Sunday, June 24, 2007


July 24, 2007

The environment and economic activity

Mankind's economic activity - the production and consumption of goods and services - adversely affects the natural environment in many ways. It causes pollution, the using up of natural resources and the endangering of species. Linked with mankind's economic activity as a cause of environmental damage is the growth in the human population. More people mean more disturbance to the natural environment.

Economic activity will have a damaging effect on the environment no matter what system is used to organise that economic activity, whether it be a market system, command system or traditional system. However, since our economy is organised using the market system, we will focus on the way a market system affects the environment.

Economic arguments for preservation of the environment

There are four main economic arguments in favour of the preservation of the natural environment:
1) environmental assets. Environmental assets (such as clean air, clean water, attractive views, native species and fish in the sea) are just as much economic resources as the resources on which economics traditionally focuses: land, labour, capital and enterprise. Environmental assets are used in the process of production and consumption and are scarce (in limited supply). They are not 'free goods' because they can be used up. (Note: air can't be used up, but clean air can be.) If environmental resources can be used up, they should not be used wastefully, but used with economy ie allocated to their most efficient use. The main difference between traditional economic resources and environmental assets is that traditional economic resources have clearly defined private property rights, whereas environmental assets are common property. The price mechanism (and economic analysis) has difficulty coping with resources that are common property (ie market failure), but this isn't a reason to ignore environmental assets.

2) satisfaction of wants. The goal of economics is to maximise the satisfaction of the community's wants. It's clear that, as well as its material wants (more goods and services), the community has environmental wants (eg clean air and water, attractive views and the preservation of species). If economics ignores environmental wants because the market mechanism finds it hard to cope with them, it will not help maximise the community's satisfaction. It seems that, as the community's material standard of living rises, the value it places on environmental wants ('quality of life') increases.

3) environmental feedback. Much economic activity depends on the preservation of the environment eg effect of environmental damage on tourism; effect of land degradation on farming; effect of water quality on commercial fishing; over-harvesting of fish. As well, some environmental damage generates private costs eg double-glazing of windows to reduce noise pollution.

4) inter-generational equity. Much environmental damage is irreversible (eg clearing of land, building dams, destruction of native forests and extinction of species) and some resources are non-renewable. Current economic activity has implications for the environmental inheritance of future generations.

Economic arguments against preservation of the environment

There are three main economic arguments against preservation of the environment:
1) opportunity cost. Just as some material wants may only be satisfied at the expense of others, so some environmental wants may only be satisfied at the expense of some material wants. This is the correct way to express alleged economic arguments against environmental protection eg banning the logging of native forests will 'destroy jobs'; banning mining in national parks will 'harm the balance of payments'. A higher 'quality of life' may well involve a lower material standard of living. This is not a problem as long as the community understands the consequences of the choices it makes.

2) distributional implications. The costs and benefits of environmental protection may not be shared equally across the community. eg the people who gain most satisfaction from protecting native forests may not be the same people who lose their jobs.

3) the value of labour. Economists seek to make the most economical use of all resources, including man-made capital and labour. But environmentalists are concerned to make the most economical use (or even minimum use) of only natural resources, including energy. Implicitly, they attach little value to capital and labour. Because of the high cost of capital and labour, the market (and market-based intervention) will not produce as much recycling and avoidance of waste of raw materials as environmentalists desire.

Conflict between economic growth and environmental protection

The mainstream economists' view is that there is a conflict between man's desire to increase his material standard of living (ie produce more goods and services) and his desire to preserve the environment. The conflict arises because resources are scarce but wants are infinite. The opportunity cost of faster economic growth is more damage to the environment; the opportunity cost of less damage to the environment is slower economic growth.

There is, however, an exception to this general proposition: instances of government failure. Underpricing of publicly owned resources (eg forests, minerals) and underpricing of publicly provided services (eg electricity and water) can cause misallocation of resources and faster depletion of natural resources or unwarranted environmental damage (eg land degradation through irrigation; need to build more dams).

This is not to say that we face a mutually exclusive choice between either economic growth or environmental protection. It means the community must decide what trade-off it wants to make, what balance it wishes to strike, between these two valid, but conflicting, objectives. Economists are very familiar with trade-offs between conflicting objectives - which is why they developed the concept of opportunity cost.

Normally, the community determines the trade-off it desires between conflicting objectives in the market place via the price mechanism. It votes with its dollars. However, in the case of the conflict between economic growth and environmental protection, the market mechanism is not very effective in providing the community with the trade-off it desires. This is because environmental assets are common property rather than private property. Economic activity generates environmental externalities for third parties which those third parties lack the property rights to do anything about. This market failure means governments have to intervene in the market to ensure that the community's desired trade-off between economic growth and environmental protection is achieved. However, the political process by which governments seek to implement the community's preferences is an imperfect one where the true opportunity costs of choices may not be understood by the community.

Government policies to preserve the environment

Government policies to preserve the environment can be divided into two broad classes: command and control measures and economic instruments.

Command and control. In practice, most environmental intervention takes the form of legislation to prohibit or limit undesirable emissions and other activities. Local government zoning regulations limit polluting activities to certain areas, generally away from residential areas. State environment protection agencies set emission standards and rules for the disposal of waste and prosecute firms which fail to comply.

To the public, politicians and many environmentalists, regulation is the obvious way to respond to environmental problems. Regulation deals with the problem directly.
However, while economists accept that regulation and prohibition may be the only practical responses in some circumstances, they believe that, generally, regulation will not produce the best trade-off between SoL and environmental protection. This is because regulations impose costs without always creating incentives to find cheaper ways of reducing environmental damage.

Economic instruments. In our efforts to preserve the environment, economists favour the use of instruments which harness market forces to the service of the environment, believing that this will achieve the government's environmental objectives with minimum loss of economic growth. Economic instruments aim to 'internalise' externalities and, in the process, create incentives to meet environmental standards in ways that allocate resources efficiently.

Tradable permits. Governments may set an environmental standard which determines an acceptable level of emission, then award (or auction) permits to emit pollution up to the standard. Producers with low costs of controlling pollution have an incentive to do so, so they can sell part of their pollution rights to producers who face high costs of controlling pollution. The effect is to reduce the industry's overall cost of compliance with the standard. Tradable permits have an advantage over pollution taxes because the rate of emission is certain and the price of the permits uncertain, whereas with pollution taxes the rate of tax is certain and its effect on the level of emission is uncertain. Tradable permits can be used for other environmental protection, such as minimising the economic costs of limits on irrigation or fishing catches.