Managerial Economics

Unit 15

Unit 15

Natural Environment and Business

Structure: 15.1 Introduction Objectives 15.2 Externalities 15.3 Environmental degradation 15.4 Business and natural environment 15.5 Externalities, environmental degradation and market failure 15.6 Internalizing externalities 15.7 The global environment threat 15.8 Summary 15.9 Terminal Questions 15.10 Answer

15.1 Introduction
When Dr. R. K. Pachauri was awarded the Nobel Prize along with Al Gore for Environment, it was seen as a victory for the cause of economic development with an environmental face. Over the years, sustainable economic development has become the major goal in many countries of the world. It demands higher rates of economic growth with environmental preservation. Environmental degradation in the process of rapid growth has become the main concern in recent times. Global warming and damage to the ozone layer are the talk of the day. There is great need for taking extra care to maintain ecological balance in the entire world. A healthy globe can emerge only with a healthy environment. Business has close relationships with natural environment and business units have greater responsibilities in this direction. Maintenance of reasonable ecological balance has become one of the pre-requisite conditions for any business to flourish. This unit deals with various facets of environmental degradation and its harmful effects on business and the entire society.

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Learning Objectives: After studying this unit, you should be able to 1. Define externalities and environmental degradation. 2. Describe environmental problems and its effects on productivity. 3. Explain the relationship between business and natural environment. 4. Appraise the importance of global environment and discuss the major issues on global environment threat.

15.2 Externalities
It is a common factor to observe that almost all economic activities are interrelated and inter connected to each other either directly or indirectly. On account of one particular economic activity, it may have positive or negative effects on others. Such effects are so common in our day to day life. The concept of externalities gives us the idea about such types of effects in either private or public activities. xternalities or spillover effects or neighborhood effects are common in almost all kinds of economic activities. Externalities are an effect of one economic agents action on another in such a way that one agents decisions make another better or worse-off by changing their utility or cost. Externalities occur when one persons actions affect another persons well-being and the relevant costs and benefits are not reflected in market prices either at the micro level or macro level. In short, externalities occur when business firms or people impose costs or benefits outside the market place. The term externalities refer to a benefit or cost associated with an economic transaction, which is not taken into account by those directly involved in making it. External costs and benefits together are called externalities. Externalities are of two types. They may be either positive or beneficial and negative or harmful. Positive externalities confer external benefits while negative externalities involve external costs. These externalities arise in case of both consumption and production. et us take some simple illustration to explain both of them. 1. Positive externality in consumption When the government makes arrangement for various kinds of vaccinations, in that case they not only help the person vaccinated but also the entire

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neighborhood where the person lives in by preventing the spread of different kinds of contagious diseases. 2. Negative externality in consumption When a young man rides a noisy motor cycle, he will get greater amount of enjoyment if he create more noise. But this will disturb the peace and tranquility in the near by areas and create displeasure among the people 3. Positive externality in production Beekeepers try to put their beehives on farms because the nectar from the plants increases the production of honey. he farmers also receive advantages from the beehives because the bees aid pollination of the plants. 4. Negative externality in production When an industrial unit dumps its industrial wastages in to the near by river, in that case people cannot use the water for drinking purposes. Now let us discuss these two kinds of externalities in some detail. 1. Positive or beneficial externalities A positive externality arises when due to the action of one person or firm others get the benefits. For example, at the micro level, if a person or an organization constructs a free hospital, a temple by spending private money, all people living in that area certainly will get some general or external benefits. The external benefits are the benefits the individual or firm gives to others without receiving any monetary compensation in returns. Similarly, at the macro level we can give several such examples. The government provides many public goods for the benefits and convenience of the general public in all countries. The external benefits derived from expenditures on national defense, maintenance of law and order, control on terrorism, etc. In all these cases, all members of the society will get the same amount of security irrespective of the group to which one belongs. In some other cases, the government may charge a nominal amount for certain items. But the amount of benefits derived from such goods and services are far greater than the money paid for them by common man. Development of all the means of transport and communication systems, construction of dams, generation and supply of electricity, supply of essential goods through public distribution system etc are a few examples. As an economy grows, provision of such types of external benefits to the
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members of the society becomes a common feature. In this case, all will enjoy certain benefits due to the actions of either micro units or macro units. 2. Negative or harmful externalities A negative externality arises when one persons or firms actions harm others in the society. When polluting air, water or soil, factory owners may not consider the costs that pollution imposes on others or the government. Creation of such external costs are said to be the negative externalities. The external cost is the uncompensated cost an individual or the firm imposes on the others or the government. We can give a few examples to illustrate this point. When a firm dumps toxic or chemical wastes in to a stream, it may kill fish and plants and reduce the streams value for recreation. Again when industrial wastes are thrown in to the river, water cannot be used for consumption purposes. Refineries may pollute the air, paint industry may create bad odour, atomic and nuclear wastes may create respiratory track infections and other kinds of diseases to all the people living in the area i.e. around the factories. This is a negative externality created by a firm because it does not compensate people for the damages it has created. The government is very much concerned about these types of negative externalities because it imposes extra financial burden on it. Thus, negative externalities will increase the social cost as the cost on the clean up and health will increase. External cost due to traffic jams, an individual deciding to go for a drive in the peak hours and increasing the travel time of the other drivers are all examples of negative externalities. They are defined as third party effects arising from production and consumption of different goods and services for which no appropriate compensation is paid. The study of externalities by various economists has assumed greater significance in recent years as there is a direct link between the management of the economy and environment. Externalities create a sort of divergence between private and social costs. For example, costs of pollution is not included in the production costs of an organization which is creating pollution, but it is included in the social cost as the community has to bear the cost in one way or the other. Thus, to day modern governments are spending lots of money to prevent the adverse effects of negative externalities in all most all nations. ence, there is lot of concern about these types of externalities.
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In the study of externalities, one has to look in to two important concepts. They are marginal social benefits and marginal social costs. Marginal social benefits are those additional benefits which are enjoyed by the entire society on account of an additional economic activity and marginal social cost refers to the cost incurred by the people or the government due to an additional economic activity. Marginal Social Benefit [MSB] = Marginal Private Benefit + Marginal External Benefit. Hence, MSB = MPB + MEB. Marginal Social Cost [MSC] = Marginal Private Cost + Marginal External Cost. Hence, MSC = MPC + MEC. It is clear that When MSB = MSC, there is over all economic efficiency in resource allocation to produce different goods. If MSB > MSC, in that case, it gives green signal to produce a commodity in larger quantities because the benefits exceed costs. On the other hand, if MSC > MSB, in that case, it gives danger signal so that one has to decrease its production as costs exceed benefits. Thus, the fundamental criterion is to see that both MSB and MSC are to be balanced to each other to maximize benefits.

15.3 Environmental Degradation

In recent years, there has been very fast and quick economic growth in many countries of the world. There is a visible change in the pattern of economic growth. In the name of quick economic development in a very short period of time, there is fast depletion of all kinds of resources and many types of resources may be exhausted in the near future. There has been excessive and over-utilization of many resources. Shortsightedness in the developmental policies has shifted the emphasis from future to the present welfare of the people. This has been responsible for environmental disorder, dislocation and degradation. There is widespread air, water, soil and noise pollution on account of rapid industrialization and growth in all modes of transportation. There is environmental decay and degeneration all round the world. The destruction in eco-system has dangerous and demoralizing effects on the
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economy. Degradation and destruction of resource-base is unpardonable. They have adverse effects on health, efficiency and quality of life of the people. Hence, there is cry for environmental protection in recent years. Unless concrete measures are taken in right time, the man kind may have to pay a heavy price in the near future. In this background, to day economists are talking about the concept of sustainable economic development Sustainable economic development seeks to meet the needs and aspirations of the present without compromising the ability of future generations to meet their own needs. It is felt that sustainable development can be achieved only when the environment is protected, conserved, saved and improved consciously by the people in a country. The process of development will become sustainable only when the stock of various types of resources are maintained and further improved. The various sources of resources, their quantities represent a common heritage for all the generations. Hence, all out efforts are to be made to augment these resources in several ways and means. There should be proper balance between the present and future use of resources. There should be proper balance between short-run and long run interests. Hence, it has been suggested that there should be some form of environmental accounting system in the development policy measures. While estimating the national income of a country, under the new system of accounting, one has to take in to account of the total physical volume of resources and their monetary value. The total depreciation charges include the wear and tear of capital assets, depletion of natural resources, various kinds of losses arising out of environmental decay and degradation etc. This will give us a new measure of environmentally adjusted national output. Environmental damages may be in the following categories. They are as follows 1. Water pollution: It is one of the most important types of pollution that is taking a heavy toll in recent years. The main water pollutants are disease-causing agents which include bacteria, viruses, protozoa and parasitic worms that enter water from domestic sewage and untreated human and animal wastes, oxygen-depleting wastes, inorganic plant nutrients, fertilizers, pesticides, water-soluble inorganic chemicals which includes acids, salts, and compounds of toxic metals such as mercury
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and lead, organic chemicals like oil, gasoline, plastic cleaning solvents, detergents and many other varieties of items. As industrial wastes are dumped in to the rivers and lakes, water is contaminated and it cannot be used for drinking purposes. It creates health hazards. The capacity of the water to preserve the aquatic life is becoming more and more difficult. Even underground water is polluted today on account of various reasons and is creating innumerable problems. Billions of people are affected by water contamination in the world. 2. Air pollution: The air may become polluted by natural causes such as volcanoes, which release ash, dust, sulphur, and other gases or by forest fires that are occasionally naturally caused by lightening. But there are five primary pollutants that together contribute to about 90% of the global air pollution. These are- carbon monoxide, sulfur oxides, nitrogen oxides, hydrocarbons and particular. Human sufferings increase due to the air pollution. Respiratory disorders and cancers are due to inhalation of polluted air. The vehicles increase the sulfur dioxide concentration in the air creating breathing problems for children and affect their neurological developments. 3. Soil pollution: It arises as a result of excessive use of fertilizers, soil erosion, Salinization and water logging, dumping of garbage and other kinds of unused wastes. 4. Deforestation: Forests protect environment in several ways. They provide a livelihood and cultural integrity for forest dwellers and a habitat for a wealth of plants and animals. They protect and enrich soils, provide natural regulation of the hydrologic cycle, affect local and regional climate through evaporation, influence watershed flows of surface and ground water, and help to stabilize the global climate. Hence, they play a more useful role in preserving the ecological and environmental balance and in maintaining the biodiversity and eco systems. However, in recent years, there is terrific deforestation due to reckless industrialization and growth in urban areas which is responsible for several problems. 5. Loss of biodiversity: Biological diversity, a composite of genetic information, species and eco systems, all provide material wealth in the form of food, medicine and inputs to industrial processes. It supplies the
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raw material that may assist human communities to adapt to future and unforeseen environmental stresses. Further more, many people value sharing the earth with numerous other forms of life and want to bequeath this heritage to future generations. Loss of biodiversity jeopardizes all this benefits. 6. Solid and hazardous wastes: Excessive quantities of solid wastes generation, inadequate collection and unmanaged disposal etc present serious problems for human health and productivity. Open dumping and uncontrolled land filling causes several types of diseases and contributes for the spread of diseases. Solid and hazardous wastes pollute ground water resources. Thus, several factors have contributed for environmental degradation.

15.4 Business and Natural Environment

Business and environment are very closely related to each other. The nature, magnitude, composition and direction of business basically depends upon the type of natural environment exists in a country. Business and environment has symbiotic relationship with each other. They are inseparable in nature. Natural environment includes land form, location aspects, topographical conditions, mountains, rivers, oceans, coast lines, forests, soil, weather and climatic conditions, natural endowments, flora and fauna etc. Natural environment is also called as physical environment. Ecological factors which include both renewable and non-renewable resources would affect the type of economic and business activities in a country. Geographical factors would decide the type of goods and services that may be produced most economically in a county. Natural hazards like floods, droughts, earth quakes, storms, heat and cold waves and volcanic eruptions would decide the nature of business. Thus, all business activities are guided and influenced by natural environment either directly or indirectly. Nature is a great storehouse of all kinds of materials which are to be used by a business unit in the most economical and profitable manner. Apart from it, the natural environment also provides certain physical and biological conditions with in which man lives, works and carry on his business. How best business units exploit and use these resources to
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maximize their profits and maximize social benefits is the question before any economy. Business units have to come out with such business plans which results in proper, better and full utilization of all kinds of resources in the most optimum manner leading to higher output, income and employment in the country with minimum costs. It is to be remembered that business activities should not create environmental pollution and degradation at any cost. This calls for greater social responsibilities on them. They have to realize that only good environment can bring good business. Social costs are to be considered while making private profits and private profits should not come in the way of social benefits and welfare. Hence, proper balancing is required between the two. If social costs exceed private profits, in that case, government interference will become inevitable and it will be justified in the overall interest of the entire society.

15.5 Externalities, Environmental Degradation and Market Failure

All the above three are interrelated to each other. While taking any decision, one has to weigh the impact of each one of them on another. In a competitive market oriented economy, every thing is left to the free and automatic market mechanism. The allocation of resources in to various productive channels is made by the invisible hand of price mechanism so as to meet the societys maximum needs in an optimum way. Prices of all goods and services are collectively called as the price mechanism. Price mechanism indicates the price movements caused by changes in supply and demand for goods and services in the market. It is the connecting link between different groups like consumers, producers, distributors etc operating in the market. It is self-regulating and self-correcting in nature. Order and efficiency emerge spontaneously from a seemingly uncontrolled society. All major decisions are made with the assistance of price mechanism. Vilifredo Pareto, an Italian economist has laid down an objective test of social welfare on the basis of best allocation of resources in a free and perfectly competitive economy. According to him, maximum social welfare is possible only when the resources are allocated in the most ideal manner. Social welfare is said to be optimum when nobody can be made better off without making somebody worse-off. In short, it is impossible to make any one better off without making some one worse off because already there is
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optimum allocation of resources. Thus, there is no scope for any sort of reallocation or reorganization of resources in the system. But it is to be remembered that in many cases, the market mechanism fails to achieve an efficient allocation of resources on account of several constraints. This is often called as market failure in economics. Market failures Market failures arise on account of the following reasons. 1. The assumption of perfect competition in the market is wrong: The present day markets are characterized by different degrees of imperfections. Hence, it is difficult to expect the best allocation of resources to maximize economic gains always. 2. The assumption that there is no difference between private and social valuations is wrong: Private costs of an economic activity always do not equal the social costs. They are totally different in many cases. For example, when a business unit pollutes either air or water by discharging its wastes, it can save some amount of money or private costs. This action of a business unit would certainly impose additional burden on the entire society. The market does not consider such kinds of social costs [creation of negative externalities]. 3. Failure to supply public goods: Markets fail to supply several types of public goods to the general public in the overall interest of the society. A public good is also called as social good or collective good used by all people irrespective of the class to which one belongs. For example, in case of construction of a railway line or provision of postal service, the cost of supply of the service is several times more than that of the benefits enjoyed by the people in general. Markets do not take these costs in to consideration. 4. Failure to supply merit goods: These are certain goods which are to be consumed by the people irrespective their level of income. We can give a few examples for such goods. The subsidized food, clothing, shelter, free distribution of sites to economically weaker sections, midday meal schemes etc. Markets cannot realize the value and significance of such goods.

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5. Failure to supply a few other goods: Economic efficiency calls for control on the growth of monopoly houses and their impact, better and equal distribution of income and wealth in the society, correcting regional imbalances etc. Markets cannot take in to account of these aspects. The working of the market economy is based on Darwins principle of survival of the fittest and the fittest species survive and totally ignore the economic welfare of weak and unlucky people. Free market economy creates several types of negative externalities, environmental degradation and many other problems in an economy. Hence, when markets fail, the government has to interfere and look after the general well being of the especially economically weaker sections and other downtrodden groups through various developmental and welfare programmes. Now let us analyze the impact of negative externality in consumption and the measures to be taken by the government in some detail. 1. Negative Externality in Consumption Consumers create negative externalities by purchasing and consuming certain commodities and services. A few examples are given below for our understanding. Creating noise pollution by using the car stereos, peculiar horns, smoking in public places and drinking alcohol, indulging in various types of crimes, ill-treating animals, litter on public places and on streets, pollution from cars and bikes, use of narcotic drugs etc. In our example, we assume that there are no externalities in production and as such marginal social cost and marginal private cost are equal and the competitive supply curve reflects the common marginal cost. The demand curve reflects the marginal private benefit MPB. As MSB is less than the MPB, the MSB curve is below the MPB curve.

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Y MSB P2

MSC=MPC S N Price MC & MSB P1 R

D / MPB

0 Q Q1 Quantity

In the diagram, OQ = Optimum output where MSB = MSC and OP is the original price. OQ! = Production and consumption without tax and OP1 = price without tax. In order to restrict production and consumption of output from OQ1 to OQ quantity, market price has to be increased to OP2. Hence, a tax equal to P2-P has to be levied. Now the price the consumer pays is P2 which equals the marginal private cost of production P plus the cost of externality in consumption P2 P. Again, the revenue generated from the tax could be used to compensate those who are hurt by the external cost arising from the consumption of this product. The area of ENR measures the net benefit of the tax to the society. 2. Positive Externality in Consumption Some times in order to encourage consumption, the government may have to grant subsidy to consumers. Otherwise, the total consumption in the society will be relatively lower. Hence, the government grants subsidy to consumers. We can explain the positive externality in consumption with the help of a diagram.
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MSC D

P2 Price, MC & MSB P1 P

N E

R MSB

D=MPB 0 Q1 Q X Quantity

The supply curve represents MSC which equals MPC also. The demand curve DD is the MPB curve. As there are external benefits, MSB > MPB. Consequently, the MSB curve lies above the demand curve. In the diagram, OQ = social optimal quantity of consumption where MSB = MSC. Without any sort of government intervention, the quantity produced is OQ1 and the corresponding price is P1. It is clear that there is underproduction when compared to the socially optimal level of OQ quantity. If OQ amount is produced, the market price will be P but the marginal cost of production will be P2. Thus, the consumers need to be given a subsidy equal to P2 P. The producers will get P2 price but the consumers would pay only price P. At least part of the cost of the subsidy P2 P X OQ could possibly be collected from those reaping the external benefits arising from the consumption of this commodity. The net benefit to society from the subsidy is measured by the area of ENR triangle in the diagram. It represents the excess of social benefits over social costs for the output range Q1 to OQ. 3. Negative Externality in Production Producers while producing certain types of goods like chemicals, fertilizers, pharmaceuticals etc create negative externalities. These externalities are responsible for environmental degradation. Unless the government takes certain concrete measures, the negative effects are minimized or controlled.
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Hence, there is great need for state intervention in these cases. Negative externality in production is explained with the help of the following diagram
Y MPB=MSB D MSC MPC

P E Price, MC P1 P2 R D 0 X Quantity of Output N

Q1

In this case, we are assuming that there are no externalities in consumption. The demand curve DD shows the marginal private and social benefits and MPB = MSB. The supply curve represents the marginal private costs only. The MSC curve lies above the competitive supply curve. In the diagram, OQ = original output where MSB = MSC .and OP = original price. The competitive market, if left alone, will produce OQ1 quantity with a new price of OP1. Thus, there is a tendency of over production without government regulation. At the optimal quantity of OQ output, the price is OP but marginal private cost would be P2. Now the government can levy a tax per unit of P P2 on the firm and increase marginal private cost by P P2.and reduce output from OQ1 to OQ. Consumers would pay the price P which includes marginal social cost of production. The revenue from tax could be used to pay for the external damages from the production of this quantity of output. The tax revenue could be more or less than the external damage. The revenue would equal P P2 X OQ quantity of output where as the total external cost would equal the area between MSC and MPC up to OQ.

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The net tax gain to the society is shown by the area ENR in the diagram. This is the excess of costs over benefits for the units which are eliminated by the tax. 4. Positive Externality in Production All externalities are not negative. Some economic activities benefit the others and as such these activities are to be encouraged by the government by giving various kinds of monetary and fiscal incentives like subsidies or tax-concessions. We can give a few examples for such type of activities. Subsidy for fertilizers, electricity, water and interest rates on agricultural loans etc. Positive externality can be explained with the help of the following diagram.
Y MPC D

P2 Price & MC P1 P E N R D 0 Q1 Q

MSC

D=MSB
X Quantity of Output

In this example, we assume that there are external benefits to the people. Hence, the MSC curve is below the MPC curve. It implies that MSC < MPC. The demand curve represents the marginal social private benefit. In the diagram, OQ = optimal level of output and the corresponding original price is P. This original price is determined at the point where the demand curve intersects the MSC curve. The competitive market if left alone will produce only OQ1 quantity of output where the demand curve intersects the MPC curve. Now it is clear that the output produced by the firm is too little from the point of the entire society. If the firm produces the output OQ it will charge only OP price. At this level of output their private marginal cost is OP2. It tells us that output can be
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increased by providing the producers a subsidy equal to P2 P. The consumer pays marginal costs of production P2 minus the external benefit P2 P. or a price P. in case of negative externality in production; we had a tax equal to the marginal external cost. In this case, we have a subsidy equal to the external benefit. The government pays the subsidy to producers by collecting money from the people who enjoy external benefits. It is to be remembered that the expenditure on subsidy may not be equal to the total external benefit. The net benefit to society from the subsidy is given by the area ENR in the diagram. This is the excess of social benefit over social cost for the extra units produced as the result of the grant of subsidy by the government. All externalities are not negative. Some of them benefit the others and for which no compensation is given. The important source of benefit is the creation of knowledge in modem days. Creation and improvements in knowledge by one institution would certainly benefit a large number of people and organizations in a society. Similarly, innovation by one firm leads to imitating it and improving it by the rival firm. This leads to overall improvements and spread of knowledge in the community. This is known as technology spillover. Positive externality involves the creation of knowledge and new technologies are difficult to identify and measure the benefits where as negative externalities can be easily identified and measured.

15.6 Internalising Externalities

Internalizing externality occurs when an individual business unit takes external cost or benefits in to account. In case there are external benefits, they can be internalized or external costs may be borne by the business unit itself. However, a firm has to make cost-benefit analysis in its business operations both at the micro level and macro level. Externalities will not always result in inefficiency as a firm compares the benefits also. Some sort of government intervention is necessary to overcome the market failures associated with pollution and other externalities. The government may take several measures to solve the problems arising out of negative externalities. The following measures deserve our attention in this direction. 1. Government taxes and subsidies a) If MSC > MPC of an activity, the government has to tax on producers.
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b) If MSC < MPC of an activity, the government has to subsidize producers. c) If MSB < MPB of an activity, the government has to tax on consumers. d) If MSB > MPB of an activity, the government has to subsidize consumers. Again, if the government wants to control pollution, in that case, it will collect pollution cost in the form of imposing taxes on business units. But it is to be noted that the entire pollution cost cannot be compensated by the firm. Industrial growth inevitably leads to the creation of negative externalities and the society has to bear a part of the cost unavoidably. Hence, total elimination of industrial pollution is not possible and industrial units cannot pay in the form of taxes to compensate the adverse effects of pollution. The tax amount is to be compared with loss to consumers and reduction in the quantity of output by the firms. 2. Direct government regulations In case of all kinds of pollution and other health and security externalities, the government may introduce direct regulatory controls [social regulations] over the externality by setting certain rules and regulations regarding pollution, which every industry should follow. Under the command and control regulations, the government would simply order the firm to comply, giving detailed instructions on what pollution-control technology to use and where to apply etc. For example, installation of pollution control equipment in factories and disposing the chemical and industrial wastes in a specific way is directly regulated by the government. 3. Introduction of emission standards An emission standard is a legal limit on how much pollution a firm can emit. If the firm exceeds the limit, it can face monetary and even criminal penalties. The standard prescribed by the government ensures that the firm produces efficiently. The firm meets the standard by installing pollution abatement or reducing equipment. The cost incurred by the firm to install the new equipment is included in its final market price and thus it internalizes the externalities. 4. Prescribing emission fees An emission fee is a charge levied on each unit of a firms emissions. Such emission fees would require that firms pay a tax on their pollution equal to
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the amount of external damage it causes. If a firm is imposing external marginal costs of Rs. 200-00 per ton on the surroundings, in that case, the appropriate emissions charge would be Rs. 200-00 per ton. This is another way of internalizing the externality by making the firm to include the social costs of its activities in total cost of production. 5. Introduction of transferable emissions permits Under this system, each firm must have a permit to generate emissions. Each permit specifies exactly how much the firm is allowed to emit. Any firm that generates emissions that are not allowed by permit is subject to substantial monetary sanctions. Permits are allocated among firms, with the number of permits chosen to achieve the desired maximum level of emissions. The permits are marketable-they can be bought and sold. 6. Introduction of Liability rules Instead of direct government regulations, a government may come out with the introduction of liability rules or laws. Under this approach, the legal system makes the generators of externalities legally liable for any damages caused to other persons. In effect, by imposing an appropriate liability system, the externality is internalized. 7. Defining property rights Defining individual property rights to some extent solve the problem of externalities. Property rights are the legal rules that describe what people or firms may do with their property. When people have property rights to land for example, they may build on it or sell it or protect it from interference by others. A factory constructed near a lake starts throwing wastes and toxic chemicals in the river. This leads to water pollution as people have an attitude that lake is nobodys property and convenient to dump the wastes and garbage. Cleaning of such a polluted lake either by a private institution or the government involves a free-rider problem if no one owns the lake. The benefits of a clean lake are enjoyed by many people and no one can be charged for these benefits. However, if the same lake is owned by a person or institution, they can charge higher prices to fishermen, boaters, recreation users and others who benefit from the lake. 8. Negotiation and the Coase theorem Prof. Ronald H. Coase has suggested an alternative approach to tackle the problem of externalities. Economic efficiency can be achieved without
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government intervention when the externality affects relatively few parties and when property rights are clearly specified. The Coase theorem states that when the parties affected by externalities can negotiate costlessly with one another, an efficient outcome results no matter how the law assigns responsibility for damages. In other words, when parties bargain without cost and to their mutual advantage the resulting outcome will be efficient, regardless of how the property rights are specified. For example, if a steel factorys effluent reduces the fishermans profit. Now they have two alternatives to solve the problem. The factory can install a filter system to reduce its effluent or the fisherman can pay for the installation of a water treatment plant. The efficient solution should maximize the joint profit of the factory and the fishermen also. This can happen when the factory installs a filter and the fishermen do not build a treatment plant. The optimum solution can be found out by mutual negotiations and bargaining between the two parties in an amicable manner so as to benefit both the parties. Thus, there are several techniques to internalize the externalities.

15.7 The Global Environmental Threat

Rapid industrialization, urbanization and economic growth have created innumerable global environmental problems in recent years. They have posed severe threats to the very survival of the mankind. Some of the important threats are as follows- change in climate, global warming, acid rain, ozone layer depletion, nuclear accidents and holocaust etc. Let us study them in some detail. 1. Climate change Climate is the average weather conditions of a place for a fairly long period of time covering a number of years. Climate change is a shift in the average weather that a given region experiences. This is measured by changes in all the features one can associate with weather, such as temperature, wind patterns, precipitation and storms etc. Global climate change implies changes that occur in global climatic conditions. Climate change is a normal process. The rate and magnitude of change in global climate is dramatic in recent years. It is brought about by a number of factors such as the latitude of a place, altitude of the place, and distance from the sea, ocean currents, position of mountains, direction of prevailing winds, nature of soil etc.
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The world is adversely affected by extreme climatic changes. It can bring about changes in frequency and intensity of the droughts and floods. It would affect public health adversely. It may reduce the availability of clean drinking water, contaminate water, damage sewage systems, spread infectious diseases, increase in pests and plant animal diseases, reduce food production, create starvation and malnutrition etc. Food and water shortages may lead to conflicts leading to displacement of a large number of people. Changes in climate may also affect the distribution of vector species like mosquitoes which in turn will increase the spread of diseases like malaria and filariasis and spread to new areas. Thus, climatic change may have serious impacts on human health. It may also increase various current health problems and also bring new and unexpected ones. 2. Global warming or green house effect. Global warming means an increase in the average temperature of the atmosphere, oceans, and landmasses of Earth. The average temperature has been increasing in many regions in recent decades. The average temperature of Earth is about 15C. Over the last century, this average has risen by about 0.6 Celsius degrees. Scientists are of the opinion that it may increase to 1.4 to 5.8 Celsius degrees by the year 2100. This warming will be greatest over land areas and at high latitudes. The projected rate of warming is greater than that has occurred in the last 10,000 years. This temperature rise is expected to melt polar ice caps and glaciers as well as warm the oceans, all of which will expand ocean volume and raise sea level by an estimated 9 to 100 em flooding some coastal regions and even entire islands. Some regions in warmer climates will receive more rainfall than before, but soils will dry out faster between storms. This may damage crops, disrupt food supply. Plant and animal species will shift their ranges toward the poles or to higher elevations seeking cooler temperatures, and species that cannot do so may extinct. The main causes for global warming are as follows- burning of fossil fuels such as coal, oil, gas which releases into the atmosphere carbon dioxide and other substances known as greenhouse gases. As the atmosphere becomes richer in these gases, it becomes a better insulator, retaining more of the heat provided to the planet by the sun.

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The word Green House Effect was first coined by J. Fourier in the year 1827. Greenhouse is constructed for plants mainly in the cold countries where total insolation at least during winter season is not sufficient enough to support plant growth. The glasses of greenhouses are such that they allow the visible sunlight to enter but prevent the long wave infra red rays to go out. The greenhouse effect on earth means progressive warmingup of the earths surface due to the blanketting effect of man-made carbon dioxide in the atmosphere. In short, the trapping of heat from the sun by certain pollutant gases like carbon dioxide, chlorofluoro carbons, nitrous oxide, methane etc in the atmosphere, leading to rise in the earths mean temperature, is known as greenhouse effect. The greenhouse effect is also known as global warming. Adverse effects of global warming 1. It causes climatic changes. Extreme weather conditions like floods and droughts are likely to occur more frequently. 2. It results in melting of ice and glaciers leading to rise in sea levels and flooding of coastal areas. 3. Small islands may even disappear due to submergence. 4. It leads to a change in crop pattern. 5. It creates adverse effects on eco systems biodiversity. 6. It results in changes in hydrological cycle and storms will be more frequent and intense. 7. Weather pattern becomes more unpredictable and crops are affected by different varieties of insects and plant diseases. 8. Animals find it difficult to adjust to the changed environment leading to migration. 9. More people become sick due to global warming 10. Tropical diseases such as malaria, dengue fever, yellow fever etc will spread to other parts of the world etc. 3. Acid rain The term acid rain was first coined by Robert Angus in 1872. When fossil fuels such as coal, oil and natural gas are burned, chemicals like sulfur dioxide and nitrogen oxides are produced. These chemicals react with water and other chemicals in the air to form sulfuric acid, nitric acid, and other harmful pollutants like sulfates and nitrates. These acid pollutants spread upwards into the atmosphere, and are carried by air currents, to finally
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return to the ground in the form of acid rain, fog or snow. The corrosive nature of acid rain causes many forms of environmental damage. Acid pollutants also occur as dry particles and gases, which when washed from the ground by rain, add to the acids in the rain to form an even more corrosive solution. This is called as acid deposition. Adverse effects of acid rain 1. Have ill-effects on vegetation. 2. Have ill-effects on soils and crop productivity. 3. Have effects on monuments, statues and buildings. 4. Have adverse effects due to acidification of lakes and streams and acquatic life 5. Have ill-effects on man. Human health may be affected by increased respiratory and skin problems etc. 4. Ozone layer depletion Ozone is formed by the action of sunlight on oxygen. It forms a layer 20 to 50 Kms above the surface of the earth. This action takes place naturally in the atmosphere, but is very slow. Ozone is a highly poisonous gas with a strong odor. It is a form of oxygen that has three atoms in each molecule. It is considered a pollutant at ground level and constitutes a health hazard by causing respiratory ailments like asthma and bronchitis. It also causes harm to vegetation and leads to a deterioration of certain materials like plastic and rubber. Ozone in the upper atmosphere however, is vital to all forms of life as it protects the earth from the suns harmful UV radiation. Ozone layer is a thin band in the ozonosphere which blocks out suns ultra violet rays [ie, screens out suns harmful ultra radiation] and protects life on earth from the harmful ultraviolet radiation from the sun. In the ozonosphere, small amounts of ozone are constantly being formed by the action of sunlight or oxygen. At the same time, ozone is being broken down by natural processes. Hence, normally, the total amount of ozone usually stays constant, because its formation and destruction occur at about the same rate. But unfortunately, human activities have recently changed the natural balance. Some manufactured substances, such as chlorofluoro carbons, hydrochlorofluoro and hydrochloric carbons, which are used in refrigerators, air conditioners, solvents, hospital sterilizations etc, enter

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ozonosphere and destroy ozone much faster than it is formed. The result is ozone depletion. Adverse effects of ozone depletion 1. More ultra violet radiations are harmful to the life system on the earth and natural vegetation. 2. Create adverse effects of productivity and crop yield 3. Create adverse effects on animal life and cause damage to wild life and marine life. 4. Create adverse effects on human health. It is responsible for sunburn, skin cancer, blindness etc. 5. Nuclear accidents and holocaust. Nuclear accidents refer to accidents resulting from nuclear devices and radio-active materials. It also includes accidents resulting from the release of radio active contamination. One can recollect a few nuclear accidents in some parts of the world. The Three Mile Island disaster occurred at a nuclear thermal power station at Three Mile Island in Pennsylvania in USA. Here, a private corporation constructed nuclear thermal power station and an accident took place at the nuclear power station on 28th march, 1979. In the accident, half of the nuclear power reactor was completely burnt, releasing radioactivity. Due to this accident, about 10,000 people fled away and several persons suffered form radioactivity. The Chernobyl disaster is the most serious one. This accident occurred ion 26th April, 1986 at the Chernobyl reactor near Kiev, the capital of Ukraine. This accident occurred when an explosion and fire took place at the nuclear reactor. The core fires allowed a continuous release of activity which was slowly reduced. Again a second release of activity occurred on 5th may 1986. Nearly 31 people were killed, 200 people were diagnosed as suffering from acute radiation effect. About 1 35,000 people and a large number of animals were evacuated from a 30Km radius surrounding the plant Nuclear holocaust refers to whole sale destruction caused by fully burnt nuclear weapons or bombs. The best examples of nuclear holocausts are the dropping of atom bombs by American army on Hiroshima and Nagasaki cities in Japan during the II
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world war. On 6th august 1845, the nuclear bomb was dropped on the city of Hiroshima and on 9th August 1945, another bomb was dropped over the industrial city of Nagasaki. It was estimated that as many as 1,40,000 people died in Hiroshima and about 74,000 people died in Nagasaki on account of the dropping of the bombs. The incidence is in the green memory of the entire world. All these led to the current development of the Doha Rounds which aim to address the climatic issues threatening the world by following a sustainable growth path. The carbon footprint and emission norms in cities across the world will have their implication in the way businesses have to be conducted. Activity: Find out from the net what is sustainability reporting by companies. Are their Indian companies which are incorporating this in the annual reports? Human Development Index (Table 1) 2006 Country India U.S.A. Japan U.K. Germany China HDI Value 0.609 0.950 0.956 0.942 0.940 0.762 Rank 132 15 8 21 23 94 1970 HDI Value 0.254 0.881 0.875 0.873 0.856 0.372 Rank 82 3 6 7 15 64

Note: Human Development Index (HDI) is a composite index prepared by the United Nations Development Programme on a scale of 0-1, measured by three key components longevity, knowledge and income, each measured by several parameters.

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Indices of Gender Inequality (Table 2) GDI* Country Value 2006 India U.S.A. Japan U.K. Brazil China 0.591 0.937 0.944 0.941 0.804 0.760 116 19 12 14 63 79 Rank Value 1970 0.250 0.810 0.702 0.690 0.418 n.a. 0.769 0.575 0.786 0.498 0.526 GEM* Value 2006 18 58 14 81 72 Rank

*Note: The Gender Development Index (GDI) measures the achievement in basic capabilities, viz. Longevity, knowledge and income, as in the case of the Human Development Index; it also takes into account inequality in achievements between women and men. The greater the gender disparity in basic capabilities, the lower is a countrys GDI compared with its HDI. The Gender Empowerment Measure (GEM) measures the participation of women vis-a-vis men in economic, political and professional areas. Source: Statistical Outline of India 2008-09, Tata Services Ltd. Indices of World Competitiveness* (Table 3)
Growth Competitiveness ranking Financial Market Sophistication

Labour Market efficiency

Business Sophistication

Technological

Infrastructure

Market size

Innovation

India Brazil 77 Germany U.K. U.S.A.

50 64 30 7 12 1

89 91 51 58 8 1

5 10 2 4 6 1

34 64 109 19 5 9

27 35 43 1 17 4

32 43 28 8 17 1

72 28 78 1 18 7

69 47 56 18 8 11

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readiness

Country

Overall

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*Note: Based on The Global Competitiveness Report 2008-09, prepared by the World Economic Forum. Competitiveness is defined as the ability of a national economy to achieve sustained high rates of economic growth on the basis of suitable policies, institutions and other economic characteristics. The Competitiveness has been computed largely on the basis of different criteria grouped under Twelve factors, some of which and the overall rank is shown here. Data pertains to 2007-08. Self Assessment Questions 1. External cost and benefits together are called ____. 2. ____are defined as third party effects arising from production and / or consumption of goods and services for which no appropriate compensation is paid. 3. Marginal social benefit = Marginal private benefit + ___________. 4. When there are negative externalities in ____, the marginal social cost will be more than the private marginal cost. 5. The process of development will become sustainable only when the stock of various types of resources are maintained and __________. 6. __________ on earth means progressive warming-up of the earths surface due to the blanketing effect of man-made carbon dioxide with atmosphere. 7. The term acid rain was first coined by ___________ in 1872. 8. _________________ refer to accidents resulting from nuclear device and radio-active materials.

15.8 Summary
External costs and benefits are known as externalities. External costs indicate negative externalities and external benefits indicate positive externalities. Environmental pollution is an example for negative externality. A technology spillover is an external benefit that results when knowledge spreads among individuals and the firms. A number of factors have contributed for environmental degradation in the form of water, air, soil and noise pollution, and deforestation etc. Markets do not take into account of externalities and as such there are market failures. Markets are purely guided by private profit considerations and it does not look in to the welfare of the common man in the society. In view of market failures, government
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intervention becomes inevitable in any civilized society to confer certain benefits to all members of the society in the most economical manner. Government intervention may take in the form of imposing taxes, granting of subsidies, define property rights, introduce direct government regulations, emission standards, transferable permits, emission fees, liability rules and through negotiations solve the problems arising out of externalities. In recent years we find growing international threats in several forms which are proving to be more dangerous for the peaceful living of the mankind. Some of the important threats are change in climatic conditions, global warming, acid rain, ozone layer depletion, nuclear accidents and holocausts. It is time for the governments and private organizations to think seriously about this burning problem at the global level and take concrete action at the micro and macro levels. Management students should be aware of these global problems in its right perspective as it helps them to take right decisions as prospective managers.

15.9 Terminal Questions

1. 2. 3. 4. 5. 6. 7. What are externalities? Explain positive and negative externalities. Discuss the various forms of environmental degradation. Analyse the inter dependence of business and natural environment. Identity the reasons for market failures. Explain the positive and negative externalities in consumption. Analyse positive and negative externality in production. Give an account of the measures to be taken to internalising externalities. 8. Discuss the various aspects of global environmental threat.

15.10 Answer
Answers to Self Assessment Questions 1. 2. 3. 4. 5. 6. Externalities Negative externalities Marginal external benefit. Production. Further improved. Green house effect
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7. Robert Angus 8. Nuclear accidents Answers to Terminal Questions 1. 2. 3. 4. 5. 6. 7. 8. Refer to units15.2 Refer to units 15.3 Refer to units 15.4 Refer to units 15.5 Refer to units 15.5.1 and 15.2.2 Refer to units 15.5.3 & 15.5.4 Refer to units 15.5.7 Refer to units 15.5.8

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Reference:
1. 2. 3. 4. 5. 6. Economics by Samuelson and Nordhaus Economics by Lipsey and Chrystal Managerial Economics by Christopher R. Thomas Managerial Economics by Atmanand Managerial Economics by Peterson and Lewis Managerial Economics by P. L. Mehta

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