Markets and the Environment, Second Edition

Nathaniel O. Keohane, Sheila M. Olmstead

• Publisher: Island Press
• Year: 2016
• ISBN:
  9781610916080
• Topic: Negocios y empresa
• Subtopic: Negocios en general

A clear grasp of economics is essential to understanding why environmental problems arise and how we can address them. So it is with good reason that Markets and the Environment has become a classic text in environmental studies since its first publication in 2007. Now thoroughly revised with updated information on current environmental policy and real-world examples of market-based instruments, the primer is more relevant than ever.The authors provide a concise yet thorough introduction to the economic theory of environmental policy and natural resource management. They begin with an overview of environmental economics before exploring topics including cost-benefit analysis, market failures and successes, and economic growth and sustainability.Readers of the first edition will notice new analysis of cost estimation as well as specific market instruments, including municipal water pricing and waste disposal. Particular attention is paid to behavioral economics and cap-and-trade programs for carbon.Throughout, Markets and the Environment is written in an accessible, student-friendly style. It includes study questions for each chapter, as well as clear figures and relatable text boxes. The authors have long understood the need for a book to bridge the gap between short articles on environmental economics and tomes filled with complex algebra. Markets and the Environment makes clear how economics influences policy, the world around us, and our own lives.

1

Introduction

This book is a primer on the economics of the environment and natural resources. The title, Markets and the Environment, suggests one of our central themes. An understanding of markets—why they work, when they fail, and what lessons they offer for the design of environmental policies and the management of natural resources—is central to an understanding of environmental issues. But even before we start thinking about how markets work, it is useful to begin with a more basic question: What is environmental economics?

Economics and the Environment

“Environmental economics” may seem like a contradiction in terms. Some people think that economics is just about money, that it is preoccupied with profits and economic growth and has nothing to do with the effects of human activity on the planet. Others view environmentalists as being naive about economic realities or “more concerned about animals than jobs.”

Of course neither stereotype is true. Indeed, not only is “the environment” not separate from “the economy,” but environmental problems cannot be fully understood without understanding basic economic concepts. Economics helps explain why firms and individuals make the decisions they do—why coal (despite generating significant local air pollution and carbon dioxide emissions) still generates almost 40 percent of electricity in the United States, or why some people drive large sport utility vehicles instead of Priuses. Economics also helps predict how those same firms and individuals will respond to a new set of incentives—for example, what investments electric utilities will make in a carbon-constrained world and how high gas prices would have to rise before people stopped buying enormous cars.

At its core, economics is the study of the allocation of scarce resources. This central focus, as much as anything else, makes it eminently suited to analyzing environmental problems. Let’s take a concrete example. The Columbia and the Snake Rivers drain much of the U.S. Pacific Northwest, providing water for drinking, irrigation, transportation, and electricity generation and supporting endangered salmon populations. All these activities—including salmon preservation—provide economic benefits to the extent that people value them.

If there is not enough water to meet all those needs, then we must trade off one good thing for another (less irrigation for more fish habitat, for example). How should we as a society balance these competing claims against each other? To what lengths should we go to protect the salmon? What other valued uses should we give up? We might reduce withdrawals of water for agricultural irrigation, remove one or more hydroelectric dams, or implement water conservation programs in urban areas. How do we assess these various options?

Economics provides a framework for answering these questions. The basic approach is simple enough: Measure the costs and benefits of each possible policy, including a policy of doing nothing at all, and then choose the policy that generates the maximum net benefit to society as a whole (that is, benefits minus costs). This is easier to say than to do, but economics also provides tools for measuring costs and benefits. Finally, economic theory suggests how to design policies that harness market forces to work for rather than against environmental protection.

To illustrate how economic reasoning can help us understand and address environmental problems, let’s take a look at perhaps the most pressing environmental issue today: global climate change.

Global Climate Change

There is overwhelming scientific consensus that human activity—primarily the burning of fossil fuels and deforestation caused by agriculture and urbanization—is responsible for a sharp and continuing rise in the concentration of carbon dioxide (CO₂) and other heat-trapping gases in the earth’s atmosphere. The most direct consequence is a rise in average global surface temperatures, which is why the phenomenon is known widely as global warming. (Globally averaged surface temperatures have already increased by 0.85°C, or about 1.5 degrees Fahrenheit, since the late nineteenth century.)¹ But the consequences are much broader than warming, which is why the broader term climate change is more apt. Expected impacts (many of which are already measurable) include sea level rise from the melting of polar ice caps; regional changes in precipitation; the disappearance of glaciers from high mountain ranges; the deterioration of coastal reefs; increased frequency of extreme weather events such as droughts, floods, and major storms; species migration and extinction; and spatial shifts in the prevalence of disease. The worst-case scenarios include a reversal of the North Atlantic thermohaline circulation, better known as the Gulf Stream, which brings warm water northward from the tropics and makes England and the rest of northern Europe habitable. Although there has been much international discussion about the potential costs and benefits of taking steps to slow or reverse this process, little progress has been achieved.

What are the causes of climate change? A natural scientist might point to the complex dynamics of the earth’s atmosphere—how CO₂ accumulating in the atmosphere traps heat (the famous greenhouse effect) or how CO₂ gets absorbed by ocean and forest sinks. From an economic point of view, the roots lie in the incentives facing individuals, firms, and governments. Each time we drive a car, turn on a light, or use a computer, we are indirectly increasing carbon emissions and thereby contributing to global climate change. In doing so, we impose a small cost on the earth’s population. However, these costs are invisible to the people responsible. You do not pay for the carbon you emit. Nor, indeed, does the company that provides your electricity (at least if you live in most of the United States) or the company that made your car. The result is that we all put CO₂ into the atmosphere, because we have no reason not to. It costs us nothing, and we receive significant individual benefits from the energy services that generate carbon emissions.

Economics stresses the importance of incentives in shaping people’s behavior. Without incentives to pay for the true costs of their actions, few people (or firms) will voluntarily do so. You might think at first that this is because the “free market” has prevailed. In fact, that gets it almost exactly backward. Very often, as we shall see in this book, the problem is not that markets are so pervasive but that they are not pervasive enough—that is, they are incomplete. There is simply no market for clean air or a stable global climate. If there were, then firms and individuals who contributed to climate stabilization (by reducing their own carbon emissions or offsetting them) would be rewarded for doing so, just as firms that produce automobiles earn revenue from selling cars. This is a key insight from economics: Many environmental problems would be alleviated if proper markets existed. Because those markets usually don’t arise by themselves (for reasons we shall discuss later on in the book), governments have a crucial role in setting them up—or in creating price signals that mimic the incentives a market would provide.

If this is such a problem, you may have asked yourself, why haven’t the world’s countries come together and designed a policy to solve it? After all, the consequences of significant climate change may be dire, especially for low-lying coastal areas and countries in which predicted changes in temperature and precipitation will marginalize much existing agricultural land. If you have been following the development of this issue in the global media, and you know of the difficulty experienced by the international community in coming to agreement over the appropriate measures to take in combating climate change, it will not be terribly surprising that economics predicts that this is a difficult problem to solve. Carbon emission abatement is what economists would call a global public good: Everyone benefits from its provision, whether they have contributed or not. If a coalition of countries bands together to achieve a carbon emission abatement goal, all countries (including nonmembers of the coalition) will benefit from their efforts. So how can countries be induced to pay for it if they will receive the benefit either way? This is a thorny problem to which we will return in later chapters.

As a starting point, we must understand just what the benefits of carbon emission abatement are. They may be obvious to you. Put simply, slowing climate change can help us avert damages. For example, rising seas may inundate many coastal areas. If it is possible to slow or reverse this process, we might avoid damages including the depletion of coastal wetlands, the destruction of cultural artifacts, and the displacement of human populations. Warming in Arctic regions may lead to the extinction of the polar bear and other species; the benefits from slowing or reversing climate change would include the prevention of this loss. Climate change may exacerbate local pollution (such as ground-level ozone) and boost the spread of disease (such as malaria in the tropics and West Nile virus in North America); we would want to measure the benefits from avoiding those damages as well. Policies to mitigate climate change may also bring “co-benefits,” as when a shift away from burning fossil fuels results in lower levels of local and regional air pollution from sulfur dioxide or particulate matter.

All these benefits (even the intangible ones such as species preservation) have economic value. In economic terms, their value corresponds to what people would be willing to pay to secure them. Measuring this value is easy when the losses are reflected in market prices, such as damages to commercial property or changes in agricultural production. But economists also have developed ways to measure the benefits of natural resources and environmental amenities that are not traded in markets, such as the improvements in human health and quality of life from cleaner air, the ecosystem services provided by wetlands, or the existence value of wilderness.

The economic cost of combating global climate change, meanwhile, is the sum of what must be sacrificed to achieve these benefits. Economic costs include not just out-of-pocket costs but also (and more importantly) the forgone benefits from using resources to slow or reverse climate change rather than for other objectives. Costs are incurred by burning cleaner but more expensive fuels or investing in pollution abatement equipment; by changing individual behavior, say by turning down the heat or air conditioning; by sequestering carbon in forests, oceans, depleted oil reservoirs, and other sinks; and by adapting to changing climatic conditions, for example by switching crops or constructing seawalls. Costs arise from directing government funds for research and development into climate-related projects rather than other pursuits. And of course the implementation, administration, monitoring, and enforcement of climate policy incurs some costs, as with almost any public policy.

Sound public policy decisions require an awareness of these costs and benefits and some ability to compare them in a coherent and consistent fashion. Economics provides a framework for doing so. In practice, as you will see through the theory and examples in this book, implementing the framework requires taking account of a number of other wrinkles. For example, we must worry about how to weigh near-term costs against benefits that accrue much later.

Rigorous consideration of economic benefits and costs can help answer the questions, “How much should we reduce greenhouse gas emissions in order to limit future climate change? How stringent should policies to address climate change be?” Economics can also shed light on a distinct but equally important question: “How should those policies be designed?”

For example, under the Copenhagen Accord, signed in 2009, the United States committed to reduce greenhouse gas emissions by 17 percent below 2005 levels. Although a large number of economic analyses informed the debate about this target, it was ultimately the result of political decisions rather than any explicit calculation of economic efficiency. Even so, economics can help inform the design of policies to meet the target. Emissions can be reduced in myriad ways: by requiring polluters to install and operate specific abatement technologies or to meet specific standards of performance at their facilities, by mandating tough energy efficiency standards for consumer appliances and tightening fuel economy requirements for vehicles, by levying a tax on greenhouse gas emissions, or by capping emissions and allowing emitters to trade allowances under that cap. (And that is hardly an exhaustive list!) As we will discuss at length in this book, especially in Chapters 8 through 10, both economic theory and experience provide compelling arguments for market-based policies, such as emission taxes and cap-and-trade policies, that harness market forces to achieve regulatory goals at less overall cost than traditional approaches.

In sum, economics offers quite a different approach than other disciplines to the problem of global climate change—and to a range of other environmental issues we will explore in this book. You will find that the economic approach sometimes arrives at answers that are compatible with other approaches and sometimes at answers that conflict with those approaches. Regardless of such agreement or disagreement, economics provides a set of tools and a way of thinking that anyone with a serious interest in understanding and addressing environmental problems should be familiar with.

Organization and Content of This Book

This book provides an introduction to the application of economic reasoning to environmental issues and policies. In each chapter, we draw heavily on a range of real-world examples to illustrate our points.

Chapter 2 begins by asking, “Why compare benefits and costs?” Here we introduce the central concept of economic efficiency, meaning the maximization of the net benefits of a policy to society. We illustrate the key points by discussing the abatement of sulfur dioxide at U.S. power plants, and many other examples. We introduce the key concepts of marginal costs and benefits, showing how they relate to total costs and benefits and how they inform the analysis of efficiency. We also extend the concept of efficiency to the dynamic context, in which policies are defined by streams of benefits and costs occurring over time. In doing so, we introduce the concept of discounting, the process by which economists convert values in the future to values today, and explain its usefulness in a dynamic setting.

Chapter 3 follows up on the same themes. We discuss at length how economists define and measure the costs and benefits of environmental protection. We then consider how benefit–cost analysis has been used to evaluate policies in the real world. Finally, we explore the philosophical justification for benefit–cost analysis and consider some of the most frequent criticisms lodged against its use. In particular, benefit–cost analysis focuses on the net benefits from a policy rather than its distributional consequences. Partly for this reason, economists do not advocate using a simple cost–benefit test as the sole criterion for policy decisions. Although it is a valuable source of information, benefit–cost analysis is just one of a number of tools to use in assessing policies or setting goals.

We then turn our attention more explicitly to markets: how they function, what they do well and what they do poorly, and how they can be designed to achieve desirable outcomes. We begin Chapter 4 with a key insight from economics: Under certain conditions, competitive markets achieve efficient outcomes. That is, they maximize the net benefits to society from the production and allocation of goods and services. This is a powerful result, and it helps explain the wide appeal of markets. It also aids understanding of the root causes of environmental problems: To an economist, they stem from well-defined failures in how unregulated markets incorporate environmental amenities. Moreover, it lays the groundwork for designing policies that rely on market principles to promote environmental protection.

The notion of “market failure” is the focus of Chapter 5. We discuss three ways of framing the types of market failure most common in the environmental realm: externalities, public goods, and the tragedy of the commons. In each case we offer a range of motivating examples. We then unify the discussion by showing how each of the three descriptions of market failure captures the same underlying divergence between individual self-interest and the common good.

In Chapter 6, we apply the concept of dynamic efficiency to the problem of the optimal rate of extraction of a nonrenewable natural resource, such as petroleum. We define scarcity in economic terms, which leads naturally to the concept of rent, the extra economic value imparted by scarcity. We illustrate the underlying similarities between nonrenewable resources and other capital assets and emphasize the powerful market incentives that encourage private owners of nonrenewable resources to account for scarcity in their extraction decisions.

Chapter 7 applies the same reasoning to two renewable resources, forests and fish. We develop bioeconomic models to demonstrate the efficient level of fishing effort and the efficient rotation period for a forest stand, both graphically and conceptually. In both cases, we include noncommercial benefits in an economic approach to efficient use of the resource.

Chapter 8 discusses the design of policies to overcome market failures in the provision of environmental amenities and the management of natural resources. We start by considering a central debate in economics: Should the government intervene to solve market failures? After satisfying ourselves that the answer is yes, a...