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ECON210 Final Exam Study Notes

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ECON 210
Robert Gateman

ECON 210: Professor Gateman Final Exam Study Notes December 13, 2012 ECONOMICS AND ETHICS  History of Environment and Economics:1985 discovery of ozone hole led to 1987 Montreal Protocol to ban CFCs, stabilization of greenhouse gases (that produce “global warming”) fueled 1985 Rio Summit and 1997 Kyoto Accord  3 Categories of Emission Control: o 1) Command and Control Regulation  Government “commands” companies to meet specific standards (such as amounts of particular pollutants, and “controls” the methods (such as technology) to achieve standards o 2) Incentive Based Regulation  Uses economic behaviour of firms to achieve environmental goals  Set standards and allow market to determine means  Examples: pollution tax, marketable pollution permits  Pros :  Efficient allocation of resources  Satisfy equity arguments  Encourage pollution reduction o 3) Clean Technology  Put incentives for new technology that meets lower pollution goals  How do Economics and Ethics fit together? o Economics is anthropocentric (humans = centre of attention) and utilitarian (regarding rightness as a measure against whether an action  or  human welfare)  Two views: short run and long run  In the short run, efficiency is most important  In the long run, ethics are most important o Utility Function  Parts of the utility function  Good (happiness), Bad (happiness)  Consumption bundle: market or non-market goods used by an individual o Market good: determines supply and demand  iPad, food, material items o Non-Market good: does not determine supply and demand  Clean air, sunset views, laughter, things that make you happy that you can’t buy  Total Utility (Happiness) = Utility of Consumption Bundle  U = U (X ) A A A UA= U AiPad + food + clean air + sunset views…)  Considering pollution; because it is “bad”,  pollution =  utility/happiness U = U (X , P ) where P is a “bad” (pollution) A A A A A UA= U AiPad + food + clean air + sunset views - pollution) o Assumptions of the Utility Function  1) “Growth vs. Environment” Tradeoff  Assume that more consumption leads to more environmental damage o XA leads to P A  In other words, protecting environment = lower growth, opportunity cost  2) “More is Better”  More consumption = more happiness  Even if an individual is materially satisfied himself, he can still take goods and sell them to make $ (an individual will always accept more) o Social Welfare Function  Normative assumption that social welfare (total happiness of society) is determined by adding up individual utility functions  Bentham’s idea that aggregate happiness = sun of individual happiness o Balance  happiness of one individual with  happiness of another individual, it only matters that total benefits > total costs o Potential Pareto Optimality  Imagine a scenario where A hits B with a bike in order to get to work on time. A gains 3 udals from not being fired and B loses 1 udal from getting hurt  According to PPO, the potential for A to compensate B and still incur more benefit that before justifies A hitting B with the bike as being “okay” or “beneficial”  If A compensates B 1 udal, A will have 2 udals and B will have 1 -> A still gains udals, therefore the situation after hitting B with a bike is still better than if A did not hit B with a bike  HOWEVER, note that A does not actually have to compensate B, the potential for A to compensate already justifies the situation  Problem: The result is more total benefit, but NOT more equitable benefit – NOT distributional, equitable justice  Assumptions of Social Welfare Function, aka. Classical Liberal Utility Function  These assumptions define the 3 Pollution Standards  What are the assumptions of Bentham’s statement of “greatest good for the greatest number”?  1) Blind Within Generations o Assumes “everyone is equal” o Does not address distributional justice o If +1U for me and -1U for you, it’s all equal and okay o Equal Marginal Utility of Consumption -> additions to consumption are valued equally by individuals  BUT 1U for me does not necessarily = 1U for you o BUT Supreme Court of Canada says that fairness does not mean everyone is treated equally, but fairly  For instance, we have to accommodate disabled persons  2) Blind Across Generations o Ignores intergenerational comparisons o Neglects that current welfare can increase at the expense of future generations o Doesn’t take into account pop’n after we die o Neglects that we have to make value judgement between caring or not caring about children and future apocalypse o Neglects that we should be “trustees of the environment”  3) Blind Across Victims and Beneficiaries o Potential Pareto Optimality o Victims don’t have special rights o Ignores compensation o World is better even though you lost  ALL IN ALL: Classical Liberal Utility Function says that all that matters is an INCREASE in CURRENT NET BENEFITS, REGARDLESS of who WINS or LOSES o Standard microeconomic efficiency argument  Effects of Consumption on Environment o I = PAT  Environmental IMPACT depends on POPULATION, AFFLUENCE and TECHNOLOGY  Population: too many people (more damage) o # people  Affluence: too much consumption (more damage) o # gas burnt / person  Technology: damage per unit of consumption inflicted by technology o perhaps counterbalance with clean tech? (less damage?) o # damage / gas burnt  Can also think of Gateman’s Problems with the World  Overproduction (T?), overreproduction (P), and overconsumption (A) o Ratchet effect: push up expectations; once accustomed to more consumption, hard to reduce consumption o Consumption is supposed to quadruple by 2050! = environmental decline o Ecos / Tech pessimists: support safety & ecological standards – command and control or incentive based regulation, worried about over-consumption o Technos / Tech optimists: support clean technology, don’t think there’s over-consumption  Does MORE = BETTER? (Utility Function Assumption 2) o Easterlin Paradox: rising income is positively correlated to happiness, up to about $75000  Debatable  Self-reported happiness  Problems: can’t account for relative happiness between people  In USA, over last 50 years, consumption doubled but happiness stayed the same  Hard to define “emotional happiness” and “life evaluation”  “Emotional happiness” may level off at $75000 but “life evaluation” continues to rise with more $  “Life evaluation” = leading the best life possible o 3 Reasons MORE ≠ BETTER  1) Conspicuous Consumption Goods  3 Social Motives for Consumption o Bandwagon Effect: conform to social norm  Eg. Buying Canucks fan gear to be part of the hockey craze o Snob Effect: differentiate from social norm, make a statement  Eg. Getting a tattoo to look cooler o Veblen Effect: elevate from social norm  “Conspicuous consumption goods”  Eg. Rolex, Polo Ralph Lauren  Telling people you spent a lot of money  Not economically inefficient because fulfill utility  When 3 effects dominate, creates competitive consumption, causes social welfare to decline o Basically, all 3 effects are fueled by individual drive to be cooler, more popular, more “happy” o Problem: Prisoner’s Dilemma  Individual Utility: Makes sense to consume more to be more happy  Eg. Can’t see at a concert, so decide to stand up  Eg. Want to look wealthy, buy a Rolex  Social Welfare: Competitive consumption leads to Prisoner’s Dilemma -> everyone will follow dominant strategies – Nash equilibrium, “rat race”  Eg. Everyone stands up = result is worse because not everyone is at the same level (once again) , but now everyone is wasting energy standing  Eg. People want to fit in, everyone buys a Rolex – as a result everyone is equally as wealthy-looking, but now everyone wasted $ and no one looks relatively more wealthy  Cooperation vs. competition  Individual vs. social welfare conflict  2) Positional Goods  Relative positioning of a good  Similar to Veblen effect  Positional Goods have fixed long run supply, can be public or private goods o Valued by a possessor because it’s not possessed by others o Eg. limited # of seaside homes, limited supply of freshwater, clean air, green space in city, commuter highways, seat in quota faculty o Private Positional Goods are rationed through price – Eg. Sell seaside homes at a high price o Public Positional Goods are rationed through congestion – Eg. Everyone fights for clean air, limited supply of freshwater -> overuse more quickly  Also results in Prisoner’s Dilemma, “rat race” o Eg. More seaside homes = lower value of them; seaside homes incur higher costs with more competition o Eg. Everyone fights for freshwater = faster damage of environment  3) Consumption Externalities  Spillover effects by act of consuming  Negative Consumption Externality = cost o Eg. People talking loudly on cellphones, lack of social etiquette creates noise pollution o Eg. Education leads to credentials inflation, everyone has Bachelor’s Degree – now it doesn’t mean much  Positive Consumption Externality = benefit o Eg. Vaccines, reduce societal spread of flu; others benefit from me getting vaccinated o Eg. Education leads to a more literate population, more intelligence everywhere  Negative Consumption Externalities; Competitive Consumption leads to Prisoner’s Dilemma and decline of Social Welfare  ALL IN ALL:  If social norms (3 motives) push consumption, positional competition is prevalent, and there are negative consumption externalities, consumption lowers social welfare  BUT, if environmental goods are “non-competitive”, (like appreciation of nature and respect for non-human life), consumption increases social welfare  How to control consumption? o 1) Command and Control Regulation  Regulation of advertising o 2) Incentive Based Regulation  Pigovian (consumption) tax o 3) Shared Sacrifice  BUT if happiness depends on relative consumption, shared sacrifice won’t work o 4) Change of Heart  BUT how to change consumer culture, values, incentives? ENVIRONMENTAL ETHICS  Environmental Policy deals with: o Pollution  Car exhaust, airborne toxins, waterborne toxins, noise pollution o Acid rain o Ozone depletion (CFCs) o Global warming (GHGs) o Waste  Natural Resource Policy deals with: o Renewable resources: fish, forestry, animals o Non-renewable resources o Land  What are greenhouse gases? GHGs o H 2 (60% water), CO (20% carbon dioxide), CH (104 methane), NO (10% nitrous oxide) o Come from fossil fuels, land deforestation, agriculture, fertilizers, CFCs  A few key terms: o Externalities  DEFINITION: non-priced third-party cost or benefit  “Spill-over effect on bystanders”  Effect on someone other than buyer or seller  Negative Externalities: external cost, Marginal Private Cost   Positive Externalities: external benefit, Marginal Private Benefit  o Private Cost  Cost to the buyer or the seller  Opportunity cost valued by the producer o Social Cost  Private Cost + Third Party Costs  Opportunity cost to society  Externalities = MARKET FAILURE o Efficiency condition: Marginal Cost = Marginal Benefit  Marginal Social Cost = Marginal Social Benefit o Market failure = inefficiency, creation of deadweight social loss  Externalities create market failure because MSC ≠ MSB rd  3 party costs are ignored!  Externalities cause discrepancy between private and social costs  Allocatively inefficient o Technological Externality: external cost transmitted through production possibilities  Eg. Factories, through production, creates pollution o Pecuniary Externality: external cost transmitted through price change  Eg. Akerlof`s “The Market for Lemons”: assymetric information about used cars, don’t know if they are cherries (good used cars) or lemons (bad used cars), as a result, the buyer is only willing to may price of an average car – which means that the price will be lower than that of the cherries’ value. This poses a negative externality that cherry owners will not sell their car, and drives amount of cherries down in used car markets = more used cars = lower price of used cars, lower quality, etc = more and more lemons  Negative Externalities – Tragedy of the Commons o STEP 1: No negative externality; market is allocatively efficient privately and socially  How do we know allocatively efficient?  Definition: Pareto Optimality - cannot make one party better off without making the other party worse off o Cannot make top triangle (consumer surplus) bigger without making bottom triangle (producer surplus) smaller  Test: MC = MB, maximize economic surplus  Demand: MB = MPB = MSB  Supply: MC = MPC  Private Output = Q wPere MPC = MPB  Price = Marginal Cost -> perfect competition MPC, supply CS PS MPB, demand QP  Law of Diminishing Marginal Utility:  Demand = marginal utility / marginal benefit  Demand slopes down  Marginal cost rises because after a point, no longer getting specialization of labour, but rather saturation  Supply = marginal cost  Consumer Surplus: “free happiness” for buyers = when price is lower than the utility gained (get more happiness from product than $ lost)  Producer Surplus: “free happiness” for sellers = when price is higher than utility given up / cost (get more happiness from $ than product lost) o STEP 2: Effect of externality  Production creates a negative externality  Why does the demand curve shift?  Income  Future expectations  Taste  Pollution does not directly affect buyer’s demand, thus negative externality  Since the demand doesn’t change, pollution affects supply curve  MPC: Eg. Cost to produce gasoline  MSC: Eg. Cost to produce gasoline + cost to society o MPC + MEC (external cost) = MSC o MPC forgot to account for effect on polar bears, so MSC does o Minimum price to sell gas at when accounting for cost to society  Socially optimal output = QSwhere MSC = MSB  Note: non-zero, does not mean that there should be no pollution at all  Actual output = Q Ps social overproduction  Still producing at this level if self-interested and not care about environment  Market equilibrium only reflects PRIVATE costs of production MSC External Cost (costs to society) MPC MSB QS QP  There is a deadweight social loss (DWSL), because of not having to pay for pollution MSC EC Total Social Benefit MPC DWSL Total Social Cost Private cost MSB of Production Q Q S P  Market is producing at a level where a certain amount of production -> MSC actually exceeds MSB o Total surplus can still be increased by producing at socially optimal level (Q ) s o Market Equilibrium = total surplus = (CS – EC1) + (PS – EC2) – remaining EC3which is DWSL o Socially Optimal Level, total surplus changes to account for EC, so final result is new CS + new PS, which is equal to original (CS – E1 ) + (PS – 2C ) but no more remaining EC (3o DWSL) o At Market Equilibrium, consumers are paying too low a price to consume something that produces environmental damage -> price should be higher, supply should be lower o STEP 3: Impose Pollution Tax  Pollution tax = External Marginal Cost  Called “internalizing the externality” – alter incentives so that people take account of the external effects of their actions  Impose a tax on consumers that is equal to Marginal External Cost MSC Tax (used to be EC) MPC PBEFORE Original Market Equilibrium MSB Q S Q P  Because of tax, cost of consumption goes up, because consumers have to pay extra $ for incurring carbon damage, P goes up  Demand for the product shifts down by the size of the tax  Demand falls, quantity demanded is less, quantity produced falls o Q P> Q S o Buyers and sellers share tax burden, buyers pay more, sellers sell less MSC Tax (used to be EC) MPC P buyers pay P Original Market Eq BEFORE P sellers receive MSB old MSB new QS QP  Damage of environment saved because > loss of happiness o Total benefit > total cost o Tax revenue = external cost of pollution up tS Q o Tax creates DWSL  New CS + PS + Tax Revenue – DWSL (blue bordered area) = PS + CS before negative externality  The DWSL is the same amount of DWSL imposed by negative externality MSC MPC Benefit to society Tax Tax Revenue DWSL MSB old MSB new Q QP S o Yellow area = benefit to society, which is the total external cost foregone o With carbon tax, there is a net benefit to society, which is the yellow area above the blue border o Result = same as without carbon tax except save amount of environmental damage, prevent cost to society  BUT: Carbon tax is only helpful IF tax $ actually goes towards saving the environment, and compensating for the damage of pollution  ALL IN ALL:  Before carbon tax, producers made a certain amount of money, consumers gained a certain amount, and the society suffered a certain amount due to pollution o For example:  Producers gain 10U of $  Consumers gain 10U from consumption  Producers and Consumers cause Society to lose 5U from pollution  Total utility of society: 10 + 10 – 5 = 15U  After carbon tax, producers made less than before, consumers gained less than before, government took money from both producers and consumers to compensate for pollution damage, society suffers less from pollution o For example:  Producers only make 8U of $ now  Consumers gain only 7U from consumption now  Government makes 5U from tax, compensates society for pollution damage  Producers and Consumers continue to cause Society to lose 4U from pollution, rather than 5U from before – because they are producing and consuming less  That means society gains 5U and loses 4U = +1U  Total utility of society: 8 + 7 + 1 = 16U  Carbon tax  total utility compared to without carbon tax, thus good policy! o BUT Carbon tax is only beneficial if it is used to compensate societal damage from pollution  For example, if government doesn’t repay the 5U to society, total utility will be 8 + 7 – 4 = 11U  Society is worse off!   Is it justifiable for government to take money and spend it on other things? 3 ENVIRONMENTAL STANDARDS: EFFICIENCY STANDARD (BIGGER PIE)  Pareto Optimality = Pareto Efficiency = Allocatively efficient = Cannot make someone better off without making someone worse off  “net benefit test”  Weighing marginal costs and marginal benefits  According to efficiency standard, one should only reduce pollution if the marginal costs of pollution exceed the marginal benefits (benefits gained from the processes that make pollution – like convenience of cars, or $ from factories)  ASSUMES: Blind WAV o Social Welfare = Utility of A + Utility of B  GOAL: Maximize net benefit, doesn’t care who actually gets the benefit and who gets costs  ETHICS: More efficiency -> bigger PIE = everyone benefits in the long run  POLICY: Potential Pareto Improvement o Kalder-Hicks Efficiency / Compensation Principle o Winner can compensate loser and still be better off o Conditional on existing income distribution (what each person had initially)  PROBLEMS: o Fairness  Blind WAV  Says that any level of pollution is Pareto Optimal o Reality  Assumes marginal utility of incomes is equal  Assumes MIB  Ethical basis of efficiency standard questionable SUSTAINABILITY STANDARD (HOW SUSTAINABLE? THINK OF THE FUTURE)  “ecosystem test”  Protect ecosystems from major change, unless costs are prohibitive  According to sustainability standard, one should protect environment to prevent loss of unique genetic code  ASSUMES: Utility of future person = utility of current person, no longer Blind A, but still Blind WV o Social Welfare = Utility of A + w(Utility of B)  Weigh the future generation (B) more heavily – saying my children matter  GOAL: weighing future person more heavily ensures that happiness for current person A will not come at the expense of future person B  ETHICS: Not blind to intergenerational comparison of utility  POLICY: Pareto Improvement o At least one person has to be better off WITH COMPENSATION  Key terms: o Natural Capital: natural resources and environmental sinks  Difference between capital and consumption  Capital: use to make consumption goods  Consumption: use for utility, final happiness o Environmental sinks: absorptive capacity of environment  Ability of the environment to recuperate and review itself, like a sponge o Physical or Created Capital: plants, equipment, inventory, residential construction (PEIR)  Eg. Cleaner burning cars o Stock Pollutants: pollutants that accumulate, damage over time  Eg. Nuclear o Flow Pollutants: diluted, damage quickly  Eg. Noise pollution  Main Issue of Sustainability Standard o To what degree can created capital substitute for natural capital?  How can it compensate for the fact that we use up na
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