Economics for the Environment: A Primer
1. Welfare Economics and Marginal Analysis
Much of what we know as environmental economics can best be thought of as applied economics. The positive side of environmental economics uses micro and macroeconomic theory to learn more about the ways in which economic factors influence the consumption of environmental goods and services. Positive environmental economics is largely descriptive and predictive. The normative aspect of environmental economics is largely prescriptive and applies principles of welfare economics to determine the allocation of environmental goods and services that generates the greatest economic good for society.
Normative welfare economics provides a framework to determine how society “should” allocate resources, assuming that economic welfare is a good measure of society’s well-being. Pareto pointed out that an optimal allocation of goods exists when any reallocation would only make one person better off at the expense of another; we call this allocation a Pareto efficient or economically efficient allocation. At sub-optimal allocations, we could potentially reallocate resources to make everyone better off as whole. Reallocations away from the sub-optimal towards the optimal are known as Pareto improvements. Using the ideas of Pareto, normative environmental economics provides a framework for finding the economically optimal allocation of environmental resources.
Talking about the greatest good to society and measuring this good are quite different things. To make discussions of well-being more tangible, economists need to find concrete ways of capturing the values people give to goods, resources, and even services. Generally, we say that someone values a good if they are willing to give up something they already have or are entitled to have to obtain the good in question. In subsistence economies, people may trade their time (say, time spent hunting) in order to get things they value (such as game). In barter systems, people trade among each other by offering one good for another. In market systems, we trade currency (whether be it Euros or Treasury Notes) for goods. The reasons people are willing to make sacrifices to get goods or services may be complex. Nevertheless, the fact that people are willing to make tangible trades gives us clues about people’s valuations and choices.p. xii
a. Measuring the Value of Goods
The market price of a good is an important indication of the value a consumer places on that good. Since people presumably do not value currency in and of itself, economists accept that the amount paid in currency is a simple reflection of the current value a consumer places on a good. When consumers hand over 50 cents to buy an apple, they reveal that they place a value on that apple of at least 50 cents. Even when goods are sold individually it is common for consumers to buy more than one unit of a good, either at once or over the course of some period of time. The total number of units bought depends on the price; when prices are high consumers buy less of a good and when prices are low consumers buy more. As before, the consumer only buys apples as long as the value he or she places on each apple exceeds the price per apple in the market. Of course, the consumer never buys an infinite number of apples, so we know immediately that the value a consumer places on any individual apple must fall as that consumer acquires more and more apples. We call the value that consumers place on each newly purchased apple their marginal willingness to pay for that last apple. The consumer will keep buying a good as long as his/her marginal willingness to pay for the good is at least equal to the price of the good. Therefore, if a consumer buys 10 apples at 5 cents/apple we know that the value of the last apple is 5 cents/apple. Does that mean the value of all 10 apples is 5 cents times 10 or 50 cents? Not necessarily. To understand why, we need to think about why a consumer buys more when the price is low and less when the price is high. We call the study of this relationship of prices and quantities “demand analysis”, and the relationship a demand function.
In the market, we observe regular patterns in which the quantity of a good purchased by a consumer varies with the price of the good. We call the quantity of a good that a consumer would like to buy for a given price, the demand for that good. When prices are high, demand is small, and vice versa. While prices usually determine demand, we have already shown that when a consumer makes a purchase, the purchase price reveals the value that the consumer places on a good. A consumer places a higher value on a single apple than on one of 10 apples, especially if the 10th apple is consumed after the first 9 have been eaten.
We call the schedule of quantities demanded at different prices the Marshallian demand function or simply the demand curve for a good.p. xiii
The demand function reveals how much of a good a consumer would buy at a given price (e.g., when the price is 2, the demand is 7). Figure 1a shows that at a price (drawn on the horizontal axis) of 0, the consumer would demand (drawn on the vertical axis) 8 units and at a price of 16 the demand falls to 0 (we call this the choke price). The actual schedule of prices and quantities demanded depends on the consumer’s personal characteristics, including income. For instance, rich people may buy more of a good at a given price than poor people. The slope and the shape of the demand curve (a demand curve can bend in towards the origin) depends on such things as how essential the good is or how many substitutes for the good are available to the consumer.
If we switch the axes of our graph, we now have a schedule that reveals the value a consumer places on each unit of a good, depending on how many units already have been consumed. As before, we call the value that is placed on one more unit of a good, the marginal willingness to pay for that unit, and the new schedule of prices as a function of quantity the inverse demand function or curve.
Once again, when 7 units are purchased, the 7th unit is valued at 2. Note that the 8th unit has zero value, that is, the consumer would consume up to 8 units if they were free, but any more than that would not make the consumer any better off.
The inverse demand curve also reveals both the value of the last marginal unit (the marginal willingness to pay) and also the cumulative value that the consumer would place on the consumption of all the units consumed (the total willingness to pay). The marginal willingness to pay is simply read off the inverse demand curve. The total willingness to pay, however, mustp. xiv
be found by summing together the marginal willingness to pay for every individual unit. For example, the total willingness to pay for 3 units would be equal to the marginal willingness to pay for each unit separately (Figure 1b, areas a + b + c). A continuous inverse demand function, however, shows that the marginal willingness to pay varies for even small fractions of a unit.
The stair steps of areas a, b and c in Figure 1b only approximate the total willingness to pay for 3 units of the good. The marginal willingness to pay is an exact measure only of the infinitely small fraction of the last unit consumed. If we make the units smaller and smaller, the exact total willingness to pay is found by summing up increasingly tiny slivers under the demand curve. The summation of these slivers equals the area under the inverse demand curve up to the quantity consumed.1 In Figure 1c, we draw the total willingness to pay for 3 units.
Readers familiar with calculus may recognize that the total willingness to pay is simply the integral of the marginal willingness to pay evaluated from 0 to the quantity consumed. Conversely, marginal willingness to pay is the derivative of total willingness to pay.
While total willingness to pay represents the gross value a consumer places on the consumption of a good, economists generally are interested in the benefit of a good or resource net of the cost of obtaining that good. From the consumers’ perspective, the cost of a good is the total price paid for a good (price × quantity). If only a single, uniform price is charged for each p. xvunit of a good, then the total willingness to pay for a good will exceed the cost to the consumer (price paid). The difference between total willingness to pay and the actual amount paid is called consumer surplus (Figure 1d).
This is the most basic measure of the contribution of a good to a consumer’s well-being. Other more precise measures of welfare include the compensated welfare measures (e.g., compensating variation and equivalent variation).
c. p. xviAggregate Demand and Society’s Welfare
The leap from measuring the welfare of a consumer to measuring the welfare of society requires some sort of aggregation of values across people. If we examine the problem strictly from the perspective of market demand, we can simply add together the demand that each consumer expresses for a good at the given price. For instance, if at a price of 2 cents, José demands 5 apples and Sue wants 3 apples, then their combined demand is simply 8 apples when the price is 2 cents. By adding up across individual consumers, we can derive a market demand function that has all of the properties we described above (e.g., inverse demand still reflects marginal willingness to pay, but now for all consumers). In a similar manner, we calculate consumer surplus for all consumers that participate in the market.
An economy consists of more than consumers; we also need to look at the supply of goods and the costs of providing goods. Supply analysis can be graphically demonstrated using the same marginal framework we developed for demand. The cost of providing one more good is the marginal cost of that good. As before, we draw the quantity of a good provided on the horizontal axis. The cost of providing one more unit of a good, its marginal cost, is drawn on the vertical axis. The relationship between quantity and marginal cost is called the supply function or the marginal cost function. Marginal cost may increase, remain constant, decrease, or even develop an irregular shape known as a backward bending supply curve. The total cost of supplying a good is found by determining the area under the supply curve between zero and the quantity supplied.
Producers will supply goods as long as the price on the market is greater than the marginal cost of production. If the supply curve is upward sloping, then the price will exceed the marginal cost for every unit but the last and the producer will earn a benefit known as rent or producer surplus. Figure 2 demonstrates an upward sloping supply function, price, and the associated producer surplus that comes from supplying goods up to the point where marginal cost equals price. In the aggregate, there exists a market supply function that reflects the marginal costs of supplying goods when all producers are considered. Some producers may be able to produce goods at low marginal costs and others may produce at higher marginal costs. Those that can produce goods more cheaply will earn more benefits and thus more rent or producer surplus.p. xvii
2. Market Equilibrium and Market Failure
In market economies, prices are not set arbitrarily, but are the outcome of the forces of supply and demand. Producers will supply goods as long as consumers are willing to pay at least the marginal costs of supply. Consumers will buy goods as long as their marginal willingness to pay (marginal benefit) exceeds the costs charged by producers. Through market processes of bids and offers, consumers and producers make trades. If consumers demand more goods than a given set of producers can provide, new producers will enter the market as long as they can supply goods at a cost less than the consumers’ willingness to pay. As more and more goods are produced and consumed, two things may happen: (1) because of the property of declining marginal benefits, the consumers’ willingness to pay will fall; and (2) the marginal costs of production may remain constant or increase, perhaps due to technological reasons. Eventually market trades reach a point where the marginal cost of production equals the marginal benefit to consumers. We call this an equilibrium point (demonstrated in Figure 3a) where q* is the equilibrium allocation and p* is the equilibrium price.
If the amount supplied is less than q*, a producer can earn rent by increasing the supply. If more than the equilibrium quantity is supplied, consumers will not pay a price sufficient to cover marginal costs and some producers will lose money and reduce their supply.
As long as market costs reflect the actual cost of goods, consumers and producers will trade at an allocation that maximizes welfare to society, p. xviiiwhere welfare is consumer surplus plus producer surplus or net social surplus (Figure 3b).
(When net social surplus is maximized, we say we have an economically efficient allocation.) This welfare maximizing property of free markets p. xixhas led many to support market-based mechanisms for the allocation of resources (market environmentalists), and has given rise to a movement known as Free Market Environmentalism. The conditions under which a market must operate to achieve the maximum welfare for society are, however, difficult to find. At the minimum, a well functioning market needs to be one in which property rights for resources are well defined, there are many buyers and sellers, and prices most accurately represent the costs of providing goods. Frequently these conditions are not met and we say the economy experiences market failure.
The efficient allocation of natural resources and environmental goods is routinely impeded by market failures. Property rights do not exist for many resources (e.g., deep sea minerals or open ocean fisheries). If resources are open to all (open-access resources), the market will not allocate these resources in a way that maximizes the benefits to society. Sometimes the lack of property rights stems from a difficulty in laying claim to fugitive, mobile and remote resources. When this is the case, steps can be taken to assign property rights, thus improving the degree to which the market functions properly. In other cases, resources lack “owners” because their very nature defies ownership. When consumers cannot be excluded from enjoying a resource and when the enjoyment of that resource by one consumer does not diminish the enjoyment of that resource by another, we call the good in question a public good. Examples of public goods include national defense, air quality, and whale conservation (public bads include things like global warming and coastal pollution). Because property rights cannot be assigned to public goods, the market is unlikely to allocate public good resources in a way that is economically efficient (i.e., the welfare maximizing allocation is not chosen by the market).
Often environmental impacts are the byproduct of other activities. Recycling trucks create noise when they drive through your neighborhood to pick up bottles; power plants emit smoke and steam that can obstruct views; surfers can create entertaining viewing for beachgoers. In all three cases, we find that the people who bear the costs or enjoy the benefits of the “byproducts” of these activities may be different than the people whose activities create these “byproducts”. When costs and benefits of an activity are not borne by the immediate consumer or producer, we call these costs negative externalities and the benefits positive externalities. As in the examples of open access and public goods, the problem is that property rights to the externalities have not been properly defined. When property rights for an externality are well defined (e.g., people have property rights to be free from noise or recycling trucks have the right to make noise), we expect a well functioning market to allocate resources efficiently (see Coase Theorem). Property rights can sometimes be assigned directly to p. xxexternalities. In other cases, government can internalize externalities by determining the economic value of an impact and directly charging those responsible for negative externalities (see, for example, Pigouvian taxes) or by subsidizing positive externalities.
3. Non-Market Values and Total Economic Value
Many environmental and natural resources are not traded in markets, either because they are public goods or because property rights to these goods have not been properly assigned. Unlike most standard market goods (say a candy bar), certain environmental goods may possess values that can be considered as public goods and other values that are purely private in nature. It would be hard to imagine how a candy bar could be anything other than a private good. On the other hand, consider a tree. When a tree is cut for timber, it is consumed as a private good. That same tree, however, could also have been viewed by hundreds of hikers had it remained alive in the forest. Viewing that tree would represent a public good value associated with the tree. The fact that natural and environmental resources tend to have properties that are both public and private, utilitarian and spiritual, practical and intangible means these goods are far more complex than standard market goods. To understand when and why markets allocate and misallocate environmental and natural resources, we need to start by understanding the types of values these environmental goods can possess.
To start, we break down the total economic value of an environmental good or service into those values that people derive from direct use (called use values) and those values that do not require direct use by the consumer (non-use or passive use values). Use values include all of those transitive, active uses of a good or resource. Some use values have properties of private goods. These values typically involve some kind of extraction or consumption that allows the consumer to exclude others from using the good or resource. Timbering a tree is one example, but many less dramatic examples also exist, including picking up seashells or diverting water from a lake to irrigate your garden. When a good is removed from its place in nature and consumed in a way that makes exclusion possible, we call the value associated with that good an extractive use value. If environmental goods had only extractive use values, we would expect that the market might be able to allocate these goods in an economically efficient way. However, the very same goods may also have non-extractive use values. Non-extractive use values are those values that emanate from the use of a good that do not require removal from nature and subsequently are difficult p. xxito exclude from use by others. Viewing a tree is a non-extractive use value, wading in the ocean and sailing on a lake are both activities that generate non-extractive use values.
Environmental goods differ from other common market goods in that many environmental goods possess non-use or passive use values. Non-use values are values that a consumer derives from a good that they never use or do not plan to use directly. For instance, some people may derive utility just from knowing that sea otters exist somewhere in California (we call this existence value). These people may even be willing to pay to protect these animals (direct evidence of the minimum value they place on this passive use). Other passive use values include bequest value and option value. Whether non-use values are true values, distinct from some sort of expected use value, is a matter of some debate. Furthermore, the universal acceptance of non-use values by many policy makers is hindered by the difficulty economists have had in finding reliable techniques to measure these values. Nevertheless, a “blue ribbon” panel convened by the National Oceanic and Atmospheric Agency of the United States (NOAA panel) found that non-use values were at least sufficiently legitimate to be used as a starting point for assessing economic losses in a judicial setting.
4. Measuring Non-Market Values
Measuring the non-market values of environmental goods has been one of the greatest challenges for environmental economics during the last 30 years. To capture the very real value of these goods, environmental economists have undertaken two avenues of empirical elicitation that can loosely be divided into “revealed preference, or non-hypothetical approaches” and “hypothetical, or contingent market” approaches. (As the science advances, these two approaches continue to blend together, but we treat them separately here to get several key points across.)
By definition, prices for “non-market” goods simply do not exist. Nevertheless, environmental values do influence market activities by influencing prices for certain goods (as complements or substitutes for market goods) and by influencing spending on other market goods. For instance, all things being equal, houses where the air is clean have higher market prices than houses in smoggy neighborhoods. When the quantity or quality of environmental goods and services affects consumer behavior we often can tease out the economic “value” of the environmental good through econometrics. We say that people “reveal their preferences” for environmental goods by their consumption behavior. Statistical methods can then be applied to econometric models of consumption that account p. xxiifor the ways in which environmental goods influence consumers’ preferences for other goods. The class of methods that employs empirical statistical analysis of consumption behavior with models of consumption is known as the class of revealed preference methods. In the field of environmental economics, standard travel cost methods, random utility models and hedonic methods are three important revealed preference methods used to elicit the value of non-market environmental goods.
In many cases, it is impossible to observe the ways in which environmental goods influence market goods. Sometimes, the environmental good of interest is independent of other market goods. Other times, the provision or loss of the good is rare or even entirely novel to the consumer – consider the loss of wildlife in Prince William Sound following the grounding of the Exxon Valdez or the hypothetical extinction of the blue whale. When the provision or loss of an environmental good is beyond our experience or falls outside of what we would normally consider complements or substitutes to market goods, we must turn to more hypothetical, or contingent, approaches to valuing environmental goods. The contingent methods use a variety of techniques to determine how consumers would value hypothetical changes in the quantity or quality of goods. The most basic of the contingent models use survey techniques to estimate the respondents’ willingness to pay for the provision of an environmental good or the removal of an environmental bad, or their willingness to accept compensation for the opposite. Other contingent methods elicit values for environmental goods and services by having respondents rank environmental non-market goods with other market goods (contingent ranking). Increasingly, the contingent method are designed to look more and more like market transactions. In the stated preference method, respondents are given a choice between hypothetical “bundles” of goods with each bundle containing at least one environmental good, and with hypothetical prices for every bundle. The consumer then chooses the bundle he or she prefers. In the stated preference approach, consumers’ hypothetical choices can be treated much like the actual choices analyzed in the revealed preference methods. Finally, environmental economists can combine both revealed preference and stated preference approaches to fully utilize the full suite of available empirical and hypothetical data to provide clues about the values people give to non-market environmental goods.
To address issues of sustainability, we must expand our discussion of resource allocation to include the idea that there may be an optimal way p. xxiiiof distributing resources across time as well as among people. Under the umbrella of sustainability, we can consider two principal questions: (1) how long will our resources last, given current consumption patterns? and (2) how should we manage our resources so that future generations have access to the same quality of life as present generations?
The first question of resource longevity is really one of prediction and accounting; how do technology, taste, population, and natural regeneration influence the stock of environmental goods that will be available from one year to the next? Questions about how long resources will last have long concerned planners and economists who have worried that the world is running out of agricultural land, fish, and other important environmental goods. While scarcity may simply be defined as a quantity below which a good has a price in the market, the topic of sustainability attempts to frame the discussion as the degree to which a good is becoming more scarce. Malthus wrote that land for agriculture would become scarce, not because the quantity was disappearing but because the demand for land, driven by a growing population, was increasing dramatically. David Ricardo, on the other hand, pointed out that land may indeed become scarce, but not because it was in short supply. On the contrary, Ricardo believed land itself was abundant, but good, high quality land for agriculture was scarce and becoming scarcer for the same reasons proposed by Malthus. In either case, the concern was that the supply of a resource was not growing to keep pace with increasing demand.
A variety of indices have been developed to measure the degree to which resources are being consumed sustainably. In their most basic form, these indices simply divide stocks by consumption rates. More elaborate indices take into account the fact that changes in taste or technology may reduce future demand while natural regeneration, especially for biological resources, may increase stocks to keep pace with increasing demand. Generally, poor foresight has left predictions about resource sustainability wanting in accuracy. In a now famous bet, Professors Paul Ehrlich and Julian Simon wagered respectively that five important resource commodities were growing more scarce or less scarce. Ehrlich chose to bet that $1000 invested equally in five metal commodities would increase in real value over a 10-year period due to increasing scarcity. In fact, the real value of these commodities declined by more than 50 percent to $423.93. Clearly, a better understanding of trends in demand and technology are necessary before we can say with confidence how environmental quality and goods will fare in a consumption-based world.
The falling commodity prices shown in the wager between Ehrlich and Simon may have been misleading. Ten years is a short time frame. What might have happened after 50 or 100 years? Also, market prices may signal p. xxivmarket scarcity, but fail to indicate local scarcity. As markets grow and become global in scope, market signals for scarcity will also become global, revealing global conditions but masking local conditions of supply and demand.
The second question of sustainability “how should we manage our resources?” requires that we have some management target for the way in which resources are distributed across generations. The concept of Pareto optimality, useful in the analysis of welfare within a generation, is more difficult to apply when we do not know the tastes, preferences or technologies of future generations. Consumers tend to be impatient, preferring consumption this year over next (this is why we borrow). Are we to ignore this impatience when thinking of sustainability or should we include society’s impatience by discounting the value of future consumption when we decide how to manage for sustainability? What about expected improvements in technology? Could saving too much of our natural and environmental resources make future generations better off at the expense of present generations?
The “we” in the second question of sustainability “how should we manage…” implies that there is some sort of shared vision about the goals of sustainability. While oft attempted, efforts to define a single target for sustainability have failed to achieve global consensus. Neoclassical economists often see the maximization of net present value as a metric against which to measure the sustainability of proposed resource use over time. Others have set out to define more broadly appealing, but less easily operable, definitions of sustainability.
The United Nations, under the mantle of the United Nations Commission on the Environment and Development (UNCED), turned to Gro Harlem Brundtland and a task force of experts (also known as the Brundtland Commission) to define sustainability. The Brundtland Commission, in turn, sought to frame the debate on sustainability in the context of economic development. While still vague in its prescriptions, the Brundtland Commission’s positions on sustainable development made the trade-offs clear: economic growth should not come at the expense of future generations. Moreover, since the Commission’s report sustainable development has been expanded to encompass three pillars: social, environmental and economic development Of course, determining its definition and what paths of resource use constitute a cost to the future still remain topics of debate. However, whether sustainability and sustainable development ought to refer to the maintenance of the status quo, economic growth, redistribution of wealth, the protection of capital stocks or the preservation of natural capital, will vary by individual. Related to these concepts is the notion of weak sustainability. It supposes that we p. xxvcan substitute between human-made capital and natural capital in production and consumption, such that economic growth can be associated with improvements in environmental quality. By contrast, strong sustainability posits that natural and human-made capital are complements and cannot be substituted for each other in either production or consumption. Consequently, economic growth that uses natural resources and generates wastes must increase environmental degradation.
Regardless of the targeted goal of sustainability, the debate surrounding the topic has led to broad changes in the ways in which scholars think about resource use and the ways planners move forward with development projects. Today, a growing field of study known as Ecological Economics acts as a forum for exploring new ways to combine ecological knowledge with economic policy and analysis. In 1992, the United Nations hosted the Conference on Environment and Development in which many concepts of sustainability were formally institutionalized through an international declaration and a unified program of action.
Outside of the policy sphere, industry is weaving sustainability canon into its business practices. In fact, through networks, such as the Global Reporting Initiative (GRI) and the World Business Council for Sustainable Development (WBCSD) among others, many firms are contributing to the definition of sustainability. Corporate social responsibility (CSR) is now underscored by the triple bottom line, an accounting framework encompassing the three pillars: economic, environmental and social development. Other corporate conscience initiatives, including carbon footprinting and fair trade, have gained traction among progressive enterprises. The effectiveness of such practices is still debatable; however, industry is tepidly moving towards a more holistic operating vision. Shareholders’ interests are no longer the sole concern of business; stakeholders are slowly gaining influence.The debate on sustainability and sustainable development is far from over. Few agree on the ability of technology to slow resource use or the ability of human-made capital to substitute for natural capital. For others, the debate centers on the fact that most programs designed to achieve a more sustainable world require substantial sacrifice that may not be shared equally among all. Nevertheless, the renewed focus on resource limits, first highlighted by Malthus and Ricardo, has led to the careful reconsideration of resource limits in models of development, growth and economic thought. In doing so, the scholarly and pragmatic pursuit of environmental understanding is increasingly realistic, more thorough and more in tune with the ways in which economics, human society and the environment are linked.