Assignment Code: MEC-108/ASST/2022-23

Course Code: MEC-108

Assignment Name: Economics of Social Sector and Environment

Year: 2022-2023

Verification Status: Verified by Professor

Answer all the questions.

Section A 

Answer the following questions in about 700 words each. 20x2

Q1) In the context of ‘Future Time Preference’, discuss the importance of ‘Discounting of Costs and Benefits Flows’.

Ans) There is a significant difference between social and private costs and benefits as a result of the externality issue and market failure. Therefore, imputation of shadow pricing through the use of "non-market" valuation methodologies is necessary when performing a cost-benefit analysis of measures intended to improve environmental quality and ecological services. The advantages or costs often spread over a specific time horizon because the majority of commodities and services have depletable stock values. This necessitates discounting to convert all monetary values into present value terms.

Discounting of Cost and Benefit Flows

The foundation of welfare economics is the idea that people prefer to improve their "utility" sooner rather than later, or that they have a higher "time preference" for the present than for the future. As a result, all monetary costs and gains must be converted into present value terms. CBA utilises the practise of discounting in order to account for this aspect. When the present value of benefits exceeds the present value of expenses, a project or intervention is decided to move forward. The "discount rate" is used to calculate how much future cash flows are discounted. The revealed temporal preference is the extent to which we favour the advantages of the present above those of the future.

The opportunity cost of an investment is how much it yields compared to other applications of the same resource. We arrive at the notion of discount rate, which is used to calculate the worth of future gains, by combining the concepts of revealed time preference and opportunity costs. It is the percentage by which a benefit loses value annually going forward. The discount rate (δ) in financial transactions is often set at or near the current market interest rates.

Thus, the time effect is taken into account when all costs and benefits are discounted using a discount rate. The present value of cost or benefit [PV (X)] received in time t is calculated as follows:

PV(Xt) [(1+δ)t]=Xt or

PV(Xt)=Xt[(1+δ)-t].

The expression (1+δ)-t or 1/[(1+δ)t] is known as the discount factor, having the property of always lying between 0 and +1. The further away in time the cost or benefit occurs, the higher the value of ‘t’ and lower the discount factor. The higher the discount rate δ for a given t, the lower the discount factor.

Environmental issues including biodiversity loss, ecological disruption, and climate change are exacerbating the discussion over discounting the future in public investment. All of these issues will undoubtedly have a lasting effect on us as well as future generations. Intergenerational equity is therefore a concern.

The well-being of different generations would be unequally valued in this environment of "poor intergenerational equity." In this context, the idea of a social discount rate refers to how a society values today's well-being in relation to projected future well-being. The right choice of a social discount rate is essential for cost-benefit analysis since it has significant effects on how resources are allocated. Social discount rates vary widely, with industrialised countries often using a lower rate than poor countries.

Since it suggests larger risks to the assumption that the project's benefits will be realised, a higher social discount rate decreases the likelihood that a social project will be funded. It is crucial to be as precise as possible when determining which rate to employ because even a minor change in the social discount rate can have a significant impact on benefits that will be received in the future. When discounting the costs and benefits of intergenerational projects like those intended to fight climate change and environmental degradation, there is a compelling argument for taking the equity issue into account. Depending on a number of variables and the entrepreneurs' preferred timing, discounting can be set relatively high in a CBA for a private venture.

The appraisal of projects linked to social and private discount rates exhibits a variety of qualitative distinctions. Because measuring the advantages of social projects necessitates making moral judgments about the benefits to society as a whole, the governance of social project finance is distinct. Future generations are therefore valued more highly when decisions are made regarding the SDR of environmental protection programmes, like as funding the abatement of global warming.

Q2) In instituting regulations in the healthcare insurance sector, in what way the issue of ‘government failure’ assumes importance. Discuss.

Ans) The absence of a functioning market is a prerequisite for government involvement. In theory, government policies can use a variety of tools at their disposal to address misallocations brought on by market failure. Many instances of "government failure" are caused by the challenges of reaching consensus on goals, picking the best values for a wide variety of policy tools, and making these choices. Public choice literature provides numerous examples of issues in developing and putting policies into effect. It makes an effort to simulate how political decisions are made.

One of the basic tenets of the theory of regulation is that the regulator is aware of the proper course of action. The regulator is portrayed as an all-knowing, forgiving autocrat who makes decisions based on what is best for the economy. Evidence suggests that interested parties frequently influence regulations in numerous marketplaces so as to serve their own interests. A group of economists have claimed that the regulation process, like many others, is a "maximising" process where a regulator solicits "votes" from potential beneficiaries as evidence in support of this. With these votes, wealth can be transferred from those who are regulated to those who stand to gain from them.

As a result, a greater tax rate on those who are regulated would garner more support, assuming that the regulator seeks support by imposing a percentage "tax" on those who are regulated, with the tax proceeds being distributed to the beneficiaries. But it might also enlist more adversaries.

Let's say the regulator sets a low tax rate as a starting point. Two factors result in favourable votes for the imposition and growth of this rate:

1. The likelihood of support from potential recipients is increased by the revenues.

2. The value of the distribution to the beneficiaries is increased by the revenues.

People who would be subject to regulation would be against a transfer since it came from them. They will become more hostile as the tax rate rises. The regulator operates best when "marginal benefits from regulation equals the marginal costs," to put this "opposition effect" in monetary terms which is:

Marginal opposition from increased taxes=Marginal increase in probability of support × Marginal revenue product from those regulated

The two components on the right-hand side of the aforementioned equation imply that regulation will be sought in the presence of a sizable supporting base or a more nimble, well-organized organisation that anticipates significant gains. As a result, regulations may be enacted to the advantage of special interest groups, or tiny but well-organized groups of prospective gainers.

Bureaucracy and Efficiency

Legislation is passed by legislators, but it is carried out by bureaucrats. Even though we don't know a lot about how efficient bureaucracies are technically, it is obvious that they are not subject to the market's discipline. In light of this, it is conceivable that governments employ less sophisticated technology than the private sector. Government programmes are prone to serious problems of allocative inefficiencies, i.e., there may be too little or too much of a programme, in addition to the inefficiency associated with failure to minimise the expenses of bureaucracy. The most plausible scenario is that programmes grow too big because those who support them are driven by self-interest to exaggerate the advantages and minimise the disadvantages.

These arguments forewarn us against the risk of assuming that whenever there is market failure, government intervention inevitably enhances social welfare. Governmental failure can be caused by bad policies, significant levels of technical and allocative inefficiency, and other important factors. The reality that most nations have significant issues with their healthcare systems underlines the limits to greater levels of government engagement, just as the fact that many nations have national health insurance schemes suggests limitations of the hybrid private-public system.

According to a recent OECD analysis that evaluated the effectiveness of various systems, no healthcare system consistently outperforms the others in providing high-quality care at a reasonable cost in all economic and political contexts. The virtues and limitations of both market-based and centralised command-and-control systems may be seen. This suggests that what matters is how the system is administered rather than the type of system itself.

Section B

Answer the following questions in about 400 words each. 12x5

Q1) Outline the Multi Factor Extension approach in the context of ‘rate of return’ to education.

Ans) The methods used to calculate rate of return presuppose an idealised scenario with no uncertainties and no adherence to standards. Adjustments must be done for things like real growth in earnings, mortality, unemployment, taxes paid to the government, etc. in order to get an accurate picture of the factors affecting graduates' earnings. Psacharopolous and Patrinos' estimates of the observed wages of graduates can thus be represented as follows:

†m=Wm(1+g)(1-m)(1-y)(1-t)

where g stands for real growth of earnings adjusted for rate of inflation; m is the rate of mortality, u is the rate of unemployment and t is the tax rate. Using †m we can arrive at the adjusted net benefit of education as (†m-Wu). Further, groups with different level of education tend to differ in their attributes which too bear an implication on their earnings. Thus, ‘ability,’ which encompasses different kinds of attributes like personality, persistence, intelligence, etc. need to be factored in. A person with greater ability, if assisted to invest in his human capital, could have greater earnings in his employment.

If Y is total earnings, r is the average rate of returns, C is the total investment for acquiring human capital by way of education and training and X is the earning without investment in human capital formation, we have the following relationship:

Y=X+r C

Where ‘r’ gives an estimate of the ‘ability’ of individuals. If the distribution of X is ignored, then the earning would depend upon only the ‘rate of return.’ In other words, we will assume that the investment cost is held constant. Since ‘r’ and ‘C’ are correlated, the amount invested (C) would depend upon the rate of return ‘r.’ This means, a person who is more able, would get greater returns by investing in education and would also have more incentive to invest than others.

The differential wage or the adjusted net benefit becomes {(†m-Wu)*(1-â)}, where â stands for the differential innate ability i.e., the portion of differential earning attributable to one’s ability. {(†m-Wu)*(1-â)} is thus the differential wage attributable to the number of years invested in education, after factoring out the difference in ability. Research has revealed that as much as 33 percent of the private earning differential is attributed to ability and therefore the differential ability needs to be accounted for.

Q2) Discuss the argument behind the Efficiency Wage Hypothesis in Health Sector.

Ans) According to the efficiency wage theory, wages are not determined by market clearing, at least in some markets. It specifically refers to the motivation managers have to pay their staff more than the market-clearing salary in order to boost output, boost efficiency, or cut costs. The higher wages are covered by the greater labour productivity and/or lower costs. The efficiency wage theory is applied in a real society, according to Paul Krugman. Since each worker's productivity E(w) is a function of their compensation, the sum of their individual productivities equals their overall productivity. As a result, employment (L) and individual productivity become a function of the firm's sales (V), to which the employees belong.

Therefore, the company's profit P is: P=V(LE)-wL

If we assume that higher is the wage of the workers, higher would be the individual’s motivation for higher productivity, we have: dE/dw>0. If the employment is to be so chosen that the profit is maximised, under the optimising condition, we should have:

dP=[δV/δ(LE)]LdE-Ldw

i.e., dP/dw=[δV/δE] x [dE/dw]-L

The gradient δV/δE (i.e., the slope) is positive because higher the individual’s productivity, higher is the sales. Since dP/dw cannot be negative (because of the optimising condition), we have dP/dw>0. This means that if the firm increases their wage, their profit also will increase up to an optimum level. Thus, the efficiency wage theory motivates the owners of the firm to raise the wages for increasing the profit of the firm.

Alfred Marshall coined the phrase "efficiency-wages" to describe the pay per productive unit of labour. As a result, under Marshallian efficiency wages, employers would have to pay workers differently depending on their level of efficiency. The word is also used in modern contexts to suggest that paying workers more would boost their productivity through a variety of routes, making it advantageous for employers to pay workers more than what the market will bear. The idea of an efficiency salary allows for a more welfare-focused approach in the health sector. This means that providing more compensation to employees as a fringe benefit can raise their level of productivity and wellness.

Q3) Explain the Portfolio Balance Equation in the context of Non-Renewable Resources.

Ans) Making the assumption that change occurs constantly rather than at discrete moments in time is one technique to model the dynamics of natural resource optimization. In relation to non-renewable resources, the portfolio balance equation is as follows:

Here, we look at possible outcomes for the net price and resource price in the event of both technological advancement (which tends to lower costs over time) and an offsetting stock effect.. In this case, we assume the extraction cost function: c(x, b, t), where cx(x,b,t)>0, cxx(x,b,t)>0, cxb(x,b,t)<0 and cxt(x,b,t)<0.

The associated present value Hamiltonian for a competitive firm with such a cost function will be:

A portfolio balancing equation known as the "basic equation of non-renewable resources" is equation (3). The immediate return from investing in the resource or refraining from obtaining a small bit of the resource is the LHS of Equation (3). It includes any increase in resource prices, future lower marginal costs of extraction due to marginally higher remaining reserves, and future lower marginal costs brought on by technical advancement.

The RHS represents the immediate return from taking a small amount of the resource and depositing it in a bank to earn a return rate equal to the discount rate. Depending on the relative magnitude of  and , the resource and the net price may be rising or falling over time. Therefore, the price of the resource, the cost of extraction, and the cost to the consumer may all alter according to the type of technical change.

Q4) Distinguish between the concepts of ‘weak sustainability’ and ‘strong sustainability’.

Ans) Environmental economists have engaged in lengthy debates on what sustainability means. The disagreement, which is characterised as weak if substitutability is allowed and strong if it is not, centres on the interchangeability of "natural capital" and "made capital."

Weak Sustainability

Weak sustainability is the preservation of per capita income over time, without taking into account the capital stock's composition. In other words, it is presumed that the various types of capital are interchangeable. So long as the depletion of natural resources is balanced out by gains in the capital stocks of various types, weak sustainability permits their degradation. Weak sustainability makes the implicit assumption that savings be used to purchase manufactured or human capital, both of which are perfect substitutes for natural capital. Additionally, levels are meaningless, only changes matter. The little pacific island nation of Nauru is an illustration of the extreme implications of inadequate sustainability. One of the richest phosphate resources in the world in 1900 was found on Nauru. But today, due to more than 90 years of phosphate mining, nearly 80% of the island is completely destroyed.

Strong Sustainability

Strong sustainability necessitates the autonomous maintenance of all forms of capital. This view makes the implicit premise that all forms of capital are complimentary, i.e., that all forms are required for any form to have value. For instance, if there are no stocks of timber to harvest, produced or production capital invested in harvesting and processing timber is worthless. Strong sustainability advocates contend that non-declining revenue production is only possible by retaining both natural and generated capital holdings intact. By preserving the stock of human capital, technological capability, natural resources, and environmental quality, strong sustainability is attained.

Strong sustainability criteria require that certain minimum levels of various types of capital be independently maintained in both actual physical and biological terms. This demand is largely driven by the realisation that natural resources are necessary inputs in economic production and that, as a result, the aggregate welfare cannot be maximised by replacing physical or human capital for natural capital. Ecosystems and environmental assets are consequently prioritised in strong sustainability in the sense that they either provide distinctive needed services or distinctive irreplaceable non-use value.

Q5) Write a note on IPAT and KAYA identities.

Ans) Although it is numerically expressed, the starting point for the debate of technological development is mostly a conceptual articulation of what causes environmental damage in the first place. In the equation, population (P), wealth (A), and technology (T) are combined to create the environmental effect (I) (T).

Which is:

Impact = Population × Affluence × Technology

where affluence (or consumption) is measured as gross domestic product (GDP)/population, and technology as impact/(population × affluence).

The genesis of IPAT equation and related developments could be traced to the environmental movement around 1970.

The approach, which was initially designed to measure unsustainable contributions, has been reinterpreted to determine the most viable route toward sustainability. The revisionism can be understood as a component of a larger shift in many environmentalists' perspectives on technology. This straightforward equation highlights the reality of numerous environmental change causes and their compounding impacts.

Yoichi Kaya used a nearly equivalent equation to further explore the following causes of greenhouse gas emissions:

Total emissions = population × (GDP/population) × (energy/GDP) × (emissions/energy)

i.e., Total Emissions = Population × Affluence Per Capita × Energy used per unit of Affluence × Emissions per Unit of Energy Used.

The majority of climate predictions, including those made by the Intergovernmental Panel on Climate Change, continue to utilise the Kaya identity to project future greenhouse gas emissions. The two comparable formulations have helped generational thinking grow, but they also have their own limitations. For instance, both models presuppose unit elasticity, meaning that a percentage change in one of the variables on the right-hand side results in an equivalent change in the stress on the environment.

IPAT and Kaya identities, employed with unit elasticities, understate the effects of population expansion. Empirical assessments have indicated that such a proportionality assumption is dubious, i.e., most research have found that the consequences of rising population are higher than proportional. Additionally, they cannot be used to investigate the potential impact of these drivers because they do not explicitly account for culture and institutions. As a result, IPAT and Kaya have been proven to be helpful as good beginning points, but further development calls for a new generation of models that estimate rather than assume the impacts of each driver net of the others.