Economics and policy literature
Week 1
Introduction to Environmental Economics chapter 1
Economics has an important contribution to make in helping us understand and solve the many
environmental problems facing people throughout the world today. We believe strongly that an
environmental policy which does not address the economic behaviour of consumers and firms is
likely to get things badly wrong. Economic actors such as consumers and firms can be induced to take
account of their impacts on the environment, by getting the prices ‘right’. For example firms paying
for pollution.
By the economy we mean all the firms that make up industry: households in their twin roles as
consumers and suppliers of labour; governments; the institutions that govern interactions between
these groups such as markets; the state of technology; human capital. By the environment we mean
all natural resources found in the biosphere.
Economy-environment interactions
The environment provides the economic system with inputs of raw material and energy resources
(non- and renewable). The economy uses the environment as a waste sink through many forms.
Next, the environment provides households with a direct source of amenity (impacts on well-being).
Finally, the environment provides the economic system with basic life-support services. These are
ecosystem function that produce a number of services, which contribute directly to people’s well-
being:
- Provisioning services
o Carbon sequestration and storage: less spending needed on other greenhouse gas
control
o Food provision
o Genetic resources and chemical compounds
- Regulating services
o Biological control
o Waste absorption and detoxification
- Cultural services
o Aesthetic and spiritual
o Bequest and existence
o Scientific and educational
- Intermediate services
o Biologically mediated habitat
o Nutrient cycling
o Resilience and resistance
o Water circulation and exchange: avoided flooding damages to nearby houses
Ten key insights between the interaction of economy and environment
1) Economic and environmental systems are determined simultaneously. Both have to incorporate
each other functions
2) The behavioural underpinnings of economics matter for environmental policy: people/firms
respond to incentives and the most important incentive tends to be prices. Further people/firms
, try to balance out the costs and benefits before taking decisions. And finally people/firms want
to maximize interest (utility)
3) Environmental resources are scarce, and using them in one way has an opportunity cost. For
instance economic growth gives rise to a series of environmental consequences
4) Co-evolution, meaning that the way in which the economic subsystem evolves over time
depends on the changing conditions of the environmental subsystem
5) The free market system can generate wrong level of environmental quality: the system of
property rights in existence means that no market price exists to discourage pollution or to
encourage to produce environmental benefits known as market failure
6) Markets can also be made to work for the environment: tradable pollution permits
7) Government intervention does not always make things better and can make things worse
(Common Agricultural Policy of the EU)
8) Environmental protection costs money: scarcity means that opportunity costs exist for all
choices, even those driven by moral imperatives
9) When managing renewable resources, choosing the maximum sustainable yield as the best level
is rarely optimal: because it ignores the economic costs and benefits of renewable resource
management (e.g. catching fish at the maximum sustainable yield results in too many boats
chasing too few fish)
10) Many of the world’s most serious environmental problems are global in nature, however getting
countries to economically agree to do something about these problems is very hard. Because
countries have an incentive to ‘free-ride’
Ecosystem functions as services that contribute indirectly to people’s well-being
Economists are interested in the flow of values (benefits) that people derive from these ecosystem
services, both now and in the future
Introduction to Environmental Economics chapter 2
Markets allow us to trade and we use them every day. Economist view the market as a tool people
use to create value through trade, or the voluntary exchange of goods and services regulated by
competition. Markets arise spontaneously because people have incentive to find opportunities to
,create value through trading in scarce resources. Wealth is created when resources move from low-
value to high-value uses. Market prices send signals about value: about what people want to buy and
sell; how much of the good exists today and into the future; it reflects the trade-offs people face.
Markets fail too, when prices send inaccurate signals, or when markets are too costly to construct.
Furthermore, market prices mis-state the economic value in relation to an environmental threat.
Often a wedge is driven between what people want as an individual and what society wants as a
collective. Still, society can fix existing markets or create new markets to manage our environment.
For example the cap-and-trade system for pollution, where buyers and sellers trade the right/permit
to pollute.
Power of markets
The power of markets rests in the decentralized process of decision-making and exchange, due to
specialization and comparative advantage – producing something at a lower opportunity cost than
others. The succession of this value creating process is referred to as market efficiency – trade in
which at least one person is better off and no one else is worse off (pareto efficiency). The key to an
efficient market is to have a system of well-defined property rights – it represents a set of
entitlements that define the owner’s privileges and obligations for use of a resource/asset. Property
rights are based on 4 characteristics, in which gains from trade are created:
- Comprehensive: all resources privately or collectively owned
- Exclusive
- Transferable: owner has incentive to conserve the resource
- Secure: security incentivises the owner to improve and preserve a resource
Market failure
Markets fail to protect the environment for four reasons: externalities, public goods, open access
common property and hidden information.
Market failure occurs when:
- Trade does not attain the highest social value, because there is too little or too much trade
- Free trade exacerbates perceived social inequalities (rich get richer while poor poorer) or
undermines social order within a country
- For environmental protection, when citizens and firms pollute such that people face health
risks
- When private citizens or firms o not produce the public goods society wants because free-
riding is possible
- When property rights are weak or non-existent: private actions do not align with collective
goals (or society does not define property rights)
o If every owns the right to clean air and biodiversity, then nobody owns the rights and
which private actor will step up to provide it
- When hidden actions or types do not send the right signals
Government intervention failure: the Common Agricultural Policy
Known as the CAP, it offered EU farmers higher output prices than the free market would actually
generate. The official reasons given were to support farm incomes, stabilize crop prices and increase
self-sufficiency rates for major food products. Farmers responded to higher prices by increasing
, output, by cultivating more land and increasing the intensity of production on all farmland. The most
important effects were:
- A 50-60% loss in lowland heaths
- A 95% loss in herb-rich flower meadows
- An 80% loss in chalk grasslands of high ecological value
Market incentives for environment protection
Governments and people can create new markets and revised market prices to capture non-market
values currently missing from existing markets. These market-based policies for environmental
protection are an alternative for technocratic dictates or stakeholder processes, which have their
own set of successes and failures. There are three ways of how we use markets to help protect the
environment:
- Coasean bargaining: defining property rights for the environment and setting up a market to
bargain over the relative mix of pollution and clear air
- Pigovian taxation: setting green taxes or subsidies that reflect economic values for
environmental protection
- Marketable permits (cap-and-trade): creating a fixed number of permits to pollute and
letting people buy and sell these permits in a market setting
Coasean Bargaining
The notion of property rights stresses that legal rules should be considered within economics when
addressing how to correct market failures like a pollution externality. If person B lived downstream
from person A and person A polluted the water supply of person B. In this scenario the property
rights to either polluting or clean water can be assigned. The two persons can bargain until they find
a mutually agreeable solution. One can have the right to pollute and sell the other clean water rights,
or vice versa. The outcome would be a win-win -- a decentralized process (market for pollution) that
allows the persons to buy and sell either the right to pollute or clean water. One key presumption is
that there are no cost of negotiation/zero transaction costs.
Green Taxes/ Pigovian Tax
A green tax puts a price on the non-market damages caused by pollution. It reflects the non-market
social damage missed by the marketplace. The tax changes a person’s consumption decisions
because pollution now has a price. Changes prices to reflect social damages can change behaviour. It
can also result in a Double Dividend: 1) when a green tax reduces the amount of pollution emitted;
and 2) when the revenues raised by the taxes are used to offset distortionary taxes, such as income.
However, the green tax comes at a cost as it increases market prices, which increases the cost of
living. Biggest advantage of taxes is that firms have more incentive to invest in cleaner, greener
technology than under regulation.
Marginal Abatement Cost (MAC): a novel idea on green tax
Abetement costs are the price to reduce emissions. Polluters can reduce emissions by several
alternative means: 1) installing end-of-pipe treatment plants; 2) changing their production processes
– for example by using cleaner inputs or recycling waste; and 3) reducing output: the additional cost
to reduce emissions increases if the firm cuts back on its emissions.
Cap-and-Trade
