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Microeconomics

and the Environment


by Brian Roach, Jonathan M. Harris
and Anne-Marie Codur

A GDAE Teaching Module


on Social and Environmental
Issues in Economics

Global Development And Environment Institute


Tufts University
Medford, MA 02155
http://ase.tufts.edu/gdae
Copyright © 2015 Global Development and Environment Institute, Tufts University.

Copyright release is hereby granted for instructors to copy this module for instructional
purposes.

Students may also download the module directly from


http://www.ase.tufts.edu/gdae/education_materials/modules.html#microenvironment

Comments and feedback from course use are welcomed:


Global Development And Environment Institute
Tufts University
Medford, MA 02155
http://ase.tufts.edu/gdae

E-mail: gdae@tufts.edu

NOTE – terms denoted in bold face are defined in the KEY TERMS AND CONCEPTS
section at the end of the module.

1
TABLE OF CONTENTS

1. INTRODUCTION .............................................................................................3!
2. ECONOMIC PERSPECTIVES ON THE ENVIRONMENT ..............................4!
2.1 Defining Sustainability ......................................................................................... 4!
2.2 Defining Value ..................................................................................................... 5!
2.3 Limits to Growth ................................................................................................... 6!
3. APPLICATIONS OF ECONOMIC THEORY TO THE ENVIRONMENT .........8!
3.1 Environmental Externalities ............................................................................... 10!
3.2 Public Goods and Common Property Resources .............................................. 17!
4. VALUING THE ENVIRONMENT ...................................................................21!
4.1. Nonmarket Valuation Methodologies ................................................................ 22!
4.2. Cost-Benefit Analysis........................................................................................ 25!
5. ENVIRONMENTAL POLICY ALTERNATIVES ............................................30!
5.1. Pollution Standards........................................................................................... 31!
5.2. Technology-based Regulation .......................................................................... 31!
5.3. Pigovian (or Pollution) Taxes ............................................................................ 32!
5.4. Tradable Pollution Permits................................................................................ 33!
6. ECONOMIC ANALYSIS OF CURRENT ENVIRONMENTAL POLICY
ISSUES ................................................................................................................34!
6.1. Fisheries Management ..................................................................................... 34!
6.2. Sustainable Agriculture ..................................................................................... 40!
6.3 Global Climate Change...................................................................................... 48!
KEY CONCEPTS ................................................................................................55!
DISCUSSION QUESTIONS ................................................................................60!

2
MICROECONOMICS AND THE ENVIRONMENT

1. INTRODUCTION
There are many controversies over environmental issues. Should oil drilling be
permitted in areas that provide important wildlife habitat? Should developing countries
reduce deforestation, at the risk of limiting economic development? Should society
invest heavily in renewable energy to prevent global climate change?

Resolving these controversies requires us to draw upon various academic disciplines,


such as ecology, political science, ethics, and sociology. Increasingly, the discipline of
economics is at forefront of many environmental debates.

A common viewpoint is that economic goals generally conflict with environmental goals.
But, as we will show in this module, this is not necessarily true. In fact, in many
instances a strong economic case can be made for environmental protection. The
Nobel prize-winning economist Paul Krugman has written that:

…my unscientific impression is that economists are on average more pro-


environment than other people of similar incomes and backgrounds.
Why? Because standard economic theory automatically predisposes
those who believe in it to favor strong environmental protection.1

The module is organized into five additional sections:

1. In the second section, we present different economic perspectives on


environmental issues. Different economists approach the analysis of
environmental issues in different ways. An understanding of these differences is
important in order to gain insight into why economists sometimes disagree about
environmental policies.
2. Next, we explore the main ways standard economic theory is applied to
environmental issues. One application is the theory of environmental
externalities. The other applications concern the management of common
property resources and public goods. In all these cases, we’ll see that
unregulated markets fail to produce the best outcomes for society, and that some
form of government regulation is necessary.
3. In the fourth section, we study how economists “value” the environment in
monetary terms. Through the technique of cost-benefit analysis, economists
seek to determine which policies provide the greatest overall benefits to society.
We consider both the advantages and limitations of this approach for guiding
policy decisions.
4. In the fifth section, we summarize different environmental policy options. We’ll

1
Krugman, Paul. 1997. “Earth in the Balance Sheet: Economists Go for the Green,” Slate, April 18, 1997.
2
Bolded key terms are defined at the end of the module.
3
The use of terms such as “weak” and “strong” does not imply that one is better than the other. These
3
see that there is no universal “best” approach to regulating the environment.
Different approaches are needed for different situations.
5. Finally, we apply the economic concepts discussed in the module to three
important policy issues: fisheries management, agriculture, and climate change.
In each case, we’ll see that economic policy tools can be used to promote more
environmentally sustainable outcomes.

2. ECONOMIC PERSPECTIVES ON THE ENVIRONMENT


The economic analysis of environmental issues can be approached from two different
(though sometimes overlapping) perspectives, environmental economics and ecological
economics. Environmental economics2 applies insights from traditional economics to
environmental issues. We will explore several of these insights in Section 3 of this
module, such as the analysis of environmental externalities. Environmental economists
recognize that the environment has value, but tend to focus on environmental values in
human terms, specifically those that can be measured monetarily. Ecological
economics places greater emphasis on sustainability based on ecosystem integrity,
stressing that all economic activity occurs within the broader biological and physical
systems that support life. Thus ecological economists are more likely to see the value
of nature as something extending beyond any monetary estimates.

There can be significant overlap between environmental and ecological economics.


Some of the differences between the two approaches can be viewed as variations along
a continuum rather than fundamental differences. But we can summarize their
differences by considering how they each address three important topics: defining
sustainability, defining value, and considering limits to growth.

2.1 Defining Sustainability

While the importance of sustainability is widely acknowledged, there is no universally-


accepted definition of it. According to a standard environmental economics approach,
sustainability is defined as providing future generations of humans the capacity to be at
least as well-off as the current generation. This perspective of sustainability, sometimes
referred to as weak sustainability, essentially seeks to maintain at least a constant
level of overall human well-being over time. According to weak sustainability, natural
capital (such as the quality of air and water, the amount of wildlife habitat, and effective
nutrient cycling) is largely substitutable with produced capital (such as factories, roads,
and schools) and human capital (such as knowledge and productive skills). As long as
the overall level of capital is maintained over time, weak sustainability is achieved.3

So, for example, the loss of an area of wetlands (a reduction in natural capital) can
potentially be offset by an increase in other types of capital (such as building a new
hospital or increasing educational opportunities). Another way to view weak

2
Bolded key terms are defined at the end of the module.
3
The use of terms such as “weak” and “strong” does not imply that one is better than the other. These
terms refer to the specific assumptions made in defining different concepts of sustainability.

4
sustainability is that human well-being depends on the environment, but well-being also
depends many other factors. Well-being can be maintained despite a reduction in
natural capital as long as equivalent compensation is provided. Compensation may be
something physical, such as a road or building, or it can be something intangible such
as knowledge.

Note that weak sustainability implies that we need a metric for comparing different types
of capital. For example, how do we know if building a new hospital is sufficient
compensation for the loss of 100 acres of wetlands? Environmental economics tends to
rely upon money as a common unit to compare different types of capital. Thus
techniques are required for converting environmental benefits into monetary units. We
will discuss some of these techniques in Section 3.

Ecological economics tends to advocate for strong sustainability, which does not
consider natural capital substitutable with other types of capital. Instead, the objective
of strong sustainability is to maintain the overall level of natural capital over time.
Different types of natural capital may be considered substitutes, but only if important
ecological functions can be adequately maintained. For example, cutting down a forest
or filling a wetland may be consistent with strong sustainability as long as new trees of
equivalent ecological value are planted or new wetlands are created elsewhere.

Like weak sustainability, strong sustainability requires a metric that will indicate whether
compensation is sufficient. While natural capital can be measured in monetary terms
for purposes of weak sustainability assessment, ecological economists often favor
physical measures in assessing strong sustainability. For example, the biological
productivity of particular habitats is sometimes used to measure their ecological value.
Based on this approach, habitats such as wetlands and tropical rainforests are
particularly productive, while tundra and deserts are less productive.

2.2 Defining Value

The differences between environmental and ecological economics in defining


sustainability translate to different conceptions of “value.” As environmental economics
defines sustainability based on human well-being, the environment has value only to the
extent that it is useful to humans. Some of these uses may involve extracting natural
resources, such as harvesting trees or fish, but humans may also place value on
passive uses of the environment such as watching a sunset or knowing that unspoiled
places exist in the world.

The key concept in defining value according to environmental economics is the


willingness-to-pay (WTP) principle. This states that the economic value of something
is equivalent to the maximum amount of money people are willing to pay for it. So if I
am willing to pay, say, a maximum of $50 to ensure the protection of an endangered
species, then $50 is the value of that species to me. In some cases natural resources
are sold in markets, and we can ascertain their economic value by studying such
markets. But there are no markets for such things as clean air, endangered species, or

5
National Parks. Environmental economists have developed various techniques for
measuring economic values in these instances, as we’ll discuss further in Section 4.
An advantage of the willingness-to-pay principle is that is allows economists to compare
the relative value of different uses of a natural resource. For example, whether a forest
should be clearcut or preserved for recreational uses can be assessed by measuring
people’s willingness to pay for each option. The willingness-to-pay principle can also be
considered to be democratic in the sense that the values of all affected individuals
should be elicited when making policy decisions. As long as someone is willing to back
up his or her preferences with a willingness to pay amount, then their WTP will be
counted in decision-making. However, we need to recognize that one’s willingness-to-
pay may be directly related to one’s ability to pay. So instead of operating under the
democratic principle of “one person, one vote,” the willingness-to-pay principle is based
on “one dollar, one vote.”

Some ecological economists also assess the value of natural capital using the
willingness-to-pay principle. However, ecological economists are more likely to
emphasize the limitations of this approach. In particular, natural capital such as
ecosystems and species may have inherent value – a value in itself regardless of
whether humans are willing to pay for it. Inherent value may derive from an ethical
foundation of natural rights. Some ecological economists argue that each species has
an inherent right to exist, and that driving a species to extinction, regardless of the
potential economic benefits, is never justifiable. More broadly, the functions of complex
ecosystems are essential to maintain life on earth, and degrading these ecosystems
threatens to undermine any short-term productivity gains.

Of course, inherent value and ecological complexity are difficult, if not impossible, to
measure in a quantitative sense. Inherent value is also a subjective concept, based on
individual notions of rights and fairness. An environmental economist will tend to
recommend policy options that provide the maximum human benefits over time, based
on the willingness-to-pay principle. But ecological economists may recommend other
policies that instead maintain important ecological functions or satisfy certain ethical
criteria such as providing basic needs and reducing inequality – issues that become
more pressing in the light of the next topic, possible limits to economic growth.

2.3 Limits to Growth

The final difference we’ll consider between environmental and ecological economics
concerns whether there are limits to economic growth. Measured as the sum of each
country’s gross domestic product (GDP), we can see in Figure 1 that global economic
production, adjusted for inflation, has increased by a factor of nearly 3.5 since 1971.
Can such growth continue without approaching or exceeding ecological limits?

6
Figure 1. Change in Global Economic Production, Energy Production, Food
Production, and Population, 1971-2012
350!

300!
Index!(1971=100)!

250!

200!

150!

100!
1970! 1975! 1980! 1985! 1990! 1995! 2000! 2005! 2010!
Year!

Real!GDP! Energy! Food! Popula;on!


Source: World Bank, World Development Indicators online database.

In 1798 the British economist Thomas Malthus published his famous Essay on the
Principle of Population, in which he theorized that human population growth would tend
to exceed food supplies, keeping the majority of people in a continual state of poverty.
However, the original Malthusian hypothesis proved to be incorrect – in general, food
production in Europe grew faster than population, contributing to an overall increase in
average living standards.

More recently, starting in the 1960s, some researchers have warned of an updated
version of the Malthusian hypothesis, in which natural resource constraints and
ecological degradation threaten to slow or even reverse centuries of economic
progress. As we see in Figure 1, not only has economic production continued to
outpace population growth, but per capita food and energy consumption are now higher
than at any time in human history. But these data do not indicate the importance of
issues such as ecological damage or global climate change, which have gained more
attention as potential factors limiting economic growth potential.

As we mentioned above, environmental economics considers natural capital to be


largely substitutable with produced and human capital. So even as some natural
resources have been degraded over time, advances in technology have fostered more
efficient resource use and invented substitutes. For example, as global oil production

7
from traditional wells has leveled off in recent years, new technologies have expanded
oil production from non-conventional sources such as tar sands and oil shales.

Ecological economists tend to be more concerned about the overall scale of human
economic activities. Herman Daly, widely considered to be the founder of ecological
economics, has noted that an economic system designed for continual growth is
fundamentally incompatible with a fixed biosphere. He has written that “as long as our
economic system is based on chasing economic growth above all else, we are heading
for environmental, and economic, disaster.” 4

Some ecological economists have devised methods for assessing the sustainability of
humanity’s ecological impacts. One such measure, the ecological footprint, suggests
that we are already in a state of global “overshoot,” in which humanity now requires the
equivalent of 1.5 Earths to supply its resources and adequately assimilate its wastes.5
This not only suggests that further economic growth based on expanded resource use
is unsustainable, but that humanity’s footprint actually needs to be scaled back from
current levels. Thus ecological economists are more likely to accept the idea that
natural resource constraints infer limits to economic growth, including the limited
availability of nonrenewable resources, land, and the absorptive capacity of the
atmosphere.

Finally, ecological economists are more likely to support policy action even when a
scientific consensus is lacking, if a failure to act may result in catastrophic impacts.
Referred to as the precautionary principle, this approach implies that policy should err
on the side of caution, even when the risks of a catastrophic outcome appear to be low.
For an example of how the precautionary principle can be applied to a policy situation,
see Box 1.

3. APPLICATIONS OF ECONOMIC THEORY TO THE ENVIRONMENT


Standard economic theory demonstrates that under certain assumptions unregulated
markets, guided by the forces of supply and demand, allocate resources in an efficient
manner. In other words, market outcomes maximize the net benefits obtained by
buyers and sellers. But when we consider the environmental impacts of market activity,
the conclusion that unregulated outcomes are efficient is no longer valid. Using
standard economic theory, we will show below how government intervention in markets
can actually increase economic efficiency while also reducing environmental impacts.

In this section we also analyze the management of natural resources that tend to not be
privately owned, such as ocean fisheries, groundwater, or the atmosphere. We’ll see
that market forces generally lead to over-exploitation of these resources. In these
cases also, a solution that is both economically efficient and ecologically sustainable
normally requires a policy intervention.
4
Herman Daly. 2008. “On a Road to Disaster,” New Scientist, vol. 200: 46-47.
5
Global Footprint Network. 2012. Global Footprint Network 2012 Annual Report. Geneva, Switzerland.

8
Box 1. The Precautionary Principle and Chemicals Policy

The United States Congress passed the Toxic Substances Control Act (TSCA) in
1976 to regulate the production and sale of chemicals. At the time, there were
approximately 62,000 chemicals in commercial use in the country. TSCA effectively
allows the continued use of these chemicals unless the U.S. Environmental
Protection Agency (EPA) can prove, on a case-by-case basis, that a particular
chemical is unsafe. Chemical manufacturers were not required to provide the EPA
with any data regarding a chemical’s toxicity unless requested. While the EPA
expressed concerns about the safety of 16,000 chemicals, due to resource
limitations the agency has reviewed the risks of only a couple thousand, and fully
tested only about 200.

For the approximately 20,000 new chemicals introduced since the passage of TSCA,
manufacturers are required to notify the EPA of their intention to produce the
chemical and provide any toxicity data that are available. But as there are no
minimum data requirements, the law creates an incentive for manufacturers to avoid
rigorous testing of new chemicals. Under TSCA, the burden of proof is clearly upon
the EPA to demonstrate a chemical is unsafe.

In sharp contrast to chemicals policy in the United States, the European Union’s
ambitious chemicals policy, REACH (Registration, Evaluation, Authorization, and
Restriction of Chemical Substances), went into effect in 2007, and is being phased in
over an 11 year period. According to the text of REACH, the law is “underpinned by
the precautionary principle.”

Under REACH the burden of proof regarding a chemical’s safety is on the chemical
manufacturer, not the regulating agency. If a manufacturer cannot demonstrate the
safety of the chemical, its use may be restricted or banned. REACH’s requirements
apply to all chemicals produced in or imported into the EU. The initial focus has
been on testing those chemicals produced in high volumes (greater than 1000 metric
tons per year) or of the greatest concern. By 2018 all chemicals produced in excess
of one metric ton annually will need to meet REACH’s requirement that the chemical
be registered, evaluated for safety, and been approved for manufacture.

Sources: Wilson, Michael P., and Megan R. Schwarzman. 2009. “Health Policy: Toward a New U.S.
Chemicals Policy: Rebuilding the Foundation to Advance New Science, Green Chemistry, and
Environmental Health,” Environmental Health Perspectives, 117(8): 1202-1209; European
Commission, 2006. “Environmental Fact Sheet: REACH – A New Chemicals Policy for the EU,”
(February).

9
3.1 Environmental Externalities

The concept of externalities is central to environmental economics. In economic


terms, a market transaction creates an externality when it impacts someone other than
the buyer and the seller.6 For example, a firm which pollutes a river while
manufacturing paper harms those who use the river for fishing, swimming, or drinking
water. This negative externality might be measured in monetary terms – for example,
the lost revenues of professional fishers. Some damages may be more difficult to
measure but no less important – for example, health costs caused by toxins in the
water, or the loss of enjoyment by those who can no longer swim in the polluted water.

Some economic activities may bring benefits to people other than those involved in the
activity. These third parties benefit from what economists call positive externalities.
An example of a positive externality is the case of bee-keeping. A honey farmer raises
bees for his own benefit – in order to sell the honey they produce. This is a private
activity with private benefits and costs. However, bees contribute to the pollenization of
flowers in the gardens and orchards of other people in the area, who benefit freely from
this positive externality. The owners of these gardens, harvesting flowers and fruits,
receive an external benefit from the fact that their neighbor produces honey.

Economic Analysis of Negative Externalities

In a basic economic analysis of markets, supply and demand curves represent costs
and benefits. A supply curve tells us the private marginal costs of production—in other
words, the costs of producing one more unit of a good or service. Meanwhile, a
demand curve can be considered a private marginal benefits curve because it tells us
the perceived benefits consumers obtain from consuming one additional unit. The
intersection of demand and supply curves gives the market equilibrium, as shown in
Figure 2 which presents a hypothetical market for automobiles. Notice that at the
equilibrium price (PM) the marginal benefits just equal the marginal costs. This
equilibrium represents a situation of economic efficiency since it maximizes the total
benefits to the buyers and sellers in the market – if there are no externalities.7

But this market equilibrium does not tell the whole story. The production and use of
automobiles create numerous negative externalities. Automobiles are a major
contributor to air pollution, including both urban smog and regional problems such as
acid rain. In addition, their emissions of carbon dioxide contribute to global warming.
Automobile oil leaked from vehicles or disposed of improperly can pollute lakes, rivers,
and groundwater. The production of automobiles uses toxic materials which may be
released to the environment as toxic wastes. The road system required for automobiles
paves over many acres of rural and open land, and salt runoff from roads damages
watersheds.

6
For this reason, sometimes externalities are referred to as “third-party effects.”
7
Benefits to buyers are known as consumer surplus and benefits to sellers are called producer
surplus.

10
Figure 2. The Market for Automobiles

Price

Supply (Private
Market Marginal Costs)
Equilibrium

PM
• Demand
(Marginal Benefits)

QM
Quantity of Automobiles

Where do these various costs appear in Figure 2? The answer is that they do not
appear at all. Thus the market overestimates the net social benefits of automobiles
because the costs of the negative externalities are not considered. We need to expand
our analysis so it includes all the costs and benefits of automobiles, not just the market
benefits.

In order to incorporate a negative externality into our market graph, it needs to be


represented in monetary terms. Yet assigning a monetary value to environmental
damages is not a straightforward task. How can we reduce the numerous
environmental effects of automobiles to a single dollar value? There is no clear-cut
answer to this question. In some cases, economic damages may be identifiable. For
example, if road runoff pollutes a town's water supply, the cost of water treatment gives
at least one estimate of environmental damages. However this doesn't include less
tangible factors such as damage to lake and river ecosystems.

If we can identify the human health effects of air pollution, the resulting medical
expenses will give us another monetary damage estimate, but this doesn't capture the
aesthetic damage done by air pollution. Smoggy air limits visibility, which reduces
people’s welfare even it doesn’t have a measurable effect on their health. Issues such
as these are difficult to compress into a monetary indicator. Yet if we don't assign some
monetary value to environmental damages, the market will automatically assign a value
of zero, since none of these issues are directly reflected in consumer and producer
decisions about automobiles.

Once we have a reasonable estimate of these external costs, how can these be
introduced into our supply and demand analysis? Recall that a supply curve tells us the
marginal costs of producing a good or service. The supply curve in Figure 2 shows

11
what it costs automobile companies to produce vehicles. But in addition to the normal
private production costs, we now also need to consider the environmental costs—the
costs of the negative externalities. So we can add the externality costs to the
production costs to obtain the total social costs of automobiles. This results in a new
cost curve which we call a social marginal cost curve. This is shown in Figure 3.

The social marginal cost curve is above the original market supply curve because it now
includes the externality costs. Note that the vertical distance between the two cost
curves is our estimate of the externality costs of automobiles, measured in dollars. In
this simple case, we have assumed that the external costs of automobiles are constant.
Thus the two curves are parallel. This is probably not the case in reality, as the external
costs of automobiles may change depending on the number of automobiles produced.
Specifically, the external costs of an additional automobile are likely to increase when
more automobiles are produced as air pollution exceeds critical levels and congestion
becomes more severe. This would be represented a social marginal cost curve that
slopes upward more steeply.

Considering Figure 3, is our market equilibrium still the economically efficient outcome?
It is definitely not. To understand why, you can think of the social decision to produce
each automobile to depend on a comparison of marginal costs and benefits. If the
marginal benefit exceeds the marginal cost, considering all benefits and costs, then
from the social perspective it makes sense to produce that automobile. But if the costs
exceed the benefits, then it doesn’t make sense to produce that automobile.

Figure 3. The Market for Automobiles with Negative Externalities

Price
Social Marginal Costs
(Private + External)
Social
Optimum External Costs

P*
• Market
Equilibrium
Supply
(Private Marginal Costs)
PM
• Demand
(Marginal Benefits)

Q* QM
Quantity of Automobiles
So in Figure 3 we see that it makes sense to produce the first automobile because the
demand curve (reflecting the marginal benefits) is above the social marginal cost curve

12
(reflecting the production and externality costs). Even though the first automobile
creates some negative externalities, the high marginal benefits justify producing that
automobile. We see this is true for each automobile produced up to a quantity of Q*. At
this point, the marginal benefits equal the social marginal costs. But then notice that for
each automobile produced beyond Q*, the social marginal costs are actually above the
benefits. In other words, for each automobile produced above Q*, society is becoming
worse off!

So our unregulated market outcome, at QM, results in a level of automobile production


that is too high. We should only produce automobiles as long as the marginal benefits
are greater than the social marginal costs. Thus the optimal level of automobile
production is Q*, not the market outcome of QM. Rather than producing the maximum
benefits for society, the equilibrium outcome is inefficient in the presence of a negative
externality. We can also see in Figure 3 that from the perspective of society, the market
price of automobiles is too low—that is, it fails to reflect the true costs including the
environmental impacts of automobiles. The efficient price for automobiles is P*.

Internalizing a Negative Externality

What can we do to correct this inefficient market outcome? The solution to our problem
lies in getting the price of automobiles “right.” The market fails to send a signal to
consumers or producers that further production past Q* is socially undesirable. While
each automobile imposes a cost upon society, neither the consumers nor the producers
pay this cost. So, we need to “internalize” the externality so that these costs now enter
into the market decisions of consumers and producers.

The most common way to internalize a negative externality is to impose a tax. This
approach is known as a Pigovian tax, after Arthur Pigou, a well-known British
economist who published his Economics of Welfare in 1920. It is also known as the
polluter pays principle, since those responsible for pollution pay for the damages they
impose upon society.

For simplicity, assume that the tax is paid by automobile manufacturers.8 For each
automobile produced, they must pay a set tax to the government. But what is the
proper tax amount?

By forcing manufacturers to pay a tax for each automobile produced, we’ve essentially
increased their marginal production costs. So you can think of a tax as shifting the
private marginal costs upwards. The higher the tax, the more we would be shifting the
cost curve upwards. So if we set the tax exactly equal to the externality damage
associated with each automobile, then the new marginal cost of production would equal
the social marginal cost curve in Figure 3. This is the “correct” tax amount—the tax per

8
If we imposed the tax on the consumer instead of the producer, we would reach the same result as we’ll
obtain here.

13
unit should equal the externality damage per unit.9 In other words, those responsible for
pollution should pay for the full social costs of their actions.

In Figure 4, the new supply curve with the tax is the same curve as the social marginal
cost curve from Figure 3. It is the operative supply curve when producers decide how
many automobiles to supply, because they now have to pay the tax in addition to their
manufacturing costs.

Figure 4. Automobile Market with Pigovian Tax

Price
Supply with Tax

Equilibrium
with Tax External Costs

P*
• Supply
(Private Marginal Costs)
PM
• Demand
P0
(Marginal Benefits)

Q* QM
Quantity of Automobiles

The new equilibrium results in a higher price of P* and a lower quantity of Q*. The tax
has resulted in the optimal level of automobile production. In other words, automobiles
are produced only to the point where the marginal benefits are equal to the social
marginal costs. Also note that even though the tax was levied on producers, a portion
of the tax is passed on to consumers in the form of a price increase for automobiles.10
This causes consumers to cut back their automobile purchases from QM to Q*. From
the point of view of achieving the socially optimal equilibrium, this is a good result. Of
course, neither producers nor consumers will like the tax, since consumers will pay a
higher price and producers will have lower sales, but from a social point of view we can

9
Note that in our example, the externality damage is constant per automobile produced. If the externality
damages weren’t constant, we would set the tax equal to the marginal externality damage at the optimal
level of production.
10
Note that the price of automobiles did not rise by the amount of the tax. In Figure 4 the vertical
distance between P0 and P* equals the per-unit tax. But the price only rose from PM to P*. So while
some of the tax was passed on to consumers, automobile manufacturers also bear some of the burden of
the tax in terms of lower profits.

14
say that this new equilibrium is optimal, or efficient, because it accurately reflects the
true costs that automobiles impose on society.

Our story tells a convincing argument in favor of government regulation in the presence
of negative externalities. The tax is an effective policy tool for producing a more
efficient outcome for society. But should the government always impose a tax to
counter a negative externality? The production of nearly all goods or services is
associated with some pollution damage. So it may seem that the government should
tax all products on the basis of their environmental damage.

However, determining the appropriate tax on every product that causes environmental
damage would be a monumental task. For example, we might impose a tax on shirts
because the production process involves growing cotton, using petroleum-based
synthetics, applying toxic dyes, etc. But we would theoretically need to set a different
tax on shirts made with organic cotton, or those using recycled plastics, or even shirts of
different sizes!

Rather than looking at the final consumer product, economists generally recommend
applying Pigovian taxes as far upstream in the production process as possible. An
upstream tax is imposed on raw materials and other inputs into production processes,
such as the crude oil or raw cotton used to make a shirt. If we determine the
appropriate Pigovian tax on cotton, then this cost will translate to a higher final selling
price of a shirt. We could focus our taxation efforts on those raw materials that cause
the most ecological damage. So we might tax fossil fuels, various mineral inputs, and
toxic chemicals. This limits the administrative complexity of tax collection, and avoids
the need for estimating the appropriate tax for a multitude of products.

Positive Externalities

Just as it is in society’s interest to internalize the social costs of pollution using Pigovian
taxes, it is also socially beneficial to internalize the social benefits of activities that
generate positive externalities. Just as with a negative externality, the free market will
also fail to maximize social welfare in the presence of a positive externality. And
similarly, a policy intervention will be required to reach the efficient outcome.

A positive externality is an additional social benefit from a good or service above the
private, or market, benefits. Since a demand curve tells us the private marginal
benefits, we can incorporate a positive externality into our analysis as an upward shift of
the demand curve. This new curve represents the total social benefit of each unit.

Figure 5 shows the case of a good that generates a positive externality—solar panels.
Each solar panel installed reduces emissions of carbon dioxide, and thus benefits
society as a whole. The vertical distance between the market demand curve and the
social marginal benefits curve is the positive externality per solar panel, measured in
dollars. In this example, the social benefits are assumed to be constant per panel, so
the two benefit curves are parallel.

15
The market equilibrium price is PM and quantity is QM. But notice in Figure 5 that
between QM and Q*, marginal social benefits exceed the marginal costs. Thus the
optimal level of solar energy is Q* – where social marginal benefits just equal the
marginal costs – not QM. So we can increase net social benefits by increasing the
production of solar energy.

Figure 5. The Market for Solar Energy with Positive Externalities

Price

Supply (Private
Marginal Costs)

PM
• Social Marginal
Benefits
External Benefits

Demand (Private
Marginal Benefits)

QM Q*
Solar Energy
In the case of a positive externality, the most common policy to correct the market
inefficiency is a subsidy. A subsidy is a payment to producers to provide an incentive
for them to produce and sell more of a good or service. The way to illustrate a subsidy
in our market analysis is to realize that a subsidy effectively lowers the cost of producing
something. So a subsidy lowers the supply curve by the amount of the per-unit subsidy.
In essence, a subsidy makes it cheaper to produce solar panels. The “correct” subsidy
shifts the supply curve such that the new market equilibrium will be at Q*, which is the
socially-efficient level of production. This is illustrated in Figure 6. The principle mirrors
the use of a tax to discourage economic activities that create negative externalities—
except that in this case we want to encourage activities that have socially beneficial side
effects.

16
Figure 6. The Market for Solar Energy with a Subsidy

Price

Supply (Private
Marginal Costs)


Supply with Subsidy
PM


P* Social Marginal
Benefits
External Benefits

Demand (Private
Marginal Benefits)

QM Q*
Solar Energy

3.2 Public Goods and Common Property Resources

The above analysis shows that unregulated markets are not efficient in the presence of
externalities. While private goods, such as automobiles, apples, and computers, are
normally distributed through markets, economic analysis of other goods requires
different models. In this section we consider the allocation of common property
resources and public goods. These are resources and goods that are usually not
privately owned, leading to different outcomes both in terms of economic equilibrium
and environmental externalities.

Private goods are excludable, meaning that the legal owners of them can prevent other
people from enjoying the goods’ benefits. For example, if I am the owner of an
automobile, I can legally prevent anyone else from using it. But many natural resources
are nonexcludable, meaning that the benefits of these resources are available to
anyone. For example, in absence of regulation an ocean fishery can be accessed by
anyone, or the atmosphere is freely available to all as a repository of pollution.

Economists differentiate between public goods and common property resources. While
both of these are nonexcludable, they differ in terms of whether multiple people can
benefit from them at the same time. Public goods are nonrival, meaning that many
people can enjoy these goods at the same time, without affecting the quantity or quality
of the good available to others. An example of a public good is national defense – the
benefits I get from national defense do not diminish the benefits others receive.
Common property resources are more often rival, meaning that use of the resource by
one person reduces the quantity or quality of the resource available to others. An

17
example of a common property resource would be groundwater. If I withdrawal some
groundwater, that water is not available for others to use.

Management of Common Property Resources

This section considers whether regulation is necessary in the case of a common


property resource, using the example of an ocean fishery. Initially, assume that the
fishery is not regulated, so that anyone who wants to can access the fishery. If only a
few people access the fishery, then adding one more fisher is unlikely to affect the catch
of anyone else. But as total fishing pressure increases, eventually adding more fishers
will begin to harm the health of the fishery, thus reducing the catch of each fisher. We
can think of this situation as similar to a negative externality – in an already crowded
fishery an additional fisher imposes a cost on all other fishers. But as each fisher only
considers his or her own profits, this external cost does not enter into their fishing
decision.

Figure 7 illustrates this situation. Suppose that it costs $15,000 to operate a fishing trip,
including the cost of labor, fuel, and supplies. If there are only a few fishing trips
occurring in the fishery, each boat trip yields $25,000 in revenues, and thus a $10,000
profit.11 This is true as long as the total number of fishing trips is less than 100, as
shown in the figure.

Figure 7. Common Property Model of a Fishery


Thousand)
Dollars)per)
Trip
Social)
Cost

25
22

Private)
15 Cost

Revenue

100 175 250 Fishing)


Trips

11
In this simple example we assume that all fishing trips are the same. Thus the cost of each trip is
constant at $15,000 and the revenue per trip does not vary for different fishers.

18
But once the fishing pressure exceeds 100 trips, the amount of fish caught per trip
begins to decline as the health of the fishery is impaired. Each additional fishing trip
above 100 trips further reduces the revenue per trip for everyone – the fishery has
become rival. While the fishers will notice the decline in their revenues, as long as each
one is still making a profit they will continue to fish. In the figure, we see that the
revenue per trip exceeds cost per trip up to 250 fishing trips. So as long as there are
less than 250 trips being taking, there is an incentive for more trips to occur as each trip
will be profitable. Only when we get to 250 trips does the revenue per trip equal the
cost per trip, and there is no further incentive for more trips. Thus 250 trips is the
outcome in the fishery without any regulation.

Is this outcome optimal from the perspective of the fishery as a whole? When only 100
trips were being taken, each fisher was earning a $10,000 profit per trip. But at 250
trips, each fisher is barely covering his or her costs. So from the industry perspective,
250 trips are clearly not optimal. Further, from an ecological perspective the health of
the fishery is likely to further decline as it is being overfished. This outcome is known as
the tragedy of the commons, in which individuals acting in their own self-interest tend
to exploit a common property resource, leading to a sub-optimal social outcome and
resource degradation.

We can determine the optimal social outcome using the same principle that we applied
to internalizing a negative externality. The problem is that individuals don’t consider the
cost their actions on others when deciding whether to fish. The blue Social Cost line in
Figure 7 adds to the private cost of fishing the amount that each additional fishing trip
reduces the profits of all other fishers. In other words, the Social Cost line represents
the $15,000 private cost of operating a boat trip plus the external cost equal to the
reduction in others’ profits.

The socially efficient level of fishing trips is 175 in Figure 7. Up to this point the revenue
per fishing trip exceeds the social cost. This level of fishing maximizes the profits in the
fishing industry. Also, this lower level of fishing effort is more likely to be ecologically
sustainable.

One solution to avoid the tragedy of the commons is to institute a fee for each fishing
trip, much like a Pigovian tax. The correct fee to charge is the amount that fully
internalizes the external cost of an additional fishing trip at the optimal level of fishing.
At 175 trips, the external cost of an additional fishing trip is $7,000 (the difference
between the social cost and the private cost). So if the fee for a fishing trip were
$7,000, then there would be no incentive for fishers to take additional trips beyond 175
trips. Above 175 trips, the total cost of a fishing trip would be $22,000 (the $15,000
private cost plus the $7,000 fee) but the revenue would be less than $22,000.

Another solution is to institute individual transferable quotas (ITQs). With this


approach a government sets the total allowable fishing effort – in this case, 175 trips –
and then permits for each trip are allocated either for free or at auction to the highest
bidders. Holders of ITQs can use these permits to fish, or sell them to interested

19
parties. In principle, the value of a permit would equal the potential profits to be made
from a fishing trip. The price of ITQs are not set by the government, but allowed to vary
based on supply and demand. ITQ programs for ocean fisheries have been established
in several countries, including Australia, Canada, Iceland, and in some United States
fisheries.

Management of Public Goods

Public goods are both nonexcludable and nonrival. So even if everyone in society
benefits from a public good, degradation of the good is not a potential problem. Instead,
the problem with public goods is that they tend to be under-supplied by private markets,
if they are supplied at all. With a private good, the fact that people must pay the market
price for it in order to receive its benefits allows sellers to make a profit from the good.
But with a public good, people can obtain the benefits of the good without paying.

Consider national defense as an example of a public good. Could we rely upon some
mega-corporation to provide national defense in a market setting? No, because there
would be no way for the corporation to sell the product to individual buyers. No
individual would have an incentive to pay because they could receive essentially the
same level of benefits without paying. Thus the “equilibrium” quantity of public goods in
a market setting is normally zero, as no company would want to produce something that
no one is willing to pay for.

Perhaps we could rely on donations to supply public goods. This is done with some
public goods, such as public radio and television. Also, some environmental groups
conserve habitats that, while privately owned, can be considered public goods because
they are open for public enjoyment. Donations, however, generally are not sufficient for
an efficient provision of public goods. Since public goods are nonexclusive, each
person can receive the benefits of public goods regardless of whether they pay. So
while some people may be willing to donate money to public radio, many others simply
listen to it without paying anything. Those who benefit from public goods but do not pay
are called free riders.

While we cannot rely on private markets or voluntary donations to fund the provision of
public goods, their adequate supply is of crucial interest to the whole society. In
democracies, decisions regarding the provision of public goods are commonly decided
in the political arena. This is generally true of national defense. A political decision must
be made, taking into account that some citizens may favor more defense spending,
others less.

Similarly, decisions on the provision of environmental public goods are made through
the political system. The U.S. Congress, for example, must decide on funding for the
National Park system. Will more land be acquired for parks? Might some existing park
areas be sold or leased for development? We may obtain information on whether the
current supply of certain public goods is too high or too low based on opinion surveys.
Or we may rely upon elected officials to make public goods decisions on behalf of their

20
constituents. Once the appropriate level of public goods provision is determined, the
necessary funds are obtained through taxes.

Paying for public goods using taxes effectively avoids the free rider problem. However,
issues of fairness may arise, as the structure of the tax system determines who pays for
public goods, and how much. Inevitably, some people will feel they are taxed too
heavily, or that they are paying for public goods from which they do not benefit
personally. Resolving these issues demonstrates that management of public goods is
as much a political problem as an economic problem.

4. VALUING THE ENVIRONMENT


As we discussed in Section 2, environmental economics measures value according to
the willingness-to-pay principle. Ecological economic is more likely to consider the
inherent value of natural capital. In either case, economists recognize that the
environment has value beyond just its market uses, such as supplying timber, fish, and
agricultural land. Thus we need to assess whether natural resources should be used
for market benefits such as these, or non-market benefits, including:

1. Recreation: natural sites provide places for outdoor recreation including


camping, hiking, fishing, hunting, and viewing wildlife
2. Ecosystem services: these are tangible benefits obtained freely from nature
as a result of natural processes, including nutrient recycling, flood protection
by wetlands, waste assimilation, carbon storage in trees, water purification,
and pollination by bees.
3. Nonuse benefits: these are non-tangible benefits that we obtain from nature.
Nonuse benefits include the psychological benefits that people gain just from
knowing that natural places exist, even if they will never visit them. The value
that people get from knowing that ecosystems and species will be available to
future generations is another type of nonuse benefit.

The total economic value of a natural system is the sum of all the benefits people are
willing to pay for. Thus the total economic value of a National Forest would be the sum
of any profits obtained from timber harvesting, the willingness to pay of all those who
recreate in the forest, the value of the ecosystem services such as soil erosion
prevention and carbon storage, and the nonuse benefits people obtain by simply
knowing the forest exists.

It is important to realize that in calculating total economic value priority is not given to
any particular use of the forest. When uses are incompatible, such as deciding whether
a particular tract of forest should be clear cut or preserved for recreation and wildlife
habitat, economic analysis can help to determine which use provides the highest overall
value to society.

21
4.1. Nonmarket Valuation Methodologies

If we are to estimate total economic value, we need techniques to estimate such values
as recreation benefits, ecosystem services, and nonuse values. In addition, we need a
measure of the damages caused by negative environmental externalities. These
techniques are referred to as nonmarket valuation, because they produce benefit
estimates for goods and services that aren’t directly traded in markets. There are four
main types of nonmarket valuation techniques:

1. Cost of illness method


2. Replacement cost methods
3. Revealed preference methods
4. Stated preference methods

Each of these methods has advantages for analyzing particular issues, and also has
some disadvantages and limits, as summarized below.

Cost of Illness Method

The cost of illness method is used to estimate the damages of reductions in


environmental quality that lead to human health consequences. Conversely, it can be
used to estimate the benefits of improvements in environmental quality (i.e., the avoided
damages). This method estimates the direct and indirect costs related to illnesses
attributed to environmental factors. The direct costs include medical costs such as
office visits and medication paid for by individuals and insurers, and lost wages due to
illness. Indirect costs can include decreases in human capital (such as a child missing
a significant number of school days due to illness), welfare losses from pain and
suffering, and decreases in economic productivity due to work absences.

The cost of illness method generally only provides us with a lower-bound estimate of
the willingness to pay to avoid illnesses. The true WTP could be greater, since the
actual expenses may not capture the full losses to individuals or society from illness.
But even a lower-bound estimate could provide policy guidance. For example, the cost
of asthma in the U.S. was estimated to be $56 billion in 2007, based on direct medical
costs and productivity losses from missed days of school and work.12 The costs for a
typical affected worker amounted to about $3,500. These estimates provide a starting
point to determine whether efforts to reduce asthma cases are economically efficient.

12
Barnett, Sarah Beth L., and Tursynbek A. Nurmagambetov, 2011. “Costs of Asthma in the United
States, 2002-2007,” Journal of Allergy and Clinical Immunology, 127(1): 142-152.

22
Replacement Cost Methods

Replacement cost methods can be used to estimate the value of ecosystem services.
These approaches consider the cost of actions that substitute for lost ecosystem
services. For example, a community could construct a water treatment plant to make
up for the lost water purification benefits from a forest habitat. The natural pollination of
plants by bees could, to some extent, be done by hand or machine. If we can estimate
the costs of these substitute actions, in terms of construction and labor costs, these may
be considered an approximation of society’s willingness to pay for these ecosystem
services.

While replacement cost methods are often used to estimate ecosystem service values,
they are not necessarily measures of WTP. Suppose a community could construct a
water treatment plant for $50 million to offset the water purification services of a nearby
forest. This estimate doesn’t tell us whether the community would actually be willing to
pay the $50 million should the forest be damaged. Actual WTP could be greater or less
than $50 million. So in this sense, replacement cost estimates should be used with
caution.

Revealed Preference Methods

While markets don’t exist for many environmental goods and services, we can
sometimes infer the values people place on them through their behavior in other
markets. Revealed preference methods are techniques that obtain nonmarket values
based on people’s decisions in related markets. Economists generally prefer deriving
nonmarket values based on actual market behavior. Thus revealed preference
methods are considered the most valid approach to nonmarket valuation. However
there is a limited category of environmental benefits that can be estimated using
revealed preference methods.

One common type of revealed preference method is travel cost models. These
models are used to estimate the economic benefits people obtain by recreating at
natural sites such as National Parks or lakes. Even if the recreation site doesn’t charge
an entry fee, all visitors must pay a “price” equal to their costs to travel to the site, such
as gas, plane tickets, accommodations, and even the time required to travel to the site.
As visitors to a recreation site from different regions effectively pay a different price,
economists can use this information to derive a demand curve for the site using
statistical models, and thus estimate consumer surplus – the net benefit derived by
consumers from recreation at this site. Travel cost models are most applicable for
recreation sites that attract visitors from distant places, in order to provide enough
variation in travel costs to estimate a demand curve.

Numerous travel cost models have estimated the recreational benefits of natural sites.
For example, a 2014 study of recreational visitors to the West Garda Regional Forest in
northern Italy found that the average visitor received a net benefit of 5 to 9 euros per

23
visit.13 Travel cost models have been used to explore how changes in the fish catch
rate affect the consumer surplus of anglers visiting sites in Wisconsin,14 and how a
drought affects the benefits of visitors to reservoirs in California.15

Another type of revealed preference method is the defensive expenditures approach.


In some situations people are able to take actions to reduce their exposure to
environmental harms. For example, people with concerns about their drinking water
quality may choose to purchase bottled water or install a water filtration system. These
expenditures may reflect their willingness to pay for water quality. For example, a 2006
study in Brazil found that households were paying US$16-$19 per month on defensive
expenditures to improve drinking water quality.16

A limitation of the defensive expenditures approach is that people may be taking


defensive actions for a variety of reasons, some unrelated to environmental quality. For
example, other reasons for buying bottled water may include convenience or status.
Thus attributing the entire cost of bottled water as a measure of concern about drinking
water quality would not be appropriate in such cases. It also suffers from the inherent
problem of any market valuation: the preferences of the rich weigh much more heavily
than the preferences of the poor. Plenty of people around the world who are actually
suffering from the health effects of impure water may not be able to afford to buy bottled
water; thus their willingness to pay is made invisible by inability to pay.

In addition to the problem of unequal ability to pay, the approaches just described—the
defensive expenditures approach and travel cost models—cannot be used to obtain
benefit estimates for many ecosystem services and nonuse values. Thus in order to
obtain estimates of total economic value for many environmental goods and services,
we need a technique that can provide us some estimate of these values.

Stated Preference Methods

The final nonmarket valuation technique we consider is the most used, as well as the
most controversial. Stated preference methods directly obtain information on
someone’s preferences in a hypothetical scenario. The most common stated
preference method is contingent valuation, in which survey respondents are asked
questions about their willingness to pay for hypothetical outcomes.

13
Martina, Menon, Federico Perall, and Marcella Vernonesi. 2014. “Recovering Individual Preferences for
Non-Market Goods: A Collective Travel-Cost Model,” American Journal of Agricultural Economics, 96(2):
438-457.
14
Murdock, Jennifer, 2006. “Handling Unobserved Site Characteristics in Random Utility Models of
Recreation Demand,” Journal of Environmental Economics and Management, 51(1): 1-25.
15
Ward, Frank, Brian Roach, and Jim Henderson, 1996. “The Economic Value of Water in Recreation:
Evidence from the California Drought,” Water Resources Research, 32(4): 1075-1081.
16
Rosado, Marcia A., Maria A. Cunha-e-Sa, Maria M. Dulca-Soares, and Luis C. Nunes, 2006.
“Combining Averting Behavior and Contingent Valuation Data: An Application to Drinking Water
Treatment in Brazil,” Environment and Development Economics, 11(6): 729-746.

24
The main advantage of contingent valuation is that surveys can be designed to ask
respondents about any type of environmental benefit. For example, a 2014 study found
that citizens in the Philippines were willing to pay 233 to 437 pesos (about $5 - $10) to
preserve an important coral reef.17 A 2012 study found that households in Spain were
willing to pay an average of $22 per year for a hypothetical reduction in highway noise
and air pollution.18

While hundreds of contingent valuation studies have been conducted over the last
several decades, the validity of the results remains highly controversial. Given that
respondents’ preferences are based on a hypothetical scenario, and they don’t have to
actual pay anything, some economists consider the results flawed due to various
biases. For example, a respondent who generally favors habitat preservation may have
an incentive to overstate his or her actual WTP in order to influence the policy process.
Some respondents may not accurately consider their income limitations when stating
WTP values; this gets around the “ability to pay” problem, but does not produce the kind
of WTP estimates that many economists seek as “realistic”.

Some of the problems associated with contingent valuation can be avoided by using
contingent ranking, another stated preference method. With contingent ranking,
respondents are asked to rank various hypothetical scenarios according to their
preferences. Thus there is no potential for respondents to exaggerate their willingness
to pay.

4.2. Cost-Benefit Analysis

The nonmarket valuation methods discussed above can be used to estimate the
positive and negative externalities associated with different products. They can also
provide guidance on appropriate public policies. For example, consider how we might
evaluate a proposed law to increase air quality standards. We might ask whether the
benefits of the policy exceed its costs. Environmental economists use the technique of
cost-benefit analysis (CBA) to estimate the net benefits (i.e., the benefits minus the
costs) of proposed projects or policies, measuring impacts in monetary units.

In theory, measuring all impacts in dollars (or some other currency) produces a “bottom-
line” result (i.e., a single number) so we can choose which option results in the greatest
net social value. In practice, however, cost-benefit analyses are often incomplete. The
results may be dependent on specific assumptions. Sometimes one side of the
analysis—the costs, or the benefits—may be much more fully developed than the other,
making it difficult to obtain an objective recommendation.

17
Subade, Rodelio F., and Herminia A. Francisco. 2014. “Do Non-users Value Coral Reefs? Economic
Valuation of Conserving Tubbataha Reefs, Philippines.” Ecological Economics 102:24-32.
18
Lera-Lopez, Fernando, Javier Faulin, and Mercedes Sanchez. 2012. “Determinants of the Willingness-
to-Pay for Reducing the Environmental Impacts of Road Transportation,” Transportation Research: Part
D: Transport and Environment 17(3):215-220.

25
The basic steps of a cost-benefit analysis are relatively straightforward:

1. List all costs and benefits of the project or policy proposal. Typically this is
done for several different scenarios.
2. Convert all costs and benefits to monetary values. Some values can be
obtained based on market analysis, while other values will require nonmarket
valuation.
3. Add up all the costs and benefits to determine the net benefits of each
scenario. Sometimes the results are expressed as a ratio (i.e., benefits
divided by costs).
4. Choose the scenario that is the most economically efficient.

Perhaps the most appealing feature of CBA is its seeming objectivity. It also presents a
way to argue for environmental protection in economic terms, rather than on ethical or
ecological terms. Many CBAs have shown that the willingness to pay for environmental
protection can be quite large.

Of course, all the problems with the nonmarket valuation techniques discussed earlier
can complicate cost-benefit analysis. Two additional issues often arise in environmental
CBAs: how to value costs and benefits that occur in the future, and how to value human
lives.

Discounting the Future

Many environmental policies involve paying costs in the short term, while the benefits
arise further in the future. For example, the cost of installing pollution control equipment
is an upfront cost, while the health benefits of reduced cancer rates will only be realized
decades in the future. Thus we need a way to compare impacts that occur at different
times.

There is a natural human tendency to focus on the present more than the future. Most
people would prefer to receive a benefit now than a similar benefit in the future. This
may be a simple matter of personal preference, or it may be based on the economic
logic that having resources in the present allows for investment to receive greater
benefits in the future.

Economists incorporate this concept into CBA through discounting. Discounting


effectively reduces the weight placed on any cost or benefit that occurs in the future,
relative to the same impact occurring now. The further the cost or benefit occurs in the
future, the less weight is given to that impact. In order to compare an impact that
occurs in the present to an impact that occurs in the future, the future impact must be
converted to an equivalent present value using the following formula:

PV (Xn) = Xn / (1 + r)n

26
where Xn is the monetary value of the cost or benefit, n is the number of years in the
future the impact occurs and r is the discount rate—the annual rate by which future
impacts are reduced, expressed as a proportion (i.e., r=0.03 for a 3% discount rate).

A simple example will illustrate how discounting works. Suppose we are analyzing a
proposal to improve air quality. Assume that the cost of this proposal, including the
installation of new pollution control equipment, is $10 million, to be paid right now. The
benefits of cleaner air are estimated to be $20 million, but these benefits will occur 25
years in the future.19 Should we proceed with this proposal?

In order to obtain the present value of the $20 million benefit, we need to choose a
discount rate. Suppose we apply a discount rate of 5%. The present value of the
benefits would be:

PV = $20,000,000 / (1.05)25 = $5,906,055

As the present value of the $20 million benefit is only about $6 million, it does not make
economic sense to pay $10 million now to obtain this benefit. But suppose that we
instead apply a discount rate of 2%. In this case the present value of the benefits is:

PV = $20,000,000 / (1.02)25 = $12,190,617

In this case the net benefits of the proposal are positive (i.e., the present value of the
benefits exceeds the costs by about $2 million). At the lower discount rate, the proposal
makes economic sense. This example illustrates the importance of the choice of a
discount rate. We will see later in the module that this is particularly true when we
discuss analyses of global climate change.

One approach for choosing a discount rate is to set it equal to the rate of return on low-
risk investments such as government bonds. The rationale behind this is that any funds
used for a beneficial public project could otherwise be invested to provide society with
greater resources in the future. In late 2014 the nominal rate of return on a 30-year
U.S. Treasury Bond was about 3.3%.20 However this rate has varied considerably over
time, reaching 13% in the early 1980s. Thus some economists question whether we
should base the valuation of long-term environmental impacts upon an interest rate
subject to the whims of financial market conditions.

Other approaches to choosing a discount rate consider the ethical dimension of valuing
future impacts. In some sense, a positive discount rate implies that future generations
count less than the current generation. While nearly all economists believe in the

19
In reality the benefits would occur over numerous future years. Here for simplicity we assume all the
benefits occur in a single year, 25 years from now.
20
U.S. Department of the Treasury. Daily Treasury Yield Curve Rates. http://www.treasury.gov/resource-
center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield.

27
principle of discounting, those economists more concerned about long-term
environmental damages tend to prefer lower discount rates. 21

Valuing Human Lives

Another controversial aspect of CBA is analyzing policies that affect human mortality
rates. The benefits of many environmental policies, such as those addressing air and
water quality, are often expressed in terms of the number of avoided deaths. In a CBA
framework, we seek to convert all benefits to monetary values to make them directly
comparable to the costs. Suppose we are analyzing a policy that will improve air quality
at a cost of $500 million to society, but reduce the number of deaths associated with air
pollution by fifty. Is such a policy “worth it” to society?

While economists don’t value any particular person’s life, they instead estimate how
people value relatively minor changes in mortality risk, and use this information to infer
the value of a statistical life (VSL). A VSL estimate, in theory, indicates how much
society is willing to pay to reduce the number of deaths from environmental pollution by
one, without any reference to whose death will be avoided.

An example illustrates how a VSL is estimated. Let’s assume we conduct a contingent


valuation survey to ask people how much they would pay to improve air quality such
that the number of deaths from air pollution would decline by fifty. Each respondent’s
risk of dying from air pollution would decline slightly as a result of the policy. Suppose
the survey results indicate that the average household is willing to pay $10 per year for
this policy. If society comprises 100 million households, then the total willingness to pay
for the policy would be:

100 million * $10 = $1 billion

Since this is the WTP to reduce deaths by fifty, the VSL would be:

$1 billion / 50 = $20 million

Some people object to valuing human lives on ethical grounds. Others counter that we
must explicitly or implicitly analyze the tradeoffs between public expenditures and health
benefits. According to statutory law, major environmental policy proposals in the United
States must be reviewed using cost-benefit analysis, and thus government agencies
must often apply a VSL. The VSLs used by government agencies have varied but
generally increased over time, from around $2 million in the 1980s to nearly $10 million
more recently. In other words, regulations that can reduce environmental deaths at a
21
A 0% discount rate would imply that any impact that occurs in the future, even those in the very far
future, count the same as a current impact. Economists have tended to justify some discounting on the
assumption that future generations will have higher incomes and better technology, and will thus be better
equipped to deal with problems created in the present. However there are economists who focus on the
possibility of a significant number of future decades in which the problems of fossil fuel use cause an
overall decline in energy available to human beings; they do not assume higher incomes or better
standards of living for those generations.

28
cost of less than $10 million per avoided death would be considered economically
efficient. For more on the economic, and political, debate about the VSL in the United
States see Box 2.

Other Issues with Cost Benefit Analysis

Most environmental cost-benefit analyses are further complicated by several other


issues. These include:

1. Analysis of uncertainty
2. Missing monetary values
3. Sensitivity to assumptions

Consider a proposal to build a large dam for flood protection. The benefits of flood
protection depend somewhat on future climate conditions, which are difficult to predict
with a high degree of certainty. There may also be a small chance that the dam will fail,
perhaps causing catastrophic damage. Another example would be analyzing the risk of
a major oil spill. Incorporating such uncertainty into a CBA may be possible if we have
some idea of the probability of various outcomes, but some risks are fundamentally
difficult to predict. In such cases, some economists advocate the precautionary
principle: the idea that policies should err on the side of caution when there is a low-
probability risk of a catastrophic outcome.

In almost any real-world environmental CBA we will be unable to estimate all impacts in
monetary terms. For example, how can we estimate the benefits of a proposed
National Park if the park doesn’t exist yet? We may be able to “transfer” an estimate
from an existing similar park, but we can’t be sure the transferred estimate is valid for
the new site. Also, government agencies frequently don’t have the resources to fund
original studies to estimate all needed values. We may be able to make an educated
guess about certain missing values, but this obviously reduces the objectivity of a CBA.

Finally, the recommendations of many CBAs are highly dependent upon various
assumptions. As we saw earlier, the choice of a discount rate may determine whether a
particular policy is recommended or not. Other assumptions may have to do with how
risk is analyzed, or how contingent valuation results are interpreted. Ideally, a CBA
should consider a broad range of assumptions. Of course, if different assumptions
produce different results, then we must make a subjective decision about which result
we should rely upon. Again, this issue implies that CBA may not be as objective as it
may seem at first.

29
Box 2. The Politics of Valuing Life

The valuation of human lives is not merely an economic issue but a political issue as
well, as demonstrated by changes in the VSLs used by United States federal
agencies in recent years. During the George W. Bush administration, the VSL used
by the U.S. Environmental Protection Agency was as low as $6.8 million. But in
2010, the EPA increased their VSL to $9.1 million in a cost-benefit analysis of air
pollution standards. Under the Barack Obama administration, the Food and Drug
Administration also increased its VSL, from $5 million in 2008 to $7.9 million in 2010.
Based on higher VSLs, the Transportation Department has decided to require
stronger car roofs – a regulation that was rejected under the Bush administration as
too expensive.

Under the Obama administration federal regulators are also considering adjusting the
VSL based on the type of risk. For example, the EPA is considering applying a
“cancer differential” that would increase the VSL for cancer risks, based on surveys
that show people are willing to pay more to avoid cancer as opposed to other health
risks. The Department of Homeland Security has suggested that the willingness to
pay to avoid terrorism deaths is about double that of other risks.

Manufacturers and power companies have traditionally advocated the use of cost-
benefit analysis for environmental policies, essentially forcing regulators to prove the
economic efficiency of environmental improvements. But the recent VSL increases
have led them to reconsider their approach. For example, the U.S. Chamber of
Commerce (a group representing businesses) is now lobbying for Congress to have
greater oversight of federal regulators. On the other hand, even environmental
groups which remain critical of the VSL methodology have praised the Obama
administration for increasing these values.

Source: Appelbaum, Binyamin. 2011. “As U.S. Agencies Put More Value on a Life, Businesses Fret,”
New York Times, February 16, 2011.

5. ENVIRONMENTAL POLICY ALTERNATIVES

In devising policies to internalize environmental externalities, a Pigovian tax is just one


type of environmental policy. Decision-makers generally have other policy options, and
which one is appropriate depends on the particular context. The four basic
environmental policy options are:

1. Pollution standards
2. Technology-based regulation
3. Pigovian (or pollution) taxes
4. Tradable pollution permits

30
5.1. Pollution Standards

Pollution standards regulate environmental impacts by setting allowable pollution


levels or specifying the acceptable uses of a product or process. Many people
experience pollution standards at an annual automobile inspection. Cars must meet
certain standards for tailpipe emissions; if your car fails, you must correct the problem
before receiving an inspection sticker.

The clear advantage of standards is that they can specify a definite result. This is
particularly important in the case of substances that pose a clear hazard to public
health. By imposing a uniform rule on all producers, we can be sure that no factory or
product will produce hazardous levels of pollutants. In extreme cases, a regulation can
simply ban a particular pollutant, as has been the case with DDT (a toxic pesticide) in
most countries.

However, requiring all firms or products to meet the same standard is often not cost-
effective. The overall cost of a regulation can be lowered if firms that can reduce
pollution at low marginal costs reduce pollution more than firms that have high marginal
reduction costs. Thus requiring all firms to reduce pollution by the same amount, or to
meet the same standard, is not the least-cost way to achieve a given level of pollution
reduction. Another problem with standards is that once firms meet the standard they
have little incentive to reduce pollution further.

5.2. Technology-based Regulation

A second approach to environmental regulation is to require that firms or products


incorporate a particular pollution-control technology. For example, in 1975 the United
States required that all new automobiles include a catalytic converter to reduce tailpipe
emissions. While auto manufacturers are free to design their own catalytic converters,
each must meet certain emissions specifications.

Perhaps the main advantage of technology-based regulation is that enforcement and


monitoring costs are relatively low. Unlike a pollution standard, which requires that
firms’ pollution levels be monitored to ensure compliance, a technology-based approach
might only require an occasional check to ensure that the equipment is installed and
functioning properly.

Technology-based approaches may not be cost-effective, because they do not provide


firms the flexibility to pursue a wide range of options. Technology-based approaches
may, however, offer a cost advantage due to standardization. If all firms must adopt a
specific technology, then widespread production of that technology may drive down its
production cost down over time.

31
5.3. Pigovian (or Pollution) Taxes

Pollution taxes, along with tradable pollution permits, are considered market-based
approaches to pollution regulation because they send information to polluters about the
costs of pollution without mandating that firms take specific actions. Individual firms are
not required to reduce pollution under a market-based approach, but the regulation
creates a strong incentive for action.

As we saw earlier in the module, a pollution tax reflects the principle of internalizing
externalities. If producers must bear the costs associated with pollution by paying a tax,
they will find it in their interests to reduce pollution so long as the marginal costs of
reducing pollution are less than the tax.

Figure 8 illustrates how an individual firm will respond in the presence of a pollution tax.
Qmax is the level of pollution emitted without any regulation. The curve MCR shows the
marginal cost of pollution reduction for the firm. If a pollution tax equal to T is imposed,
the firm will be motivated to reduce pollution to level Qtax, at a total cost of B (equal to
the area under their MCR curve between Qtax and Qmax). If the firm maintained pollution
at Qmax it would have to pay a tax of (B + C) on these units of pollution. Thus the firm
saves area C by reducing pollution to Qtax.

After reducing pollution to Qtax, the firm will still need to pay a tax on its remaining units
of pollution, equal to area A. The total cost to the firm from the pollution tax is the sum
of its reduction costs and tax payments, or areas (A + B). This is less than areas (A + B
+ C), which is what they would have to pay in taxes if they undertook no pollution
reduction. The firm’s response to the tax is cost-effective, as any other level of pollution
different from Qtax would impose higher costs.

Figure 8. A Firm’s Response to a Pollution Tax


Marginal(Costs/(
Tax(Level

MCR

T
C
A B

Qtax Qmax Pollution(Level

32
All other firms in the industry will determine how much to reduce their pollution based on
their own MCR curve. Assuming that each firm is acting in a cost-effective manner, the
total cost of pollution reduction is minimized. Those firms that can reduce pollution at
low costs will reduce pollution more than firms that face higher costs. This is the main
advantage of market-based approaches to pollution regulation—they achieve a given
level of pollution reduction at the lowest overall cost. In other words, they are
economically efficient compared to pollution standards or technology-based
approaches.

5.4. Tradable Pollution Permits

Economic efficiency in pollution control is clearly an advantage. One disadvantage of


pollution taxes, however, is that it is very difficult to predict the total amount of pollution
reduction a given tax will produce. It depends on the shape of each firm’s MCR curve,
which is usually not known to policymakers.

An alternative is to set up a system of tradable pollution permits. The total number of


permits issued equals the desired target level of pollution. These permits can then be
allocated freely to existing firms or sold at auction. Once allocated, they are fully
tradable, or transferable, among firms or other interested parties. Firms can choose for
themselves whether to reduce pollution or to purchase permits for the pollution they
emit—but the total volume of pollution emitted by all firms cannot exceed a maximum
amount equal to the total number of permits.

Those firms with higher MCR curves will generally seek to purchase permits so they
don’t have to pay high pollution reduction costs. Firms that can reduce pollution at
lower cost may be willing to sell permits, as long as they as they can receive more
money for the permits than it would cost them to reduce pollution. With this system
private groups interested in reducing pollution could purchase permits and permanently
retire them, thus reducing total emissions below the original target level. Pollution
permits are normally valid only for a specific time period. After this period expires the
government can choose to issue fewer permits, resulting in lower overall pollution levels
in the future.

A detailed analysis of tradable permits, which we don’t present here, demonstrates that
a given level of pollution reduction is achieved at the same total cost as a tax.22 Thus
whether one prefers pollution taxes or tradable permits depends on factors other than
pollution reduction costs (however, the administrative costs of the approaches may
differ). Taxes are generally easier to understand and implement. But taxes are
politically unpopular, and firms may prefer a permit system if they believe they can
successfully lobby to receive the permits for free.

The main difference between the two approaches is where the uncertainty lies. With
pollution taxes, firms have certainty about the cost of emissions, which makes it easier
for them to make decisions about long-term investments. But the resulting level of total
22
For a more detailed analysis, see Harris and Roach, 2013.

33
pollution with a tax is unknown in advance. If pollution levels turn out to be higher than
expected, then the government might have to take the unpopular step of raising taxes
further.

With a permit system, the level of pollution is known because the government sets the
number of available permits. But the price of permits is unknown, and permit prices can
vary significantly over time. This has been the case with the European permit system
for carbon emissions. The price of permits initially rose to around €30/ton in 2006,
shortly after the system was instituted. But then prices plummeted all the way down to
€0.10/ton in 2007 when it became evident that too many permits had been allocated.
After some changes to the system, prices rose back to over €20/ton in 2008 but then fell
again down to less than €3/ton in 2013. Such price volatility makes it difficult for firms
to decide whether they should make investments in technologies to reduce emissions.

6. ECONOMIC ANALYSIS OF CURRENT ENVIRONMENTAL POLICY


ISSUES
We now apply the lessons from this module to three current environmental policy
issues: fisheries management, agriculture, and climate change. We’ll present relevant
data for each issue, focusing on historical trends and projections. In each case we’ll
see how the insights from environmental and ecological economics can help design
policies that promote sustainability.

6.1. Fisheries Management

As we have seen earlier, without sufficient regulation ocean fisheries are likely to be
subject to the tragedy of the commons. Individual fishers have little incentive to practice
conservation, for they know that if they do not catch the available fish, someone else
probably will. Technological improvements that make it easier to find and catch fish
only make matters worse. With the introduction of modern vessels like commercial
trawlers, fishing is often an operation of massive harvesting without discrimination.
Fishers can now “wipe out entire populations of fish and then move on either to a
different species or to a fishing area in some part of the world.”23

Fisheries are examples of renewable resources, which regenerate over time through
natural processes. One basic rule for renewable resource management derived from
ecological principles is that harvest levels should be kept below the maximum
sustained yield (MSY). In other words, the annual harvest of the resource should be
no more than what is regenerated annually through natural processes.

23
McGinn, Anne Platt. 1998. “Rocking the Boat: Conserving Fisheries and Protecting Jobs,” Worldwatch
Paper 142, Worldwatch Institute, June 1998, p. 15.

34
The world’s fisheries are classified into the categories, roughly based on a comparison
between harvest levels and the MSY24:

1. Underfished: Fisheries with harvest levels below their MSY. A potential may
exist to increase harvest levels.
2. Fully fished: Fisheries with harvest levels approximately equal to their MSY.
Increasing production is not ecologically sustainable.
3. Overfished: Fisheries with harvest levels above their MSY. Strict
management plans are needed to improve the biological health of these
fisheries (although such plans are normally not currently in place).

As shown in Figure 9, the world’s fisheries are becoming more exploited over time. In
recent decades the percentage of fisheries classified as overfished has more than
doubled. Meanwhile, the percentage of fisheries that are underfished, with the potential
for expanded harvest, has decreased from about 40% to 10%. The depleted state of
fisheries is due to overfishing and increasing habitat degradation.

Figure 9. Status of the World’s Fisheries, 1974 – 2011


100

90
Overfished
80

70

60

Fully3Fished
Percent

50

40

30

20
Underfished
10

Year
Source: FAO. 2014. “The State of World Fisheries and Aquaculture,” Rome.

24
Fishery classification from the FAO (Food and Agriculture Organization of the United Nations).

35
Global Fish Production and Consumption

People in developed countries currently consume 25 percent of the global fish catch;
the other 75 percent is consumed in the developing world, where fish is an important
protein source.25 Increasing population and income in developing countries will likely
produce steady growth in the global demand for fish and fish products, but supply
expansion, at least from wild fisheries, may be close to its limits.

Figure 10 shows global fish production from 1950 to 2012. World fish harvest of
naturally-occurring stocks steadily increased from 1950 until 1990. However, since then
the wild catch has leveled off at about 90 million tons annually. This is consistent with
the decline in underfished stocks shown in Figure 9. But the global fish harvest has
continued to increase as an increasing share of the total catch is produced using
aquaculture – essentially fish farming. As of 2012, about 42% of global fish production
was due to aquaculture. While aquaculture has provided a means to meet the growing
global demand for fish, a challenge is to reduce the environmental impacts associated
with aquaculture, as discussed in Box 3.

Per-capita fish consumption has doubled globally since the 1960s. The greatest growth
has occurred in developing countries, driven by population growth, higher incomes, and
improved distribution infrastructure. However, the expansion of fish consumption has
been highly uneven. China has been responsible for most of the increase in global fish
consumption, while many countries in Sub-Saharan Africa have seen fish consumption
remain constant or even decrease.

Figure 10. Global Fish Production, 1950 – 2012


160
Wild.Catch................................Aquaculture
140

120
Production*(million*tons)

100

80

60

40

20

0
1950 1960 1970 1980 1990 2000 2010

Year

Source: FAO, 2014. “The State of World Fisheries and Aquaculture,” Rome.

25
FAO, 2014.

36
Box 3. Reducing the Environmental Impact of Salmon Aquaculture

As shown in Figure 10, global aquaculture production has increased significantly


over the last couple of decades. Production has increased so much that in 2012 the
global production of aquaculture surpassed the global production of beef. Salmon is
a species that is now predominantly produced using aquaculture. According to the
environmental group WWF, salmon farming is the fastest growing food production
system in the world.

Until recently, consumers concerned about the environment were advised to avoid
consuming aquaculture-grown salmon. One reason is that salmon, which are
carnivorous, are fed animal proteins that could instead be used to feed humans
directly. Another reason is that toxic chemicals used in the production of farmed
salmon can pollute the ocean. Finally, salmon can escape their pens, spreading
disease and degrading the wild genetic pool.

Back in 2002 WWF partnered with salmon farmers to seek ways to reduce the
environmental impacts of the industry. Finally, in 2010 this initiative led to the
establishment of a set of standards for sustainable salmon farming, referred to as the
Aquaculture Stewardship Council (ASC). Among the ASC standards are limits on
the proportion of escaping salmon, a prohibition on genetic engineering, limits on
antibiotics, and guidelines on the food that is fed to salmon.

So far only a few salmon farms meet these standards. But in 2013 a group of 15
large salmon farmers, representing 70% of the global market, pledged that all of their
salmon would meet ASC standards by 2020. According to WWF:

This should measurably reduce the impact of salmon production on some of the
world's most ecologically important regions. This approach will change
aquaculture—and can have ripple effects through the entire global food industry.
[This commitment] shows once again that the global marketplace can be a powerful
tool for conservation.

Sources: Howard, Brian Clark. 2014. “Salmon Farming Gets Leaner and Greener,” National
Geographic News, March 19; WWF website. 2013. “Spawning a Sustainable Industry for Farm-Raised
Salmon,” August 15, http://www.worldwildlife.org/stories/spawning-a-sustainable-industry-for-farm-
raised-salmon.

Sustainable Fisheries Policies

Clearly the open-access outcome described in Section 3 is not consistent with


environmental sustainability. In the case of a common property resource such as a
fishery, economic incentives work in a perverse way. In response to declining yields,
operators increase their effort, often investing in more efficient equipment, which
accelerates the decline of the fishery.

37
It also poses further ecological problems because modern fishing methods often cause
a high death rate among non-target species. Also, many target species fish are
discarded after being caught, because they are either undersized or nonmarketable.
This wasted portion of the global harvest is called bycatch. A 2009 paper found that:

38.5 million tonnes of annual bycatch can be identified, representing 40.4 percent
of the estimated annual global marine catch of 95.2 million tones. … [E]normous
quantities of biomass are being removed from the ocean without any form of
effective management. The approach outlined in this paper therefore exposes
bycatch as an insidious problem of invisible fishing resulting from widespread
unmanaged fisheries. … Few industries would tolerate levels of wastage and/or
lack of sustainable management of around 40 percent.26

Although identifying the maximum sustainable yield for a fishery can help
maintain an individual species, the issues of ecological sustainability are more complex.
Depleting one species may lead to an irreversible change in ocean ecology as other
species fill the ecological niche formerly occupied by the harvested species.27 For
example, dogfish and skates have replaced overfished cod and haddock in major areas
of the North Atlantic fishery, and are now themselves threatened with overfishing.
Fishing techniques such as trawling, in which nets are dragged along the bottom of the
ocean, are highly destructive to all kinds of benthic (bottom-dwelling) life. In large areas
of the Atlantic, formerly productive ocean floor ecological communities have been
severely damaged by repeated trawling.

The World Bank and FAO stress the critical need to reform fisheries management:

Failure to act implies increased risks of fish stock collapses, increasing political
pressure for subsidies, and a sector that, rather than being a net contributor to
global wealth, is an increasing drain on society. … The most critical reform is the
effective removal of the open access condition from marine capture fisheries and
the institution of secure marine tenure and property rights systems. Reforms in
many instances would also involve the reduction or removal of subsidies that
create excess fishing effort and fishing capacity. Rather than subsidies, the
World Bank has emphasized investment in quality public goods such as science,
infrastructure, and human capital, in good governance of natural resources, and
in an improved investment climate.28

From an economic point of view, the tragedy of the commons occurs because important
productive resources—fisheries in this case—are treated as free resources, and are
therefore overused. One potential solution is to privatize fisheries, in the hopes that
owners would manage fisheries for sustainable profitability. However, an ocean fishery
does not permit the private ownership solution. The oceans have been called a comm.
on heritage resource—they belong to everyone and no one. But under the 1982 Law of

26
Davies, et al., 2009
27
See, for example, Ogden, 2001.
28
World Bank and FAO, 2009, p. xxi

38
the Sea treaty, agreed to under United Nations auspices, nations can claim territorial
rights to many important offshore fisheries. They can then limit access to these
fisheries by requiring a fishing license within their Exclusive Economic Zones (EEZs),
which normally extend 200 miles from their coastlines.

Within each country’s EEZ, they can implement the economic policies we discussed in
Section 3, including charging fishing license fees or instituting individual transferable
quotas. To determine the maximum sustainable yield, policymakers must consult
marine biologists. Once ecological sustainability has been assured, the ITQ market will
promote economic efficiency. Those who can fish most effectively will be able to outbid
others to acquire the ITQs.

A more difficult problem concerns species that are highly migratory, or are principally
located outside of any nation’s EEZ. Tuna and swordfish, for example, continually
travel between national fishing areas and the open ocean. Even with good policies for
resource management in national waters, these species can be harvested as an open-
access global resource, which almost inevitably leads to stock declines. Only an
international agreement can solve an issue concerning global commons.

In 1995, the first such international agreement was signed – the Straddling Fish Stocks
Agreement.29 This treaty embodies the precautionary principle, discussed in Section 2.
For example, the treaty states that the “absence of adequate scientific information shall
not be used as a reason for postponing or failing to take conservation and management
measures.”30

Changes in human consumption patterns are also important. Public education


campaigns that identify fish and seafood produced with environmentally damaging
techniques may lead consumers to avoid these species. For example, a boycott of
swordfish aimed at stopping the decline of this species has gained the support of
numerous restaurant chefs and consumers.

Ecolabeling, which identifies products produced in a sustainable manner, has the


potential to encourage sustainable fishing techniques. Products of certifiably
sustainable fishing practices can often command a slightly higher market price. By
accepting this price premium, consumers implicitly agree to pay for something more
than the fish they eat. They pay a little extra for the health of the ocean ecosystem and
the hope of a supply of fish to feed people in the future as well as in the present. These
consumer choices give the fishing industry a financial incentive to use sustainable
methods. A prominent example is "dolphin-safe" ecolabeling, which has been
instrumental in reducing the numbers of dolphin killed as bycatch during tuna fishing.
Governments can institute subsidies when certain activities create positive externalities,
as discussed in Section 3. For example, subsidies can assist in developing or acquiring

29
A straddling fish stock is one that migrates through or occurs in more than one EEZ.
30
United Nations. 1995. “Agreement for the Implementation of the Provisions of the United Nations
Convention on the Law of the Sea of 10 December 1982 Relating to the Conservation and Management
of Straddling Fish Stocks and Highly Migratory Fish Stocks,” A/CONF.164/37. Article 6, page 6.

39
equipment designed especially to release bycatch, or to avoid major disturbances of the
seabed. This may moderate political opposition from fishing communities to
government intervention aimed at eliminating destructive fishing practices.
Unfortunately, most current fishery subsidies are counterproductive, increasing
economic incentives for overfishing.

6.2. Sustainable Agriculture

We saw in Section 2 that predictions indicating that humanity will be unable to feed itself
have been proven wrong. On average, humans are currently better fed than ever.
Among the Millennium Development Goals set by the United Nations in 2000 was the
goal to halve the proportion of malnourished people globally by 2015. Recent estimates
suggest that this goal is within reach. In the early 1990s, about 19% of people
worldwide were malnourished, but by 2012-2014 that percentage had fallen to 11%.31

But like the expansion of fish consumption, progress on reducing hunger has been
uneven across global regions. As shown in Figure 11, the greatest progress has
occurred in Asia and Latin America. The reduction in malnourishment has been less
significant in Africa and Oceania. Even as the percentage of malnourished people has
decreased in Africa, the actual number of people affected by hunger has increased from
182 to 227 million, due to population growth.

The reduction in malnourishment is not only attributed to increased food production, but
also to higher incomes and wider food availability. One factor that hasn’t contributed to
the increase in the global food supply is an expansion of agricultural land – according to
the World Bank agricultural land area has remained relatively constant since the early
1990s. Instead, improvements in agricultural technology and efficiency have been the
drivers leading to a larger food supply.

With the human population projected to increase to 9.6 billion by 2050 according to the
United Nations, can we further increase the global food supply to meet expected
demands? Even as diets change with higher incomes and changing preferences, most
researchers conclude that the answer is yes.32 However, there are several important
caveats to this conclusion:

1. Biofuel expansion: Biofuels are fuels made from living organisms, most
commonly crops such as corn and sugar cane. Currently, less than 10% of
the world’s crops are used for biofuels and other industrial uses.33 While
some expansion of biofuels is expected, a significant reallocation of crops
away from human consumption toward biofuels could reduce the ability to
meet future food demands.

31
FAO. 2014. “The State of Food Insecurity in the World,” Rome.
32
Wise, Timothy A. 2013. “Can We Feed the World in 2050? A Scoping Paper to Assess the Evidence.”
Global Development and Environment Institute, Working Paper 13-04.
33
Cassidy, Emily S., Paul C. West, James S. Gerber, and Jonathan A. Foley. 2013. “Redefining
Agricultural Yields: Tonnes to People Nourished per Hectare,” Environmental Research Letters 8:1-8.

40
Figure 11. Percentage of Undernourished People, by Region, 1990 – 2014

30!

25!
Percent!Malnourished!

20!

15!

10!

5!

0!
World! Africa! Asia! La;n!America! Oceania!
&!Caribbean!

1990H1992! 2000H2002! 2012H2014!

Source: FAO. 2014. “The State of Food Insecurity in the World,” Rome.

2. Climate change: The impact of climate change on agricultural production is


not precisely known. While production could increase in some areas due to
an expansion of the growing season, such as in Canada and Russia, the net
impact of long-term climate change on global food production is expected to
be negative. Current models of the future food supply do not adequately
account for climate change.
3. Environmental damage: While total agricultural production may rise, this may
mask long-term damage to water, soil, and ecological systems. We address
these issues in the next section.

41
Environmental Impacts of Modern Agriculture

In addition to being affected by a changing environment, modern agricultural practices


impact the environment on local and global scales. We consider four environmental
impacts in this section:

1. Deforestation
2. Soil erosion
3. Use of chemical inputs
4. Emissions of greenhouse gases

While the overall land area devoted to agriculture globally has not significantly changed
recently, new lands are constantly brought into agricultural production as the
productivity of existing plots decline. Through the practice of slash-and-burn
agriculture, primarily practiced in tropical regions, land is cleared for farming by first
cutting and burning the existing vegetation. The remaining ash infuses the soil with
nutrients, which are then used to support agriculture. However, the soils in tropical
forests tend to be nutrient-poor. Thus once the nutrients from the burnt vegetation are
depleted, often in a matter of a few years, farmers must move on to new lands and
repeat the cycle.

While slash-and-burn agriculture has primarily been practiced on a small scale by


subsistence farmers, increasingly deforestation is occurring as a result of large-scale
commercial agriculture. According to a 2012 report prepared for the governments of the
UK and Norway:

Commercial agriculture (including livestock) is the most important driver of


deforestation in Latin America leading to around 2/3 of total deforested area. In
both Africa and (sub)tropical Asia commercial agriculture accounts for around 1/3
of deforestation and is of similar importance as subsistence agriculture. Based
on this synthesis of nationally reported data, agriculture is estimated to be the
proximate driver for around 80% of deforestation worldwide.34

The causes of deforestation are presented in more detail in Figure 12. We see that
more deforestation is occurring in Latin American than in Africa and subtropical Asia. In
Latin America, commercial agriculture is responsible for nearly three times as much
deforestation as subsistence agriculture. In Africa and Asia, small-scale and large-scale
agriculture are responsible for about an equal amount of deforestation. In all three
regions, agriculture is clearly the dominant cause of deforestation.

34
Kissinger, Gabrielle, Martin Herold, and Veronique De Sy. 2012. “Drivers of Deforestation and Forest
Degradation: A Synthesis Report for REDD+ Policymakers,” Lexeme Consulting, Vancouver, Canada,
August 2012, p. 11.

42
Rates of forest loss in the developing world have been increasing in recent decades.35
Tropical deforestation is a particular problem, as these forests provide habitat for a
majority of the world’s biodiversity. As we have seen before, economic theory can
provide insight into both the nature of the problem and potential solutions. Farmers,
small- or large-scale, tend to only consider their own financial situation when making
decisions, failing to account for social costs. Thus even if sustainable uses of forests
provide society with the greatest net benefits, forests will still be converted to agriculture
if the private benefits exceed the private costs. Thus the challenge is:

to make users internalize all the social costs associated with converted forests.
This will both increase the price and cost of the converted forest, and will also
reduce the net marginal benefits of converted forest.36

We will discuss sustainable agricultural policies in more detail later in this section.

Figure 12. Causes of Deforestation, 2000-2010

50000
Average'Annual'Deforestation,''''200042010'(km2/yr)

40000
Infrastructure/Urban0
Expansion

30000 Mining

20000 SmallAscale0
Agriculture

Commercial0
10000 Agriculture

0
Africa Latin0America Subtropical0Asia

Source: Kissinger, et al., 2012.

Another environmental impact of modern agricultural is excessive soil erosion. Soil is a


natural resource that regenerates over very long time periods – the average rate of soil

35
Benhin, James K.A. 2006. “Agriculture and Deforestation in the Tropics: A Critical Theoretical and
Empirical Review,” Ambio 35(1): 9-16.
36
Benhin, 2006, p. 15.

43
formation is only one centimeter every 178 years.37 Yet soil can be eroded at much
higher rates when it is left exposed to rain and wind, commonly 10-40 times the rate of
natural formation.

Soil erosion results in economic losses as agricultural land becomes less productive. In
the United States, annual economic losses from soil erosion have been estimated at
around $40 billion, and globally the cost is 10 times higher.38 Soil erosion also results in
environmental problems. For example, when eroded soil is deposited into rivers and
lakes it can harm the health of these ecosystems. The siltation of rivers in the United
States due to soil erosion is considered the second leading cause of water quality
impairment in the country.39 Soil erosion can also contribute to air pollution when winds
carry off exposed soils.
Rates of soil erosion can be significantly reduced by implementing good agricultural
practices that minimize soil disturbance, reduce soil exposure to the elements, and slow
down water runoff. For example, rather than intensively tilling the soil prior to planting,
in which nearly all plant residue is buried below the surface, the practice of conservation
tillage leaves at least 30% of these residues on the soil surface in order to reduce soil
exposure and slow runoff.

A third environmental impact of agriculture is the release of numerous chemicals into


the environment. The widespread use of pesticides, herbicides, and other chemicals
has clearly increased agricultural productivity and reduced global hunger. But this has
come at an environmental cost. The negative impacts of these chemicals first came to
light in the 1960s, most famously with the publication of Rachel Carson’s Silent Spring.
Carson documented the problem of bioaccumulation, whereby pesticides stored in the
fat tissue of animals become more concentrated further up the food chain. Top
predators such as bald eagles are particular susceptible to high concentrations of toxic
chemicals, leading to egg shell thinning and increased mortality.

Environmental problems are also associated with the application of fertilizers to


agricultural crops. For example, nitrogen fertilizers can run off into waterways and
promote algal blooms (a process known as eutrophication) that can kill fish and other
aquatic animals. The production of fertilizers, along with other agricultural chemicals,
can release toxic chemicals into air and water. The production of phosphorus fertilizer
in India leads to air pollution from sulfur dioxide and heavy metals. Inhalation of the
emissions from fertilizer plants have been associated with increased risk of autoimmune
disorders and lung disease.40

37
See http://www.swac.umn.edu/classes/soil2125/doc/s4chp4.htm.
38
Lanf, Susan S. 2006. “’Slow, insidious’ soil erosion threatens human health and welfare as well as the
environment, Cornell study asserts,” Cornell Chronicle, March 20, 2006.
http://news.cornell.edu/stories/2006/03/slow-insidious-soil-erosion-threatens-human-health-and-welfare
39
Kertis, Carol A., and Thomas A. Iivari . 2006. “Soil Erosion on Cropland in the United States: Status
and Trends for 1982-2003,” Proceedings of the Eighth Federal Interagency Sedimentation Conference
(8thFISC), April 2-6, 2006, Reno, NV.
40
Mishra, C.S.K., Soumya Nayak, B.C. Guru, and Monalisa Rath. 2010. “Environmental Impact and
Management of Wastes from Phosphate Fertilizer Plants,” Journal of Industrial Pollution Control,
26(1):57-60.

44
Once again, this issue can be framed as a negative externality. As long as chemical
manufacturers and farmers do not pay for the external costs of agricultural chemicals,
these chemicals will be overused from the viewpoint of economic efficiency. Thus a tax
is one economic instrument that could reduce chemical use toward an economic
optimum.

Denmark is one of a handful of countries that have instituted taxes on agricultural


chemicals. First implemented in the mid-1980s, during the 1990s the Danish tax rates
reached 54% of the wholesale price of pesticides and 34% of the wholesale price of
herbicides and fungicides.41 To reduce the net impact of the tax on farmers, over 80%
of the revenue is returned back to the agricultural sector in the form of subsidies for
sustainable agricultural practices. However, the benefits of the tax have been less than
expected, as it doesn’t differentiate between the most harmful pesticides and those that
are less damaging – all pesticides are taxed at the same rate. Thus the Danish
government is now in the process of restructuring the tax so that it will be differentiated
according to a chemical’s impact on human health and the environment.42
The final environmental impact of modern agriculture that we consider is its contribution
to global climate change (discussed in more detail below). Agriculture directly
contributes to climate change by releasing various gases into the atmosphere.
According to the United States Environmental Protection Agency, most of the total
greenhouse gas emissions related to agriculture is due to nitrous oxide released by
fertilizer application and methane released by the digestive process of farm animals.
Overall, agriculture is responsible for about 10% of total U.S. greenhouse gas
emissions.43

But other estimates suggest that agriculture’s contribution to climate change is much
greater. Indirectly, the overall food production system contributes to climate change in
other ways besides direct emissions, including:44

• As stated earlier, agriculture is responsible for the majority of deforestation


globally. Forests natural store carbon, thus reducing the amount of carbon in the
atmosphere. When forests are lost, so is their carbon storage potential.
• The processing, packaging, and transportation of agricultural and food products
also contributes to climate change. For example, about one-quarter of all
transportation in the European Union involves the commercial transport of food.
This percentage is even higher in developing countries.
• The decomposition of agricultural wastes also releases greenhouse gases into
the atmosphere. These wastes are responsible for 3-4 of global greenhouse gas
emissions.
41
PAN Europe. 2005. “Danish Pesticide Use Reduction Programme,” London, June 2005.
42
See http://eng.mst.dk/topics/pesticides/reducing-the-impact-on-the-environment/initiatives-under-the-
green-growth-action-plan/pesticide-tax/.
43
U.S. EPA. 2014. “Inventory of U.S. Greenhouse Gas Emissions and Sinks: 1990-2012,” Washington,
D.C., April 15, 2014.
44
United Nations Conference on Trade and the Environment. 2013. “Trade and Environment Review
2013: Wake Up Before It Is Too Late,” Commentary IV: “Food, Climate Change, and Healthy Soils: The
Forgotten Link.”

45
When all these other factors are considered, the overall contribution to greenhouse gas
emissions from agriculture may be much higher than the 11-15% often quoted:

Considering all these factors, it would appear that the current global food system,
propelled by an increasingly powerful transnational food industry, is responsible
for around half of all anthropogenic GHG [greenhouse gas] emissions – between
a low of 44 percent and a high of 57 percent.45

Making Agriculture Sustainable

Traditional economic analysis has considered agricultural production as a process of


combining inputs, including land, water, fertilizer, and pesticides to maximize output
(measured as yields or profits). Environmental economics focuses on the negative
externalities associated with agriculture, such as soil erosion, deforestation, toxic
chemicals, and greenhouse gases as described above. These externalities can be
addressed with economic policies such as taxes and subsidies.
But an ecological economist would argue that the crux of the problem with modern
large-scale agriculture is that it runs counter to the equilibrium that is found in natural
ecosystems. Through natural processes, important nutrients are cycled through an
ecosystem as plants die, decompose, enrich the soil, and then provide nutrients for the
next generation of plants. Different plants may serve different purposes in an
ecosystem. For example, certain plants “fix” nitrogen, a process by which nitrogen in
the atmosphere is converted into a form that is usable by other plants in the soil. The
diversity of natural ecosystems also makes them highly resilient – able to bounce back
in the presence of disturbances such as disease or extreme weather.

Industrial agriculture is normally a monoculture – meaning that a single plant species is


grown exclusively on a plot year after year. Unlike natural systems, monocultures tend
to be more vulnerable to diseases and pests, require the constant input of nutrients, and
degrade the soil. An ecological view of agricultural production sees crop output as one
part of a diverse agro-ecological system, which aims to maintain natural processes and
nutrient cycles. To achieve long-term sustainability, cultivating practices must minimize
chemical inputs and rely more on organic techniques, which return nutrients to the soil,
control pests by natural methods, and are not harmful to other species.

A sustainable agricultural system is defined here as one that produces a stable level of
output without degrading the environmental systems that support it. In economic terms,
this means no significant un-internalized externalities or excessive depletion of common
property resources. From an ecological point of view, a sustainable system minimizes
disruption to natural cycles.
Production techniques such as organic fertilization by recycling of plant and animal
wastes, crop rotation and intercropping of grains and nitrogen-fixing legumes help to
maintain the soil’s nutrient balance and minimize the need for artificial fertilizer. The
use of reduced tillage, terracing, fallowing, and agroforestry (planting trees in and
45
Ibid., p. 20.

46
around fields) all help to reduce erosion. Integrated pest management (IPM) uses
natural pest controls such as predator species, crop rotation, and labor-intensive early
pest removal to minimize use of chemical pesticides. Efficient irrigation techniques and
the use of drought- and salt-tolerant crop varieties can reduce water use. Species
diversity is promoted by multiple cropping (planting several different crops in the same
field) rather than monocultures.

The traditional view has been that sustainable agricultural methods are less profitable
than industrial agriculture. However, recent research suggests that this may not be true
over the long run, particularly when one considers that organic agricultural products sell
at a price premium. In a study conducted in Minnesota over 18 years, researchers
compared the profitability of several of the main U.S. grain crops (corn, soybeans, oats,
and alfalfa) using both organic and chemical-intensive methods.46 The paper
concludes:

These results show that with current price premiums, an organic crop farm in the
Upper Midwest can earn greater per-hectare profits … than a conventional farm
using [the practices that are] predominant in the region. [Further,] organic
premiums could decline in the future without necessarily causing organic
production to lose its profitability advantage over conventional, [chemically-
intensive] cropping systems.47

A 2009 study sponsored by the FAO reviewed the research comparing the profitability
of organic and non-organic farming techniques and found that:

… in the majority of cases, organic systems are more profitable than non-organic
systems. There are wide variations among yields and production costs, but either
higher market price and premiums, or lower production costs, or the combination
of these two generally result in higher relative profit in organic agriculture in
developed countries. The same conclusion can be drawn from studies in
developing countries but there, higher yields combined with high premiums are
the underlying cause for higher relative profitability.48

Further, the paper noted that the advantage of organic farming is even larger when one
considers that non-organic farming creates more negative externalities and receives
greater government support. A complete economic analysis of farming techniques
should not only consider financial results, but social, environmental, and health factors.

Still, the barriers to implementing sustainable farming in the U.S. and worldwide are
considerable. One major problem is access to information. Sustainable techniques
46
Delbridge, Timothy A., Jeffrey A. Coulter, Robert P. King, Craig C. Sheaffer, and Donald L. Wyse.
2011. “Economic Performance of Long-Term Organic and Conventional Cropping Systems in Minnesota,”
Agronomy Journal, 103(5): 1372-1382.
47
Ibid., p. 1381.
48
Nemes, Neomi. 2009. “Comparative Analysis of Organic and Non-organic Farming Systems: A Critical
Assessment of Farm Profitability,” Food and Agriculture Organization of the United Nations, Rome, June
2009.

47
tend to be both labor-intensive and information-intensive. In developed countries, many
farmers are not sufficiently knowledgeable about the complex techniques of organic and
low-input agriculture to be able to make them pay. It is often much easier to read the
instructions on a bag of fertilizer or a canister of pesticide. In developing countries,
traditional low-input farming systems have often been displaced by modernized “Green
Revolution” techniques, which are advocated by large agricultural companies and many
governments.

In recent years, organic agriculture has expanded rapidly. Sales of organic agricultural
products in the U.S. have increased from about $12 billion annually in 2004 to $35
billion in 2014.49 But organic products still only account for about 4% of at-home food
sales. Government policies, such as the establishment of organic standards, reform of
agricultural subsidy policies, and internalization of externalities will have an important
influence of the future of organic farming.

6.3 Global Climate Change

Global warming, more accurately described as climate change, has become a major
environmental and economic issue in recent decades. The vast majority of scientists
concur that global climate change50 is in significant part caused by human actions, in
particular the increased emissions of various greenhouse gases (GHGs).51 These
gases act much like the glass in a greenhouse—allowing solar radiation to penetrate,
but then trapping it and increasing temperatures.

While most greenhouse gases exist naturally in the earth’s atmosphere and make life
possible on earth, human activities have increased the concentration of many of these
gases, as well as introduced entirely new greenhouse gases into the atmosphere. The
most important greenhouse gas emitted by humans is carbon dioxide (CO2), which is
formed when fossil fuels (coal, oil, and natural gas) are burned. Other greenhouse
gases include methane, nitrous oxide, and chlorofluorocarbons (CFCs).52

Data and Projections

As shown in Figure 13 global emissions of carbon dioxide have increased significantly


over the last couple of decades, and are projected to increase a further 34% between

49
Greene, Catherine. 2013. “Growth Patterns in the U.S. Organic Industry,” Amber Waves, U.S.
Department of Agriculture, Economic Research Service, October 24, 2013.
50
We use the term “climate change” instead of “global warming” because in addition to warmer average
temperatures there are numerous other effects of this hugely complex system change—sometimes even
including colder than normal temperatures in certain locations.
51
See, for example, Cook, John, Dana Nuccitelli, Sarah A Green, Mark Richardson, Bärbel Winkler, Rob
Painting, Robert Way, Peter Jacobs and Andrew Skuce. 2013. “Quantifying the Consensus on Anthropogenic
Global Warming in the Scientific Literature,” Environmental Research Letters, vol. 8(2): 1-7.
52
CFCs have also been implicated as ozone depleting substances. It is important to note that the
degradation of the ozone layer, while serious, is an issue almost entirely unrelated to global climate
change.

48
2015 and 2040. We see that virtually all of the increase in emissions in the coming
decades will be a result of higher emissions in developing (non-OECD) countries.
However, we need to be aware that most of the carbon emitted from human activities so
far has come from developed nations. Also, CO2 emissions per capita are much higher
in developed countries, and will continue to be so for the foreseeable future. For
example, annual CO2 emissions per capita are currently about 18 tons in the United
States, 9 tons in Germany, 7 tons in China, 2 tons in India, and 0.3 tons in Kenya.

Figure 13. Past and Projected Global Emissions of Carbon Dioxide, 1990-2040
60

50

40
Billion&Metric&Tons

30 Non6OECD&Countries

20

10
OECD&Countries
0
1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040
Year

Note: OECD is the Organization for Economic Co-Operation and Development, comprised mostly of
developed nations.
Source: United States Energy Information Administration database

As atmospheric concentrations of GHGs increase, the world is expected to become


warmer, on average. Not all regions will warm equally, and some regions may actually
become cooler. Warmer average temperatures increase evaporation, which in turn
leads to more frequent precipitation. But again, all regions will not be affected equally.
In general, already wet areas will become wetter and dry areas will become drier.
Climate change is also expected to result in more frequent and more intense tropical
storms. The melting of polar ice caps and glaciers will contribute to rising sea levels.
Sea levels are also rising because the volume of ocean water expands when it is
heated. Among the ecological and human effects climate change are higher rates of
species extinctions, lower average agricultural production, reduced freshwater
availability, higher rates of several diseases, and increased risk of violent regional
conflicts.53

53
Intergovernmental Panel on Climate Change. 2014. “Climate Change 2014: Impacts, Adaptation, and
Vulnerability: Summary for Policymakers,” Cambridge, UK and New York: Cambridge University Press.

49
Global average temperatures have already increased by about one degree Celsius (1.8
degrees Fahrenheit) over the last several decades. At a 2009 international meeting on
climate change in Copenhagen, Denmark, more than 130 nations agreed that it was
necessary to limit the eventual warming to no more than two degrees Celsius, based on
the scientific consensus that warming above this level is likely to cause dangerous
impacts.

Climate scientists have developed complex models to predict how much average
temperatures will increase as carbon dioxide concentrations in the atmosphere
increase. Because there are considerable uncertainties in predicting long-term climate
trends, these models have produced a range of potential outcomes. Adding to the
uncertainty in models, the extent of warming will also be influenced by the policy
decisions made in the next couple of decades.

The Intergovernmental Panel on Climate Change (IPCC) is an organization created by


the United Nations to assess the science of climate change. A 2013 IPCC report
estimated that ambitious policy efforts, with global CO2 emissions peaking by 2020 and
rapidly declining thereafter, could limit warming to the two degree Celsius target.54
However, as Figure 13 suggests, this scenario is highly unlikely based on current
emissions projections. According to a 2014 analysis by MIT:

Progress on climate change mitigation through international agreement has been


slow, and efforts appear to be falling well behind the ambitious long-term goals
set by the international community. Whether those goals are achieved or not,
any hope of averting considerable climate consequences by stabilizing
atmospheric GHG concentrations will require significant emissions reduction.
Another 20 or 30 years of increasing emissions suggest substantial risks of
dangerous climate change.55

Economic Analysis of Climate Change

Most of the topics discussed in Sections 2 through 5 of this module are relevant to the
economics of global climate change. Environmental economists tend to view climate
change within a traditional cost-benefit analysis framework, applying the standard
techniques of economic valuation and discounting. Ecological economists are more
likely to view climate change from a strong sustainability perspective, arguing for policy
action on the basis of ecological and ethical, as well as economic, justifications.

Virtually all economists agree that carbon emissions, as a negative externality, should
be internalized through market mechanisms such as a Pigovian tax or a tradable permit
system. However, there is a lively debate among economists about how aggressive

54
Intergovernmental Panel on Climate Change. 2013. “Climate Change 2013: The Physical Science
Basis: Summary for Policymakers,” Cambridge, UK and New York: Cambridge University Press.
55
MIT Joint Program on the Science and Policy of Global Change. 2014. “2014 Energy and Climate
Outlook,” Cambridge, MA.

50
such policies should be. Until recently, most economic studies of climate change
suggested a relatively modest carbon tax, perhaps around $20-$40 per ton of carbon.
For context, a $30 per ton tax on carbon would increase the price of gasoline by about 8
cents per gallon.

The economic debate on climate change changed significantly in 2007, when Nicholas
Stern, a former chief economist for the World Bank, released a 700-page report,
sponsored by the British government, titled “The Stern Review on the Economics of
Climate Change.” Publication of the Stern Review generated significant media attention
and has intensified the debate about climate change in policy and academic circles.
Unlike previous studies, the Stern Review strongly recommends immediate and
substantial policy action:

The scientific evidence is now overwhelming: climate change is a serious


global threat, and it demands an urgent global response. This Review has
assessed a wide range of evidence on the impacts of climate change and on
the economic costs, and has used a number of different techniques to assess
costs and risks. From all these perspectives, the evidence gathered by the
Review leads to a simple conclusion: the benefits of strong and early action
far outweigh the economic costs of not acting.

The Stern Review estimated that if humanity continues “business as usual”, the costs of
climate change in the 21st century would reach at least 5% of global GDP, and could be
as high as 20%. The Review also suggested the need for a much higher carbon tax—
over $300 per ton of carbon.

What accounts for the difference between the Stern Review and most earlier analyses?
The primary difference was that Stern applied a discount rate of 1.4%, significantly
lower than the 4-5% rate used in most other studies. Stern argued that his discount rate
reflected the view that each generation should have approximately the same inherent
value. Stern’s analysis also incorporated the precautionary principle (discussed in
Section 2), in that he placed greater weight on the possibility of catastrophic damages.

Climate Change Policy

While the vast majority of physical scientists agree that humans are causing climate
change, and the vast majority of economists support policies to reduce carbon
emissions, so far the policy response has been somewhat limited. As discussed above,
any chance of limiting warming to two degrees Celsius will require significant policy
changes.

The first international attempt to address climate change was the Kyoto Protocol,
adopted in 1997. Under this treaty industrialized countries agreed to emission reduction
targets by 2012 compared to their baseline emissions, normally set to 1990 levels. For
example, the United States agreed to a 7 percent reduction, France to an 8 percent
reduction, and Japan to a 6 percent reduction. Developing countries such as China and

51
India were not bound to emissions targets under the treaty (an omission that drew
objections from the United States and some other countries).

The Kyoto Protocol includes a number of “flexibility mechanisms” designed to achieve


carbon emissions reductions at the lowest overall cost. Under the Joint Implementation
mechanism, a country can obtain credit for investing in emissions reduction projects in
other countries covered by the treaty. Under the Clean Development Mechanism, a
country can obtain credit by investing in emissions reduction projects in developing
countries not covered by the treaty, such as China and India. The treaty also allows for
emissions trading systems among the participating countries.

By 2012, 191 countries had signed and ratified the Kyoto Protocol. The United States
was the only country that signed the treaty but never ratified it. In 2001, the George W.
Bush administration rejected the Kyoto Protocol, arguing that negotiations had failed
and that a new approach was necessary. Despite the U.S. withdrawal, the Kyoto
Protocol entered into force in early 2005 after Russia ratified the treaty in November
2004.

Countries that have met their targets under the Kyoto Protocol include France,
Germany, Russia, and the United Kingdom. Countries that will apparently fail to meet
their targets include Canada, Spain, and Italy. The overall Kyoto program target of a
5% reduction in industrial country emissions is likely to be met, but only because of very
large reductions in Russia due largely to the collapse of Communist industries rather
than any deliberate policy.

Countries that failed to meet their 2012 targets were supposed to make up for it in the
next commitment period. However, attempts to create a successor to the Kyoto
Protocol have so far been unsuccessful. Perhaps the most contentious point of
disagreement is still whether developing countries should be bound by mandatory cuts
in emissions. While some countries, particularly the United States, argue that all
participants must agree to reductions in order to address the problem, developing
countries contend that mandatory cuts would limit their economic development and
reinforce existing global inequities.

As part of its efforts to meet its Kyoto Treaty obligations, the European Union instituted
a carbon trading system in 2005. The system covers more than 11,000 facilities that
collectively emit nearly half the EU’s carbon emissions. After the system’s
implementation, it soon became evident that carbon permits were over-allocated,
leading to a significant drop in the price of permits – from around €20 per ton in 2005 to
less than €1 per ton in 2007. With a reduction in the number of available permits, prices
recovered but have generally been trending downward since the global financial crisis,
with prices around €6 per ton in 2014. Despite allocation problems, the EU trading
system has led to emissions reductions estimated to be 8% below business-as-usual,
while having no negative effects on the overall European economy.56

56
Brown, Lucas Merrill, Alex Hanafi, and Annie Petsonk. 2012. “The EU Emissions Trading System:
Results and Lessons Learned,” Environmental Defense Fund, Washington D.C.

52
Other efforts to reduce carbon emissions are being implemented at national and local
levels. Carbon taxes have been instituted in several countries, including a nationwide
tax on coal in India (about $1/ton, enacted in 2010), a tax on new vehicles based on
their carbon emissions in South Africa (also enacted in 2010), a carbon tax on fuels in
Costa Rica (enacted in 1997), and local carbon taxes in the Canadian provinces of
Quebec, British Columbia, and Alberta that apply to large carbon emitters and motor
fuels. The U.S. state of California instituted a cap-and-trade system in 2013 for electric
utilities and large industrial facilities. The goal of the program is an annual decline in
carbon emissions of 3%.

Ultimately, climate change is a global problem that requires a global response. Each
individual country has little incentive to reduce its emissions if other countries do not
agree to similar reductions. Action to reduce climate change can be regarded as a
public good, and as we have noted, in the case of public goods the problem of free
riders means that they will not be provided effectively without collective action. In the
case of a global public good such as climate stabilization, this requires an international
agreement.

In 2014 the world’s two largest carbon emitters, China and the United States, agreed to
2030 emissions targets. This represents the first international commitment by China to
a specific emissions target (see Box 4 for more on this agreement). Yet as of this
writing (February 2015), broader international efforts to prepare a successor to the
Kyoto Protocol have not been successful. A goal has been set by the United Nations to
draft a legally-binding agreement no later than December 2015, when a major
conference on the issue will occur in Paris. Unlike the Kyoto Protocol, which only
applied to developed nations, the next treaty seeks to obtain the participation of all
nations.

53
Box 4. U.S.-China Climate Agreement

“China and the United States made common cause against the threat of climate
change, staking out an ambitious joint plan to curb carbon emissions as a way to
spur nations around the world to make their own cuts in greenhouse gases. The
landmark agreement, jointly announced by President Obama and President Xi
Jinping, includes new targets for carbon emissions reductions by the United States
and a first-ever commitment by China to stop its emissions from growing by 2030.”

It was hoped that the agreement could spur efforts to negotiate a new global climate
agreement in Paris in December 2015. A climate deal between China and the United
States, the world’s No. 1 and No. 2 carbon polluters, was seen as essential to
concluding a new global accord: “Unless Beijing and Washington can resolve their
differences, climate experts say, few other countries will agree to mandatory cuts in
emissions, and any meaningful worldwide pact will be likely to founder.”

In addition, the U.S. announced at the Group of 20 industrial powers meeting in


November 2014 that it would commit $3 billion to a new international fund to help the
world’s poorest countries respond to the effects of climate change.

Although these developments were positive steps in the long and tortuous path
towards global action on climate, many hurdles remained to be surmounted. India,
another major developing nation, has indicated unwillingness to make any
commitments that might impeded its economic growth. Nonetheless, indications that
the U.S. and China are prepared to lead the way struck a more positive note in the
run-up to the 2015 Paris talks

Sources: Mark Landler, “U.S. and China Reach Climate Accord after Months of Talks,” New York
Times, November 11, 2014; Coral Davenport and Mark Landler, “U.S. to give $3 billion to climate fund
to help poor nations, and spur rich ones,” New York Times, November 14, 2014.

54
KEY CONCEPTS

Biofuels: fuels derived from recently-living biological sources, normally plant matter.

Bycatch: fishery catch that is discarded because it is undersized or non-marketable.

Climate change: changes in the earth’s climate, such as warmer average temperatures
and shifting precipitation patterns, attributed to either natural or human causes

Common property resources: a resource that is not subject to private ownership and
is available to all, such as a public park or the oceans.

Consumer surplus: the benefits consumers receive from a product in excess of the
amount they pay for it.

Contingent ranking: a survey method whereby respondents are asked to rank a list of
alternatives.

Contingent valuation: an economic tool that uses surveys to question people


regarding their willingness to pay for a good or service such as the preservation of
hiking opportunities or air quality.

Cost of illness method: an approach for valuing the negative impacts of pollution by
estimating the cost of treating illnesses caused by the pollutant.

Cost-benefit analysis: a tool for policy analysis that attempts to monetize all the costs
and benefits of a proposed action to determine the net benefit.

Cost-effectiveness analysis: a policy tool that determines the least-cost approach for
achieving a given goal.

Defensive expenditures approach: a pollution valuation methodology based on the


expenditures households take to avoid or mitigate their exposure to a pollutant.

Discount rate: the annual rate that future benefits or costs are discounted relative to
current benefits or costs.

Discounting: the concept that future benefits or costs should not count as much as
current benefits or costs.

Ecolabeling: a label on a good that provides information concern the environmental


impacts that resulted from the production of the good.

Ecological economics: a economic perspective that views the economic system as a


subset of the broader ecosystem and subject to biophysical laws.

55
Economic efficiency: an allocation of resources that maximizes net social benefits;
perfectly competitive markets in the absence of externalities are efficient.

Ecosystem services: beneficial services provided freely by nature such as flood


protection, water purification, and soil formation.

Environmental economics: economics that applies the techniques of economic


analysis, such as valuation and cost-benefit analysis, to environmental and resource
issues.

Excludable: the characteristic goods where use of the good by one person exludes the
potential for use by others.

Externalites: effects of market transactions that change the utility, positively or


negatively, of those outside of the transaction.

Free rider: someone who avoids paying for a resource when the benefits they obtain
from the resource are unaffected by whether they pay; results in the undersupply of
public goods.

Greenhouse gases: gases such as carbon dioxide and methane whose atmospheric
concentrations influence global climate by trapping solar radiation.

Human capital: the knowledge, skills, and abilities of the labor force, reflecting
investments in education and training.

Individual transferable quotas (ITQ’s): tradable rights to harvest a resource, such as


a permit to harvest a particular quantity of fish.

Inherent value: the value of an organism, species, habitat, or other natural system
independent of its economic value.

Lower-bound estimate: an economic estimate that provides the lowest possible value
for some cost or benefit.

Malthusian hypothesis: the theory proposed by Thomas Malthus in 1798 that


population would eventually outgrow available food supplies.

Marginal benefits: the benefits of producing or consuming one more unit of a good or
service.

Marginal costs: the costs of producing or consuming one more unit of a good or
service.

Market equilibrium: the market outcome that results from the interaction of supply and
demand, i.e., the point where the supply and demand curves intersect.

56
Market-based approaches: economic regulations that create market incentives for
behavioral change among participants (buyers and sellers), including taxes and tradable
permits.

Maximum sustainable yield: the maximum quantity of a natural resource that can be
harvested annually without depleting the stock or population of the resource.

Natural capital: the available endowment of land and resources including air, water,
soil, forests, fisheries, minerals, and ecological life-support systems.

Negative externalities: harmful side effects, or unintended consequences, of economic


activity that affect persons, or entities (such as the environment) that are not among the
economic actors directly responsible for the activity.

Nonexcludable: a characteristic of goods where the one person’s use of the good does
not prohibit others from using the good also.

Nonmarket valuation: economic valuation of goods and services not traded in


markets.

Nonrival: goods that can be used by more than one user at a time.

Nonuse benefits: benfits people obtain without actually using a resource; nonuse
benefits include existence and bequest values.

Pigovian tax: a per-unit tax set equal to the external damage caused by an activity,
such as a tax per ton of pollution emitted equal to the external damage of a ton of
pollution.

Polluter pays principle: the view that those responsible for pollution should pay for the
associated external costs such as health costs and damage to wildlife habitats.

Positive externalities: the positive impacts of a market transaction which affect those
not involved in the transaction.

Precautionary principle: the view that policies should account for uncertainty by taking
steps to avoid low-probability but catastrophic events.

Present value: the current value of a steam of future costs and/or benefits; a discount
rate is used to convert future costs and/or benefits to present values.

Price volatility: large or frequent changes in the price of a good or service.

Produced capital: productive physical resources that are manufactured by humans,


such as buildings, roads, and computers.

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Producer surplus: the excess (summed over all the sellers in a market) of the amounts
sellers actually receive, over the amounts that would make them just willing to supply
the good or service.

Public goods: goods that are available to all (non-exclusive) and whose use by one
person does not reduce their availability to others (non-rival).
Renewable resources: resources that are supplied on a continuing basis by
ecosystems; renewable resources such as forests and fisheries can be depleted
through exploitation.

Replacement cost methods: an approach to measuring environmental damages that


estimates the costs necessary to restore or replace the resource, such as applying
fertilizer to restore soil fertility.

Revealed preference methods: methods of economic valuation based on market


behaviors, including travel cost models, hedonic pricing, and the defensive expenditures
approach.

Rival: goods whose use is limited to one user at a time.

Slash-and-burn agriculture: agricultural production technique where existing


vegetation is cut then burned to allow for the planting of crops, typically at a subsistence
level.

Social marginal benefits: the additional benefits obtained by everyone in society by


the provision of an additional unit of a good or service.

Social marginal costs: the additional costs that must be borne by all members of
society associated with the production of an additional unit of a good or service.

Stated preference methods: economic valuation methods based on survey responses


to hypothetical scenarios, including contingent valuation and contingent ranking.

Strong sustainability: the view that natural and human-made capital are generally not
substitutable and, therefore, natural capital levels should be maintained.

Subsidy: government assistance to an industry or economic activity; subsidies can be


direct, through financial assistance, or indirect, through protective policies.

Total economic value: the value of a resource considering both use and non-use
values.

Tradable pollution permits: tradable permits that allow a firm to emit a certain quantity
of a pollutant.

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Tragedy of the commons: the tendency for common property resources to be over-
exploited because no one has an incentive to conserve the resource while individual
financial incentives promote expanded exploitation.

Travel cost models: the use of statistical analysis to determine people's willingness to
pay to visit a natural resource such as a National Park or river; a demand curve for the
resource is obtained by analyzing the relationship between visitation choices and travel
costs.

Upstream tax: a tax to regulate emissions or production as near as possible to the


point of natural resource extraction.

Value of a statistical life (VSL): the willingness to pay of society to avoid one death
based on valuations of changes in the risk of death.

Weak sustainability: the view that natural capital depletion is justified as long as it is
compensated for with increases in human-made capital; assumes that human-made
capital can substitute for most types of natural capital.

Willingness to pay principle: the maximum amount of money people are willing to pay
for a good or service that increases utility.

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DISCUSSION QUESTIONS
1. Which definition of sustainability, strong or weak, do you think is the most
appropriate? Based on the material discussed in this module, how would you
quantitatively measure whether your preferred definition of sustainability is being
achieved?

2. Explain in your own words why an unregulated market outcome will not be
economically efficient in the presence of a negative externality. Then explain how
the market can achieve efficiency through the internalization of the externality.

3. Discuss how the global atmosphere can be considered a common property


resource. Do you think the atmosphere is suffering from the tragedy of the
commons? If so, what policy solutions would you recommend?

4. Do you think contingent valuation produces valid economic estimates of the benefits
of environmental resources? Can you think of ways to ask contingent valuation
questions in order to improve the validity of the responses?

5. What do you think is the main advantage of cost-benefit analysis? What do you
think is its main disadvantage? Do you think cost-benefit analysis should be the
basis for choosing environmental policy options? Why or why not?

6. List the main advantage and main disadvantage of each of the four environmental
policy options discussed in this module: pollution taxes, tradable pollution permits,
pollution standards, and technology-based regulation. Then for each of the four
options discuss one pollution scenario for which you think it would be the best policy
option to regulate pollution.

7. Do you think a carbon tax or a tradable permit system is the best approach for
regulating the emissions of greenhouse gases? Explain your choice.

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