Chapter 7: Market Failures and Environmental Externalities

In Chapter 6, the PAM methodology was used as a framework for carrying out a benefit-cost analysis of improved water control. This same methodology may also be used to analyze the effects of market externalities and environmental degredation. In the case of negative externalities, the “without” project activity arises when producers or consumers impose costs on others for which the imposerers are not charged. Market failures involving degradation refer to the overuse of resources - soil, water, air, forests - by producers or consumers. This overuse occurs, also “without” a project, because producers or consumers have little or no incentive to limit their exploitation of natural resources.

Unsustainable Versus Sustainable Production Practices

The numbers in the B-C case discussed in Chapter 6 can be reorganized slightly to examine environmental issues. Begin, for example, with the high-yielding farming system that has been the starting point for previous studies. It produces an avereage of 6 tons per acre on in an area that has good water control. It’s recent role has been as the “with” project PAM in the benefit-cost analysis.Unfortunately, these very substantial yields have come at a cost. To achieve this level of output, farmers have had to apply large amounts of chemicals and there is reason to suppose that this level of chemical additives is not sustaninable over the long. run. Not only is there a detrimental affect on rice soils but, worse,farmers aree imposing negative externalities on the system by overusing pesticides that rersult in down stream polution.

For these reasons Table 7.1, reflecting a high level of output, is an an Unsustainable PAM. It has been copied from Table 6.14.

The analysis of the Table 7.1 PAM follows the discussion in Chapter 5. The dominant feature is the subsidy on output that producers receive for their rice. Less important are the minor subsidies they receive on tradable inputs and working capital

The sustainable PAM in the present analysis is characterized by removing the chemcials in the production process. (The I-O table has blanks in the cells where there were formerly entries for pesticides, insecticides, etc. This sacrific does not come without cost, of course, and the yield figure is assumed to go from 6,000 kgs/ha to 5,000 kgs/ha.

Just to be sure about the calculations that are involved, the relevant budget tables for the first row of the Sustainable PAM follow. Table 7.2 is the standard I-O table except that it has (1) all the chemicals zerod out, and (2) the yield reduced from 6 tons per hectare to 5 tons per hectare. The resulting Sustainable PAMis shown as Table 7.4. (To can also be completed by simply removing the cost of chemicals from Table 6.13.)

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As would be expected, there is no longer a diveregence between the private and social costs of tradables in the Sustainable PAM because the production subsidy was on chemicals. The divergence in profits is reduced by the amount of the cost of the chemicals.

Constructing an Environmental PAM

The environmental PAM incorporates the effects of the government’s decision to ban use of the pesti

cide and thus create sustainability for the system. Divergences in the environmental PAM measure the differences between private returns, costs, and profits under the initial, unsustainable system (the first row of the unsustainable PAM) and the social returns, costs, and profits under the policy-induced, sustainable PAM (the second row of the sustainable PAM).

Create the environmental PAM by simply copying Table 7.2 and renaming the table heading. Copy the relevant rows from Tables 7.1 and 7.2 to create Table 7.3.

The government decided to ban the use of pesticides and remove the negative externalities afflicting downstream users of water, but it did not choose to stop protecting rice producers. The ban on pesticides and ensuing new production practices caused paddy yields to decline by from 6 to 5 tons per hectare. The private value of rice to the national economy is still valuable to the local economy, even at its reduced yield. Social profits for the economy also remain high. This extremely efficient system is thus viable even without using pesticides, although both social and private profits are reduced by the pesticide ban.

The large divergence on tradable output (paddy), is made up of two components – protection on a yield with a resulting of 6 tons per hectare with pesticide use, and a loss of social revenue because of decline from 6 to 5 tons per hectare after the ban on pesticide use. The smaller divergence on tradable inputs results largely from the decline in private costs from the elimination of pesticides.

Calculating the Costs of Compliance

The costs of compliance refer to the private and social costs of removing the negative externality and creating a sustainable agricultural system. They are found by comparing profitabilities in the unsustainable PAM (with use of the pesticide) with those in the sustainable PAM (without any pesticide use). The private cost of compliance is the decrease in private profits, the reduced profit to rice producers, associated with the policy to ban pesticide use. The social cost of compliance is the decline in social profits, the foregone national income, from banning the pesticide. The costs of compliance for the tutorial example are presented in Table 7.6. They are simply copied from Tables 7.1 and 7.4.