Pahang conserving her forests: premium for neighbourhood effects.

Some people are not happy with certain aspects of the Pahang 2010 budget. It is still a deficit budget. We have explained that deficit in isolation isn't as bad as people think it is. It's bad if the deficit is used to finance consumption spending such as financing the increase in salaries and emoluments without that corresponding increase in quality and productivity.

It's also bad as it may hide incompetency and unaccountability and blatant disregard for financial prudence. It is bad as it can also reflect lack of financial discipline and poor planning. Poor planning for example may result from low quality human resource. You can't expect high quality work from low quality man power.

Some people are also not happy about the fact that MB has gazetted 900,000 hectares or over 2.2 million acres of forest so that these areas regions remain a water catchment area. The water it is said, benefits also states like Selangor and Negeri Sembilan and others. In doing so, the MB claims that Pahang has made sacrifices and is entitled to some form of compensation from the federal government. Milton Friedman and Friedrich Hayek call these benefits- the neighborhood effects.

One commentator accused the MB of trying to get easy money from the federal government. By choosing an easy way out, the MB has in effect concealed his limitations and the writer goes on to say, that it's time for the MB to be replaced. I am sure this suggestion will be hotly debated.

But let us not dismiss outright the MB's suggestion to be compensated just because he has a very direct and crude way of saying it. Instead let's discuss whether what he wants can be justified economically. 2 years ago, when I was an ADUN, I too suggested that because Pahang voluntary chooses to retain forested region so that it can provide water to other states and while doing good to others, the state bears the cost, perhaps it can be compensated. The cost is in terms of foregoing revenue that could be earned if the forest resource is exploited commercially.

In effect, Pahang has created positive externalities to consumers in states that have insufficient water. This external benefit would increase the utility of third parties at no cost to them. Other states can go on exploiting forest resource knowing full well that big Pahang is conserving its own so that they could enjoy having ample water. If the water is obtained at the normal price without incorporating a premium, then these other states enjoy the status of a free rider.

The Pahang problem is this. If it has a choice it would want to fully exploit its forest to earn more for the state. But to do so would be selfish on its part, yet it has no way to monetise the benefits it gives to the others. The rational economic agent will want to produce less of this good since it cannot monetise them- but Pahang chooses to continue. Hence what it is asking is that the public good it gives be monetised in the form of compensation from the federal government to ensure continued supply of the public good. All it is asking is monetization of its sacrifice so that the supply of the product is market driven.

Let us regard then, compensation from the federal government as being the approach to "internalize" third party costs and benefits. But, in many cases internalizing costs or benefits is not feasible, especially if the true monetary values cannot be determined.

This is why the role of the federal government is needed. For one, we know that the monetary values of externalities are difficult to quantify, as they may reflect the ethical views and preferences of the entire population. It may not be clear whose preferences are most important, interests may conflict, the value of externalities may be difficult to determine, and all parties involved may try to influence the policy responses to their own benefit.

Because it may not be feasible to monetize the costs and benefits, another method is needed to either impose solutions or aggregate the choices of society, when externalities are significant. This may be through some form of political intervention as when the federal government intervenes to adjudicate. The government acts to distribute costs and benefits that are not solvable by purely private transactions. The value of the compensation therefore can be seen as the form of economic adjudication.

So despite the MB's plebeian way of asking from the federal government, the idea can be economically justified.