Environmental economics

DEFINITION: The study of the relationship between the economy and the environment

Environmental economics—which focuses on such areas of concern as the allocation of costs associated with pollutants, the allocation of natural resources, and efforts to place monetary values on resources for which there are no markets—provides insights into the ways in which the environment and the economy affect each other.

The concept of environmental economics grew out of the awareness of environmental issues that impinged on the social consciousness beginning in the 1960s and 1970s. Visions of a “silent spring,” polluted rivers, and smog-filled cities posed questions about whether a free market economy efficiently allocates resources. A fourfold increase in the price of oil, long lines at gas stations, and the new view of Earth from space as a small blue sphere against a black void prompted debate about whether sufficient nonrenewable resources exist to sustain economic growth. Deforestation, species extinction, and global warming raised doubts about whether markets adequately value environmental resources, prompting economists to inquire into how to value resources for which there are no markets.

Traditional economic theory largely ignores the relationship between economics and the environment. The assumption of economic rationality depicts firms as profit maximizers and consumers as pleasure maximizers. The invisible hand of the market conveys the view that voluntary exchange promotes economic harmony. Firms and consumers in pursuit of their self-interest unintentionally promote the interest of all. Nature is reduced to an input into the production process, providing both renewable and nonrenewable resources. Pollution is treated as an aberration, an example of market failure requiring some form of government intervention to restore the harmony of the market.

An alternative view, expressed by Herman E. Daly and John B. Cobb in their book For the Common Good: Redirecting the Economy Toward Community, the Environment, and a Sustainable Future (1989), conceives of the economy and nature as interdependent. Emphasis is placed on the concept of extended rationality; that is, individuals find it in their self-interest to protect the and care for future generations. The economy and nature are viewed in terms of coevolutionary processes, each affecting the other. This view focuses on creating institutions to channel self-interest in environmentally sensitive ways.

Pollution

Despite highly restrictive assumptions, economists most often use the perfectly competitive model to evaluate environmental policy. Under perfect competition, no single agent has the power to influence price, resulting in an equilibrium price that efficiently allocates resources. Efficiency means that the benefit of producing one more unit equals the cost of producing that unit. Social welfare (happiness of the individuals in society) is maximized because each unit produced prior to equilibrium yields more benefit than it costs.

For example, consider a firm engaged in the production of copper by the ton. As the consumption of copper rises, the benefits obtained from an additional ton decline; conversely, as production rises, the costs to the firm of producing an additional ton rise. The intersection of these supply and demand factors results in an equilibrium that sets a price for the copper and also determines the amount of copper that the firm should produce.

Suppose, however, that the firm also produces as a that injures others. In this case, the free market price would not reflect the external cost imposed on others or on society at large resulting from the pollution. Pollution is a type of externality, a cost involuntarily imposed on one party as a result of the activities of others. If corrections were made to the supply-and-demand equilibrium to account for the external cost, the price of the copper would rise, and production would fall. Note that correcting for external costs does not eliminate pollution; it merely requires that producers and consumers consider the external costs in their decisions.

The existence of externalities implies that the free market misallocates resources: Too much is produced for a price that does not include the external costs. Social welfare is not maximized, because costs to the firm plus external costs of the last units produced exceed the benefit of the last units.

Dealing with Externalities

Several options are available to government in correcting for externalities: standards, taxes and subsidies, property rights, and marketable permits. In the past, environmental laws generally imposed fixed standards to which all businesses must conform. The simplicity of standards from a policy point of view has made them widely used. However, standards have been criticized for their coercive element, their failure to consider local circumstances, and their apparent arbitrariness.

In the 1930s, Arthur Pigou, one of the first economists to address externalities, recommended that government impose a tax equal to the external cost. Critics, however, cite difficulty in measuring the external costs, measuring the amount of pollution, determining the location to measure the pollution, and so on.

Ronald H. Coase, in a classic article titled “The Problem of Social Cost,” advocates a free market solution. Coase recommends assigning property rights for the air or water, leading the affected parties to bargain over who pays the costs associated with pollution. If the injured party owns the resource, he or she charges the polluter an amount not less than the damages for using the resource. If the polluter owns the resource, the injured party would bribe the polluter not to pollute. The injured party would not pay an amount exceeding the damages created by pollution, and the polluter would not accept an amount less than the profits forgone. To maintain a lack of bias, Coase advocates the doctrine of ethical neutrality. In the absence of property rights, the polluter is no more responsible for pollution than is the injured party. Who pays depends on which method reduces the transaction costs (costs of identifying the party or parties harmed and transacting the compensation). In most cases, minimizing transaction costs requires the injured party or parties to bribe the polluters not to pollute.

Market permits were adopted by the Clean Air Act amendments of 1990. The government sells permits that allow purchasers to emit limited amounts of pollution. Advocates argue that such permits provide polluters with incentive not to pollute. If a firm finds that the cost of installing pollution-control equipment is less than the cost of a permit, the firm reduces its pollution. If the cost of the equipment exceeds the price of the permit, the firm buys the permit. Critics, however, charge that the option to buy such permits implies that government endorses pollution.

Renewable and Nonrenewable Resources

Natural resources may be categorized as either renewable or nonrenewable. Renewable resources are those that may be replenished, such as forests. Nonrenewable resources cannot be replenished.

The conditions for sustaining the environment are easy to identify in theory but difficult to achieve in practice. First, the harvest of natural resources must be less than the growth rates of those resources. Deforestation and the depletion of fisheries, for example, indicate that in many instances harvest rates exceed growth rates. Second, nonrenewable resources are, by definition, nonrenewable. The World Resources Institute has estimated that fossil fuels provide 90 percent of the commercial energy used in the world. The world’s reserves of have been estimated to last approximately five hundred years, and reserves of oil have been estimated to last less than one hundred years. Ultimately, if economic growth is to be sustained, renewable resources must be substituted for nonrenewable resources. Third, emissions must not exceed nature’s ability to absorb wastes. Markets can be used to provide incentives to encourage people to reduce, reuse, and recycle. Innovative businesses have reduced pollution by altering production processes and input mixes, thereby also reducing their costs.

Garrett Hardin addresses resource depletion in a classic article titled “The Tragedy of the Commons” (1968). “The commons” refers to a resource owned by no one and available to everyone. Assuming rationality, individuals exploit the resource as long as the benefit exceeds the cost. The result is that self-interest leads individuals to destroy the resource. Hardin’s recommendation is to privatize the resource.

Economists are divided on whether the market alone is sufficient to drive the transition from nonrenewable to renewable resources. Conservative economists assert that the market works. As oil production slows, the price of oil rises, providing incentives to entrepreneurs to find alternatives. This assumes that if markets are allowed to work, new technologies will be developed, making inputs infinitely substitutable.

Markets, however, rarely allocate resources in ways that preserve the environment. The interest rate, for example, reflects society’s preference between allocating resources for present use versus future use. The higher the rate of interest, the more society discounts the use of the resources in the future. If a firm finds that the market interest rate exceeds the rate of increase in the price of a resource, such as oil, then the profit-motivated firm will sell its resource and invest the proceeds.

A 2019 study indicated there was an inverted U-shaped relationship between the economic development of a country and the amount of pollution it created. As a nation experienced economic growth this came at the expense of degrading its natural environment. At a certain point of development, a country’s economy begins to evolve away from polluting industries, such as manufacturing, to less destructive enterprises. These tend to be are knowledge-based or service-oriented.

The market reflects the preferences of those who have the “dollar votes.” Nature and habitats, while important, do not vote. The services that nature provides in the forms of wastes, maintaining the climate, providing oxygen, absorbing carbon dioxide, and providing aesthetic pleasure are not reflected in market values. Hence what is most profitable is not necessarily consistent with environmental preservation.

Valuing Natural Resources

Markets allocate resources based on their price or value. How does one place a value on something for which there is no market? The answer better enables policy makers to allocate resources among competing uses, such as whether to use public lands for recreation or oil drilling. Placing a market value on natural resources generally means transforming them into commodities: a forest transformed into lumber, for example, or the mining of gold in Yellowstone. There are exceptions: The Nature Conservancy uses a strategy called debt-for-nature swaps, in which land in developing nations is purchased for preservation, thus reducing the nations’ debt and protecting rain forests. In many cases, however, such as the administration of public lands, market solutions are unavailable.

In addressing the value of a resource, economists have developed three classifications for value: user value, option value, and existence value. User value is the value to the individual in using the resource; this is reflected in the value of the resource to hikers, recreationists, and skiers. Option value is the value of having the option to develop the resource at some future point. Existence value is the value of bequeathing the environmental resources to future generations, to habitat, and so on.

To determine the value of a resource, economists have employed a number of approaches. The most widely used are known as willingness to pay and willingness to accept. Willingness to pay asks individuals how much they would be willing to pay to enjoy environmental benefits. Willingness to accept asks how much individuals would be willing to accept in order to incur some loss. The difficulties with all approaches, however, reveal that there is no objective way to determine the value of a resource.

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