energy cost/availability
•Pollution/resource shortage impacts on social & political
institutions
Optimism
•Legislative progress
•Toxic release rates down
•Competitiveness
Environmental Valuation
Contd.
Contd.
•Stewardship benefits are moral benefits that we derive
from knowing that we are doing our parts as stewards
of the worlds’ resources:

•Bequest benefits refer to utility derived from passing

an environmental resource on to children and/or future
generations.

•Existence value, or inherent benefits refer to utility

derived from the knowledge of the mere existence of
environmental resources. You might never see many
of the endangered species but you might still value
their existence.
 Concepts in Benefit Measurements
Willingness to pay (WTP) is the maximum amount of money an
individual would give up in exchange for all the benefits associated
with an environmental resource.
We can think of WTP as the area under an individual’s demand
curve as an individual would be willing to pay an amount equal to the
total benefits received from the environmental good.
Willingness to accept (WTA) is the minimum total amount of money
an individual would accept to forego all the benefits associated with
an environmental resource.
It is the opposite of WTP in terms of resource allocation or property
rights.

WTP < = > WTA?

WTP is bounded by an individual’s budget constraint (or income),

WTA is not.
 Measurement Issues
Uncertainty about the amount of benefits, especially when we talk
about future benefits
Example:
•Suppose the Department of Fish and Wildlife is considering a
management project that improves fish habitat in a trout-fishing
stream. Suppose that without the program the outcome is certain and
equal to a "Status Quo Benefit,”. The outcome of the project,
however, is uncertain with three possible outcomes for which the
department has rough probability measures:
Probability: Possible Outcome Under the Project:
1/2 Status Quo Benefit
+ $6M.
1/4 Status Quo Benefit
+ $3M.
1/4 Status Quo Benefit
+ $9M
Expected benefit:
 Measurement Issues

Expected Benefit with project = Status Quo Benefit + 1/2 · $6M +

1/4 · $3M + 1/4 · $9M
= Status Quo Benefit + $6M.
Risk aversion: If uncertainty decreases the department’s willingness
to pay relative to the expected benefit of the project.
A risk averse department has a WTP of less than $6M.

Risk Premium: The difference between the expected benefits and

maximum WTP by the department.
If the department has WTP = $5M, then the Risk Premium on the
project equals $1M.
Heterogeneity in valuation of environmental amenities.
 Market and Non-Market Valuation Methods
 Market Values: The use of market prices is the most direct
method (e.g. resort skiing, commercial whale watching, etc.).
But:

1) Market Failure often occurs when providing environmental

resources due to externalities.

2) Many environmental resources are not traded in markets due

to public good character.

 Alternative methods
Contd.
Engineering and agronomical cost methods:
•If natural resources can be restored (such as forests) engineering and
agronomical techniques of mathematical programming can be applied
to estimate the cost of restoration.
Hedonic price functions
Travel cost methods
Survey and interviewing techniques: Contingent Valuation (CV)
 Hedonic Price Functions
Goods in general can be thought of as bundles of characteristics.

The hedonic price function approach is a method that infers the

marginal value of each characteristic (Zi) form the price of the
combined bundle:

P  a1Z1  a2 Z 2 .........  an Z n

Implicit prices or valuation (ai) of environmental quality such as air

quality can be deduced from market prices of goods such as house
prices (e.g. Chay and Greenestone 2005) using statistical analysis and
econometric techniques.

Issues?
 Travel Cost Methods
The value of recreational amenities is inferred from
associated expenditures.
The travel cost method uses actual travel expenditures
(e.g. gas, plane tickets, etc.), and opportunity costs of time
(e.g. wage rate) to infer valuation of recreational activities.

Example:
•Assume there is only one lake in a region (e.g. lake Tana). It attracts
40,000 visitors/month. Each visitor spends 5 hours boating and 2
hours traveling. The opportunity cost of time is $8/hr for every
individual. Gas and car use cost $6/travel hour per visitor. Entry cost
is $2/visit. Thus, the total travel cost is:
40,000 * [8 * 7 + 6 * 2 + 2] = 40,000 * 70 = $2,800,000

Issues?
Contd.
The $2.8 million per month is an estimate of a lower bound on WTP
for recreational benefits from the lake, because anyone that finds it
optimal to spend time at the lake must receive at least enough benefit
to cover the travel cost of getting to the lake, but might receive
considerably more.
If there are other substitute lakes, travel cost methods become more
complex.
For example, closure of one lake for a specific recreational activity
will cause some people to use substitute lakes.
In turn, these get more congested and the benefits of using them will
decline.
Travel costs vary based on the starting point of the trip.
How does one account for more than one activity in one trip or visits
of multiple sites.
Survey and Interviewing Techniques: Contingent Valuation
Method (CV)
In a lot of instances, there is no other way to elicit non-
market values than just to ask people directly:
•How much would you be WTP for an amenity?

•How much would you be WTA to forego an amenity?

•How would you vote for a proposition involving an

environmental or resource use choice?

Issues?
 Major Issues with CV Estimates
Strategic bias (Not telling the truth): Individuals may report benefits
higher or lower than their true benefits in order to advance their own
agenda or to hinder the agenda of someone else.
Framing bias: People's answers may vary according to the context
in which a question is put.
For example, answers to a WTP question may differ depending on
whether the starting point of the initial value is $0 or $100.
Well-formed preferences: People may not have well-formed
preferences (e.g., WTP and WTA) for unfamiliar goods (e.g., a native
of Kansas may not have well-formed preferences for an endangered
fish in California that he had never heard of before the survey).
Information bias: Failure to comprehend or to interpret questions
correctly. People are limited in their capacity to process, analyze, and
retain information.
For example, people may infer that an issue is important (and thus
has positive WTP) simply because they receive information from a
survey, but may had zero WTP beforehand.