Environmental Economics

Introduction

One of the things that seems to perplex most activists, academics and activist academics is ‘economics’: what it means, what it aims to do and how we should respond to those who put forward economic arguments to social and environmental problems and policy.


I want to start a new series of blogs on ‘economics’. This one introduces economics and how it is applied to environmental issues. It was prompted by a lecture I did at University of NSW – and I am hoping to expand on these concepts in the coming months.


While I am no fan of those who uncritically apply economics to environmental challenges, it should be recognised that environmental economics is a field that attempts to bring together one of the fundamental premises of our society (on going economic growth) with concerns that this growth is having detrimental impacts on our environment.


As you will no doubt note, I am sceptical about this field of research, but what is important here is that it is an attempt to break through the ‘progress trap’ of ongoing economic growth. As I discuss this area of economics, please weight up in your own thoughts and reflect on the following question: is environmental economics an attempt to green the economy, or part of an ongoing process of turning the environment into a commodity traded for profit rather than sustained for our livelihoods.


Economics – some brief background

While there are many definitions of economics, for us it is the study of how people make choices about what they buy, what they produce, and how our system of exchange works. Our economy, like most around the world, operates on a market system.


There are two fundamental concepts that all economists attempt to confront no matter what system they operate in.


The first is scarcity: that is, in a society where our demands, needs and wants are ongoing and seem ever growing, we live in a world that only has limited resources. (Note that many economists argue that our desires are infinite and soon as we fill one desire another emerges, I do not agree and think that is a pretty bleak vision of human nature, but do not have the space to discuss that here). Regardless, there is a mismatch between material desires and available resources.


This concept of scarcity is one of the most important concepts in economics: it is an attempt to study and assist the many decisions on how to use those resources in the face of expanding desires.


The second concept is opportunity cost: as there is a mismatch between desires and the resources to fulfil them, there is a need to choose one desire to fulfil over another. The ‘opportunity cost’ of any decision is what you are giving up to get what you want. Consequently, if you want a holiday or a new stereo and you decide on the holiday, the opportunity cost is the stereo you are giving up. You may choose to come to class or go for coffee with someone: you have to give up one to do the other. We can think of many such examples, and in each one, you make a choice and have to sacrifice another.


No matter what decision we make, there is an opportunity cost: and it is not necessarily a monetary one.


There are also four basic questions that every economy must answer:


o What should be produced?

o How many should be produced?

o What methods should be used?

o How should the goods and services be distributed?


In a market economy, the ‘marketplace’ decides how to answer these by allowing each producer to answer these questions themselves. The success of each of these decisions is, however, determined by the marketplace. So while a producer may decide what product to sell to make money, we (the consumers) determine whether to buy or not.


Note: in most textbooks you are told that there are two types of economies: a command economy (where a government makes all the decisions) or a market economy (where we are ‘free’ to choose through the market). The truth is, however, that most (if not all) economies are a mixture of the two. Even in a market economy like Australia’s, the government involves itself in the market by offering incentives (through taxes and subsidies) to guide the market. For example, there are billions of dollars of subsidies to the coal industry (including building roads and ports to assist in the production of coal) while offering very few incentives to renewable energy sources.


Economics in environmental policy

Environmental Economics… undertakes theoretical or empirical studies of the economic effects of national or local environmental policies around the world... Particular issues include the costs and benefits of alternative environmental policies to deal with air pollution, water quality, toxic substances, solid waste, and global warming.

National Bureau of Economic Research Environmental Economics (http://www.nber.org/)


The rise of environmental economics as a discipline and a field of policy follow the growing recognition that that the environment is a scarce resource and its use requires important decisions about opportunity cost. That is, in much of modern history, the environmental was seen as boundless: being a free resource that we could use forever. For example, much pollution was dumped with minimal controls because the earth was seen as both there to be used for free, and able to handle anything we throw at it.


As economics is a field aimed at dealing with scarce resources, it is a mechanism that has been seen as being useful when dealing with environmental problems.


The fundamental principle that drives environmental economics is that the environment is costed: given a price. That is, we can put a price on the value of different aspects of the environment: be it clean air, clean water, the Great Barrier Reef or a single tree – environmental economics relies on the principle that it is possible to estimate their worth.


Once this is done, it is believed that we can make decisions about use of the environmental by weighing up the financial costs and the benefits. Hence, it is possible to estimate the opportunity cost: so the cost of protecting a river because of the ‘value’ it offers as a tourist destination, can be measured against the benefits of attracting people to the areas.


Environmental economists acknowledge the difficulty in estimate such costs and benefits; it is better to estimate them than to come to the conclusion that it is too hard. The argument also goes that using the tools available through market-based instruments, environmental and economic goals can be reached efficiently.



Are these contradictory?

In fact, as the sphere of economics has become a growing part of our lives for various reasons, the public continuously demands that this is done before decisions concerning the environment are made.


Many argue, however, that there are inbuilt contradictions in the twin objectives of economics (which focuses on growth) and environmental protection (which tends to have a conservation focus). Consequently, it is believed that a choice must be made between one and the other and that both cannot be achieved concurrently.


I will not discuss this here, but will return to it in another blog.



Market failure


Central to environmental economics is the concept of market failure. This simply means that the market mechanism has essentially failed to efficiently allocate resources:

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 want him or her to do to protect the environment. Such a wedge implies wastefulness or economic inefficiency; resources can be reallocated to make at least one person better off without making anyone else worse off.
Hanley, Shogren, and White (2007)

Common forms of market failure include externalities, common property (or non-exclusion) and public goods.


Externalities

The basic idea is that an externality exists when someone makes a choice that has affects on other people but is not accounted for in the price set by the market. The most basic example is when a company pollutes it does not take into account the true costs that this pollution imposes on others. Consequently, the firm’s choice has a negative impact on the broader population. The result is that a less than efficient result is achieved: in this case, the resource of a clean environment is not allocated in the most efficient way.


In economic terminology, externalities are examples of market failures, in which the market does not lead to an efficient outcome.


So what environmental economics aims to do is cost these externalities: put a price on them to either act as a disincentive to stop the polluters, or charge a tax so people can be compensated for their environment being polluted.


Common property

A second focus of environmental economics revolves finding solutions to a lack of property rights that emerge when it is too expensive to exclude others from accessing a resource. When this occurs, it is said that the market allocation is inefficient.


This was highlighted by Garret Hardin's (1968) concept of the tragedy of the commons (which we will discuss in a future lecture). "Commons" refer to the environmental assets that allow collectively owned.


The basic problem is that if people ignore the scarcity value of the commons, then they can be over harvested as a resource: fisheries are one of many examples. Hardin argues that in such cases resources will be abused: and hence recommends the emergence of exclusive rights.


Note: this has been disproved including the work of Ostrom (1990) who showed how people have worked to establish self-governing rules to reduce the risk of the tragedy of the commons.


Public goods:

Public goods are a third type of market failure. This emerges when the market price does not capture the social benefits of its provision. For example, protection from the risks of climate change is a public good since its provision is both non-rival and non-excludable. That is, climate protection provided to one country does not reduce the level of protection to another country; non-excludable means it is too costly to exclude any one from receiving climate protection. A country's incentive to invest in carbon abatement is reduced because it can "free ride" off the efforts of other countries.


Public goods are a market failure because the market fails to provide them because people tend to hide their preferences (and hence refuse to pay) for the good while still enjoy the benefits.



Valuation

I want now to return to the concept of valuation: that is, estimating the value of the environment (or a piece of the environment).


There are a number of problems that exist in trying to value the environment. Central here is the concept of ‘intrinsic value’: that the environment (both as a whole and in parts) has a value that we derive from it simply by existing. For example, just the idea that the Great Barrier Reef or Amazon forest are there is important regardless of any benefits that we may gain from it. We may never see it, but just knowing that it is there is important.


But let us not just think about something with such obvious environmental and ecological importance, but just general use of environment resources: How do we value the parkland at the end of our stress or a place like Coogee Beach?


One way that has been suggested is to ask people how much they would pay to observe and recreate in the environment (willingness to pay) or their willingness to accept (WTA) compensation for the destruction of the environmental good.


Note: I want you to think about a place that you really value for personal and emotional reasons:

o What you would be willing to pay to enter this place?

o How much would you need to be compensated if it was to be turned into a car park?


If I were an environmental economist, to calculate the value of one of these places I would simply aggregate what everyone is willing to pay and come up with a figure. This would allow us to estimate its value and calculate the cost-benefit of the area.


Solutions

The second dimension of environmental economics that is important is the solutions offered. Let’s look at some of the solutions that are offered.


Environmental regulations:

Here, the idea is that a regulator estimates the economic and environment impacts - usually undertaking a cost-benefit analysis. While some mat argue that this is a non-market mechanism and outside the realm of environmental economics, there is still the need for the regulator to calculate the value of any regulation (both the cost of implementing the scheme as well as the cost of doing something) and compare it to the cost of doing nothing.


Quotas on pollution:

Another method for pollution reductions is through tradeable emissions permits: this allows the owners of the permits to freely trade the right to pollute. It is argued that this creates reductions in pollution at least cost. In theory, if such tradeable quotas are allowed, then a firm would reduce its own pollution load only if doing so would cost less than paying someone else to make the same reduction.


Taxes on pollution:

Increasing the costs of polluting will discourage polluting, and will provide a "dynamic incentive" to ensure pollution levels fall. A pollution tax that reduces pollution to the socially "optimal" level would be set at such a level that pollution occurs only if the benefits to society (for example, in form of greater production) exceeds the costs.


Removal of subsidies

That is, remove any hidden subsidies to dirty industries.


Better property rights:

One of the key theories in environmental economics is that the assignment of defined property rights will lead to optimal solutions – regardless of who receives them. For example, if people living near a factory had a right to clean air and water, or the factory had the right to pollute, then either the factory could pay those affected by the pollution or the people could pay the factory not to pollute. Or, citizens could take action themselves as they would if other property rights were violated.


This allows markets for "pollution rights" to emerge – and is known as emissions trading (the focus of current debates in Australia).



Do not confuse environmental and ecological economics

It is important to note that environmental economists apply the tools of economics to address environmental problems or market failure. That is, applying economics solutions to where market economics has proven unreliable.


Ecological economists take a different approach – focusing their work on the impacts of humans and their economic activity on ecological systems. Ecological economics sees economics is a strict sub-field of ecology: the economy should only expand to the size that negatively impacts on the environment.


Ecological economics is seen to take a more pluralistic approach to environmental problems, focusing on the long-term environmental sustainability and issues of scale (that is, what is the right scale for human activity).


Environmental and ecological economics have fundamentally different philosophical underpinnings.


Conclusions

There are many limitations to environmental economics. Many have rejected this field, saying that it does not go far enough in attempting to deal with the environmental challenges facing us.


Many ‘green economists’ reject this field as simply an extension of traditional forms of economics and there should be a greater focus on a new political economy that gives a greater emphasis to the interaction of the human economy and the natural environment.


For us, we should consider whether environmental economics is simply extending current practices or offering solutions…





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Hanley, N., Shogren, J. and White, B. (2007) Environmental
Economics: In Theory & Practice, Palgrave Macmillan, 2nd ed


Hardin, G. (1968) "The Tragedy of the Commons", Science, 162, pp. 1243-1248.


Ostrom, E. (1990) Governing the Commons: The Evolution of Institutions for Collective Action. Cambridge University Press.