PRODUCT PRICE AS A MEASURE OF NATURAL RESOURCE SCARCITY

2.5 PRODUCT PRICE AS A MEASURE OF NATURAL RESOURCE SCARCITY

In this last section of the chapter, I will outline the essential roles of price in an ideal market setting, especially as a measure of natural resource scarcity. To begin this discussion, on the basis of what we have discussed so far, the following represents the key information conveyed by market price:

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Figure 2.10 Roles of market price

Price as information signal

In a market economy, one of the most basic functions of price is to provide information relevant to the culmination of transactions among buyers and sellers of a product or a resource. The demand curve provides the set of prices consumers are willing to pay for various levels of output provided in the market. Similarly, the supply curve contains the set of prices producers are willing to accept for various levels of output offered in the market. In this sense, prices are used as signals of the terms by which consumers and producers are willing to enter into a specific market transaction. For example, in Figure 2.10 , if the relevant

output level under consideration for transaction is Q 0 , any prices between P s and P d are likely candidates to

be observed in the market to set the negotiation between consumers and producers. Note that prices below P s are absolutely unacceptable to producers, and prices above P d would be rejected by consumers.

Price as market clearing signal

Price not only is used to start the negotiation process, but also serves as a means of culminating transactions. This occurs when a single price emerges that tends to equate quantity demanded and supplied

of a given product at a point in time. In Figure 2.10 ,P e would be such a price. In other words, this is a price that clears the market or brings about market equilibrium.

Price as a measure of resource scarcity

As we discussed earlier, since the prevailing (equilibrium) market price for a product is positive, it follows that the product under consideration is scarce. But scarce in what sense? To respond to this question

adequately, let us refer to Figure 2.10 again. In this figure, the market equilibrium price is P e given that S 0 is the relevant supply curve. From the consumers’ viewpoint, this price measures their willingness to pay for the last unit of the equilibrium output, Q e . In other words, it measures consumers’ marginal private benefit (MPB) at the equilibrium level of output. On the other hand, from the producers’ perspective, the prevailing

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market price, P e , measures the minimum price they are willing to accept in offering the last unit of the equilibrium output in the market. In an ideal market, where the marginal producers are just making a normal profit, this would be equivalent to the marginal private cost (MPC) of producing the last unit of output.

Given the above argument, in an ideal market setting the long-run equilibrium price has an implication that goes far beyond a market clearing condition. This price equates marginal private (consumers’) benefit with that of marginal private (producers’) costs. That is,

Furthermore, in cases where ownership rights are clearly defined, there will be no difference between private and social benefits and costs (more on this in Chapter 5 ). Thus, in an ideal market condition, the long-run equilibrium price of a product is a measure of both the marginal social benefit and the marginal social cost. That is,

It is in this context that mainstream economists base their long-standing claim that in a free competitive market, a market price tends to reflect the true scarcity value of a resource under consideration. True in exactly what sense? In the sense that, in the long run, market price reflects the social cost of using resources (land, labor, capital, etc.) to produce output at the margin.

Note that market price would fail to reflect social cost if the market price were artificially set either below or above the market equilibrium price, P e . If either one of these situations occurs, the result will be what economists commonly refer to as a misallocation of resources. To see the significance of this, let us suppose that a decision is made to lower the market price from P e to P s in Figure 2.10 . To make this possible, the supply curve needs to be shifted from S 0 to S 1’ otherwise, P s will not be a market clearing price. Suppose this is accomplished through a market intervention mechanism, such as a government subsidy (either as a tax break or a cash grant) to the firms producing the product under consideration. The question is then, how will this result in a misallocation of societal resources?

At the new and artificially established equilibrium price, P s , the market clearing output will increase from Q e (the socially optimal output) to Q 1 . For it to do so, more resources (labor, capital and natural resources) are now allocated for the production of the output under consideration. However, for any output level beyond Q e , the MSC (the supply prices along S 0 ) of using these resources exceeds the prevailing market price, P s . Clearly, then, these resources are not being used where they benefit society the most —they are misallocated. The outcome would be similar if the market price in Figure 2.10 were raised from P e to P d . This could be implemented through programs such as farm price support. As we shall see throughout this book, the concept of “resource misallocation” has widespread application in environmental and resource economics. For example, Case Study 2.1 illustrates how subsidies (in the form of investment tax credits and import duty exemptions) to ranchers by the Brazilian government obstructed important market signals that ultimately caused excessive soil loss and deforestation in the Amazon. Another way to look at this same problem, and a way that is consistent with the framework of the analysis presented in this chapter, is by assuming that, in Figure 2.10 , the product of interest is hamburgers. Given this, it would be easy to see how subsidies to Brazilian ranchers could cause a shift in the supply

curve of hamburgers from S 0 to S 1 . Essentially, if other factors affecting supply are held constant, subsidies will lower the cost of one of the major raw materials (that is, beef) needed in the production of hamburgers. As a result, society (both Brazilian society and the societies of countries importing meat from Brazil) will have more hamburgers and at a lower price. However, as Case Study 2.1 clearly reveals, this is made possible

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at a human, environmental and ecological price, a situation that comes about because the price of beef, and therefore hamburgers, is not allowed to reflect the social costs of the resources used to produce it.

Price as a signal of emerging resource scarcity

Here the focus is on examining the trend of product prices over a long period of time (for example, a period of twenty to one hundred years can be used as indicator of emerging resource scarcity or abundance). For example, the price trend of a hypothetical product depicted in Figure 2.11 signals

CASE STUDY 2.1 RANCHING FOR SUBSIDIES IN BRAZIL

Theodore Panayotou

In the 1960s, the Brazilian government introduced extensive legislation aimed at developing the Amazon region. Over the next two decades, a combination of new fiscal and financial incentives encouraged the conversion of forest to pasture land. During the 1970s, some 8,000–10,000 square kilometers of forest were cleared for pasture each year. The proportion of land used for pasture in the Amazonian state of Rondonia increased from 2.5 percent in 1970 to 25.6 percent in 1985 (Mahar 1989).

It is now clear that transforming the Amazon into ranchland is both economically unsound and environmentally harmful. Without tree cover, the fragile Amazonian soil often loses its fertility, and at least 20 percent of the pastures may be at some stage of deterioration (Repetto 1988b). Indeed, cattle ranching is considered one of the foremost proximate causes of deforestation. Furthermore, ranching provides few long- term employment opportunities. Livestock projects offer work only during the initial slash-and-burn phase. Negative employment effects have been observed when income-generating tree crops such as Brazil nuts are eradicated for pasture (Mahar 1989).

Nonetheless, the incentives designed to attract ranching, which were administered by the government’s Superintendency for the Development of the Amazon (SUDAM), were powerful. Fiscal incentives included ten- to fifteen-year tax holidays, investment tax credits (ITCs) and export tax or import duty exemptions… SUDAM evaluated projects and financed up to 75 percent of the investment costs of those that received favorable ratings using tax credit funds.

Starting in 1974, subsidized credit also played a crucial role in encouraging numerous ranching projects. The Program of Agricultural, Livestock and Mineral Poles in Amazonia (POLAMAZONIA) offered ranchers loans at 12 percent interest, while market interest rates were at 45 percent. Subsidized loans of 49–76 percent of face value were typical through the early 1980s (Repetto 1988a)….

The subsidies and tax breaks encouraged ranchers to undertake projects that would not otherwise have been profitable. A World Resources Institute study showed that the typical subsidized investment yielded an economic loss equal to 55 percent of the initial investment. If subsidies received by the private investor are taken into account, however, the typical investment yielded a positive financial return equal to 250 percent of the initial outlay. The fiscal and financial incentives masked what were intrinsically poor investments and served to subsidize the conversion of a superior asset (tropical forest) into an inferior use (cattle ranching). Moreover, a survey of SUDAM projects reveals that five projects received tax credit funds without even being implemented (Mahar 1989).

Source: Green Markets: The Economics of Sustainable Development, San Francisco: International Center for Economic Growth (1993). Case reproduced by permission of the author.

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Figure 2.11 Long-run price trend

decreasing resource scarcity over time. That is, it shows a decline in the aggregate prices (or costs) of all the factors that are used in producing the product (labor, capital, natural resources, etc.)

However, this measure of resource scarcity is at an aggregate level. That is, a trend in product price of this nature would only provide us with information about what happens to resource costs over time in general. For example, suppose the specific product under consideration is electricity. In this case, Figure 2.11 would indicate a trend of falling electricity price. This declining trend in the price of electricity may be due to increasing availability (hence, lower prices) of either labor or capital or natural resources (for example, coal) which are used to produce electricity. In fact, it is quite possible for the price of a specific factor of production such as coal to be increasing while a falling trend in electricity prices is observed. In this instance, what might have happened is that the increase in the price of coal (due to its increasing scarcity) is more than offset by a decline in the prices of other factors of production (such as labor and capital) used to produce electricity. Thus, what this situation illustrates is that the possibility exists for the price of natural resources to be increasing while the price of a product is declining. Note that this observation does not take account of technological factors. For example, it is quite possible for coal to become scarcer (hence more expensive) and prices of electricity to decline over time if power plants continue to improve on the efficiency of coal burning.

In addition, another factor that needs to be considered is factor share—the percentage of a final product’s price (for example, price of electricity) that is related to a specific factor of production (such as labor, capital or natural resources). Suppose the cost of coal accounts for only 2 to 5 per cent of the price of electricity. If this is the case, coal, as important as it may be in the production of electricity, is not a major component of the market (final) electricity price. Thus, the price of coal could increase significantly (for example, by 10 percent) and still have very little effect on the market price of electricity.

The implication of all this is quite clear. Even in a world of perfectly competitive markets setting, product price trends may not adequately signal emerging natural resource scarcity or abundance. This is because trends of product prices are influenced by the availability of other resources (such as labor and capital), the factor share of natural resources and technological factors. The question is, then, what

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alternative measures of natural resource scarcity exist? How good are these measures in signaling impending natural resource scarcity? In the next chapter, an attempt is made to address these important questions by focusing directly on the price formation (market value) of natural resources.