Environmental 
                                                                                                                                        Economics 
                                                                                                                                                 In Theory and. Practice 
                                                                                                                                                                                                                                                           Second edition 
                                                                                                                                                                                                                                                                Nick Hanley 
                                                                                                                                                                                                                                           University of Stirling 
                                                                                                                                                                                                                                Jason  F.  Shogren 
                                                                                                                                                                                                                               University of Wyoming 
                                                                                                                                                                                                                                                                                                                        and 
                                                                                                                                                                                                                                                                          Ben White 
                                                                                                                                                                                       University of Western Australia 
                                                                                                                                                                      ,·.i.. ... ,,  .  .     . 
                                                                                                                                                                                                                             a,: .. : ...     pa.lgrave ' 
                                                                                                                                                                                                                                              macmillan 
                                          .Contents 
           List of tables                                               ix 
           List of figures                                               x 
           List of boxes                                               xiii 
           Introduction and acknowledgements                            xv 
            1  Economy-environment interactions                        .  1 
            2  The economics of sustainable development                 14 
            3  Market failure                                           42 
            4  Incentive design                                         82 
            5  Pollution taxes and tradable emission permits: Theory 
              into practice                                           131 
            6  Transboundary pollution and global public goods         174 
            7  Nonrenewable resources: Market structure and policy     214 
            8  Nonrenewable resources: Scarcity, costs and 
              externalities                                            243 
            9  Renewable natural resources: The fishery                266 
           10  Forestry economics                                      303 
           11  Theory and methods for environmental valuation          322 
                                          vii 
     viii   C  ntents 
            12  Risk and the environment                                                                 368 
            13  Trade and the environment                                                                421 
            Author index                                                                                  449 
            5ubject index                                                                                 454 
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                  Market failure 
        3.1  Introduction 
        A market is an exchange institution that serves society by organizing economic activity. 
        Markets use prices to communicate the wants and limits of a diffuse and diverse society 
        so as  to bring about coordinated economic decisions at the least cost. The power of a 
        perfectly functioning market rests in its decentralized process of decision-making and 
        exchange. No omnipotent central planner is needed to allocate resources. Rather, prices 
        ration resources to those who value them the most, and in doing so, people are swept 
        along by Adam Smith's invisible hand to achieve what is best for society as a collective. 
        Optimal private decisions based on mutually advantageous exchange can lead to optimal. 
        social outcomes. 
         That is the basic idea. For the most part, markets represent one of the greatest human 
        discoveries.  Markets work to collect and disseminate information about diverse pref-
        erences and constraints in a least cost manner relative to other exchange institutions 
        like  collective  and  government allocation decisions.  Markets  use  prices  to  commu-
        nicate both the laws of nature and the laws of humanity. But for many environmental 
        goods and services,  markets fail  if prices  do not communicate society's desires  and 
        constraints accurately. Market prices can understate the full range of services provided 
        by the  natural  environment,  or  these  prices  might  not exist  to  send  an  accurate 
        signal  about the total value of the asset  (e.g.,  such as  the species  living in a  local 
        forest).  A  market failure  occurs  when the market does  not allocate  scarce  resources 
        to generate the. greatest social welfare. _A  wedge  exists between what a  private person 
        does given market prices and what society might wa~t him or her to do to protect 
        the environment. Such a wedge implies wastefulness or economic ineffi.ciency;  resources 
        can be reallocated to make at least one person better off without making anyone else 
        worse off. 
         One example of a  market failure  is  habitat destruction and threats to biological 
        diversity 
            on Earth. Biological diversity contributes to productivity, acts as insurance, is a 
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