The Economic Approach to Environmental and Natural Resources, 3e

Theory and Tools of Environmental and Resource Economics 3e Part I

Introduction • This chapter examines the relationship between the environment and the aggregate economy. • The conceptual discussion of the interrelationship between the environment and the macro economy began early in the development of the field of environmental economics. • Boulding (1966) made an analogy of the earth to a spaceship and stressed that our activities were constrained by our endowment of resources and the ability of environmental systems to assimilate wastes.

Conceptual Model of the Environment and the Economy • There are two different ways of conceptualizing the relationship between the economy and the environment. • One is to examine the relationship between the environment and individual actors and then aggregate up to effects on the total system. • A second is to view the economy and the environment as two interwoven systems, where the economic system is embedded in the larger earth system. • Which is correct depends on the issue of concern.

Interwoven Systems

The Impact of the Environment on Economic Productivity • There are three basic mechanisms by which the environment and environmental policy affect economic productivity. • One has to do with the impact of environmental regulations on productivity. • The other two have to do with the impact of environmental quality on economic productivity.

The Negative Impact of Environmental Regulations • Environmental policy forces firms to make decisions that are in the social interest, but not in their private interest. • This process of “internalizing an externality” increases the firm’s costs. • More importantly, the resources used to reduce pollution can not be used to produce economic outputs. • This will have a negative impact on GDP, especially if environmental goals are achieved through direct controls.

The Positive Impacts of Environmental Quality on Economic Productivity • A positive impact on economic productivity can occur in two different ways. • First, environmental resources are used in production processes. • Cleaner resources are more productive resources. • Second, environmental quality impacts the productivity of other inputs. • Reduced air pollution increases yield per acre of many crops.

The Positive Impacts of Environmental Quality on Economic Productivity • Important benefits can also be found through the impact on health and health care. • If the population is healthy because they have cleaner air and water, fewer resources will need to be devoted to health care. • Also, if the health care industry is characterized by increasing average costs, then a reduction in need for health care should also lead to a reduction in the average costs of health care. • Ecological services such as biodiversity, nutrient cycling, and maintenance of hydrological cycles and other services also have an important impact.

Which Effect Dominates? Theoretically this could be measured by estimating the following equation: GDP = f(L1,K1,EQ(GDP,L2,K2)), • Where: • L1 is the amount of labor used to produce GDP; • K1 is the amt. of capital directly used to produce GDP; • EQ is the level of environmental quality; • L2 is the labor used to reduce emissions, and • K2 is the capital used to reduce emissions. • Unfortunately none of the current empirical studies has attempted to measure this relationship, primarily because it is hard to identify one variable to represent environmental quality.

Which Effect Dominates? • Lack of the ability to include a comprehensive environmental measure has shaped empirical studies. • Most focus on the negative impacts. • Examples include Jorgenson and Wilcoxen study which estimated that the environmental regulations had reduced GDP by 2.592%. • Gillis et al. attempted to incorporate potential positive impacts through the computation of a general equilibrium model which included the health benefits of air quality regulations. • This study found that GDP is approx. 2% higher with air quality regulations than it would have been without the regulations.

Can Environmental Policy Make the Economy Stronger? • Michael Porter argues that stricter environmental policies require firms to cut waste, increase efficiency with which energy is used, and result in improved, more efficient technologies and can lead to reduced production costs. • Porter argues that improved efficiencies can lead to more competitive firms and greater strength in global competition.

Can Environmental Policy Make the Economy Stronger? • If stricter environmental laws lead to increased advantages in global competition, why don’t firms lobby for these laws? • Simpson (1993) argues that it is important to consider what happens to variable and fixed costs with stricter environmental laws. • New regulations may require new equipment which increases fixed costs even though this equipment may lead to production efficiencies which lower variable costs.

Can Environmental Policy Make the Economy Stronger? • While some would argue that inefficiencies and short-sightedness are barriers to adoption, it is difficult to imagine that this oversight would occur on a systematic basis and that firms would not pursue profit maximizing choices. • It is possible that firms would not pursue research into new technologies if there is not a way to protect (patent) the technology to assure a level of return on investment. • In addition, where the adoption of a new technology is associated with an uncertain outcome, it may pay to be a follower and not a leader in changing production technologies.

The Impact of the Economy on the Environment • Herman Daly argues that it is not enough to impose a pollution tax to protect the environment if the number of polluters keep growing. • He suggests that policy-makers need to consider limits to the amount of economic activity. • A counter argument is that it is not the amount of economic activity that matters, but the nature of the economic activity. • Policy could and should focus on both.

The Impact of the Economy on the Environment • One perspective argues that as the economy grows and per capita income increases, environmental quality will increase because demand for environmental quality will increase. • An “Environmental Kuznets Curve” (EKC) has been hypothesized, based on the Kuznets Curve from development literature, which argues that low-income countries have little detrimental impact on the environment because of their relatively low level of economic activity. • This impact increases with a rise in income and then, as the economy grows beyond a certain point, policies are enacted to protect the environment. • The conclusion is growth in income will lead to improved environmental quality.

Is there evidence of an EKC? • The World Bank (1992) and Shafik(1994) looked at data and found empirical evidence that supported the hypothesis. • The study looked at air pollution as a measure of environment quality and examined this as a function of per capita income. • The work showed an inverse U-shaped relationship existed.

Is there evidence of an EKC?

Is there evidence of an EKC? • Others have argued that one important problem with the WB/Shafik studies is that studies based on air pollution do not generalize well to total environmental quality. • Conventional air pollutants do not represent an environmental problem that accumulates over time. • Air pollution is not as damaging to environmental services as other types of problems. • Rothman(1998) argued that the environmental impacts should be measured not on goods produced, but on the goods consumed. This would pick up imported goods and associated pollution problems in developing countries. • A final problem is that income measurements may be flawed because of the failure to include loss of environmental capital.

GDP, Sustainability and Environmental Quality • Does growth in current income deplete future income producing capability? • What is meant by sustainable growth? • Figure 6.6 presents three growth paths originally defined by Pezzey (1989) and further discussed by Pearce and Warford (1993). • While these, as defined by the authors, pertain to social welfare, it is possible to view GDP the same way.

GDP, Sustainability and Environmental Quality

GDP, Sustainability and Environmental Quality • Path A is associated with initial levels of growth and degradation of the environment, which leads to lower future income potential. • Conventional techniques of economic analysis would look at the present value of this path and view it as optimal (max. current). • Path B is similar but less severe and the path remains above the minimum survivability level. • Path C is an example of sustainable growth and sustainable development. • The well-being of the current generation is improved without constraining the well-being of future generations.

The Role of Capital Accumulation in Sustainable Development • Early discussion of sustainability focused on the accumulation of artificial capital and natural capital. • Artificial capital consists of human-made structures and goods that are used to produce other goods and not consumed in the process. • Natural capital consists renewable and non-renewable natural resources such as oil, wood, coal, minerals, and fish.

The Role of Capital Accumulation in Sustainable Development • Barnet and Morse’s (1978) classic book, Scarcity and Growth, focused on whether we were running out of extractable resources and the implication for growth. • Hartwick (1993) derived an axiom know as the Hartwick Rule that suggests sustainability is possible as long as economic rents (the difference between revenue and cost of extraction) are reinvested in artificial capital. • The mathematical model used was based on the substitutability between artificial capital and natural capital in the production of an output.

The Role of Capital Accumulation in Sustainable Development • Hartwick’s work and others did not consider two important types of capital, human capital and environmental capital. • Environmental capital refers to renewable resource systems that provide a flow of ecological services. • The existence of environmental capital implies that the Hartwick rule cannot be true in the real world. • The Hartwick rule requires perfect substitutability of capital and while this may apply to human capital, artificial capital and natural capital, it does not apply to environmental capital.

The Role of Capital Accumulation in Sustainable Development • Evidence of the inability to “perfectly” substitute for environmental capital can be found by looking at the Mississippi River and the attempt to substitute human-made levees and other flood control structures for the natural wetlands (1993’s “25 year” rain caused a “100 year” flood). • Human capital couldn’t duplicate the complexity of the system. • Would it even be possible to substitute away from tropical rainforest carbon sequestration toward human engineered systems?

The Role of Capital Accumulation in Sustainable Development • Sustainable development then requires the maintenance of a certain stock of environmental capital, plus growth in other types of capital.

Environmental Taxation and Macroeconomic Benefits • Would macroeconomic benefits arise if the revenue associated with an environmental tax was used to reduce the level of income tax? • Some argue that there would be a “double dividend”. • The correction of a market failure associated with pollution externalities. • The reduction of the market distortion in the labor market created by an income tax. • Environmental taxes penalize something bad for society while income taxes penalize something that is good for society (people working). • The existence of a double dividend of environmental taxation is the subject of significant debate.

The Environment and International Economic Issues • There are several significant issues intertwined with international economic issues. These include: • The global public good nature of environmental resources, • Transfrontier pollution, • The effect of environmental policy on international competitiveness, and • The effect of international trade policy on environmental quality.

Global Public Goods • Environmental resources in one country generate public good benefits for people in other countries, or environmental resources span the borders of several countries. • Examples include rain forest and wetlands, which create public good benefits for citizens in other countries and oceans and aquifers, which span international borders. • Global public goods result in an international separation between those who benefit from environmental resources and those that bear the costs of preserving those resources.

Global Public Goods • Global optimality in preservation of these environmental resources cannot be generated without an international agreement. • The difficulty is that lower-income countries bear the cost of preserving the resources and higher income countries receive the benefits.

Transfrontier Pollution • Transfrontier pollution is pollution generated in one political jurisdiction that creates damages in another political jurisdiction. • The country that generates the pollution does not consider all the social costs when devising environmental policy, because some of the social costs are borne by other countries. • International negotiations must be conducted in order to generate the appropriate level of emissions.

Globalization, International Trade and the Environment • In recent years the movement towards more free trade and the “globalization” of economic activity has been under assault by critics. • Increasing trade has both positive and negative effects on the environment and it is difficult to ascertain which effects will dominate.

Globalization, International Trade and the Environment • Potential impacts of increasing trade include: • If increased trade increases economic activity, holding everything else constant, the increased activity will be associated with greater emissions of pollution. • Increased trade and increased income can give a country a greater ability to switch to cleaner technologies. • An increase in trade may change patterns of economic activity and change the mix of economic activity. The new mix can be either cleaner or more polluting. • Elimination of trade barriers may sweep away important environmental regulations.

The Impact of International Trade Policy on the Environment and Environmental Policy • A key provision of the General Agreement on Tariffs and Trade (GATT) is a feature designed to keep countries from developing artificial barriers to trade, which many activists believe prohibits discrimination on environmental grounds. • Article XX “authorized deviation from any GATT doctrines for measures ‘necessary to protect human, animal or plant life or health’ (XXb) or ‘relating to the conservation of exhaustible resources’ (XXg).”

The Impact of International Trade Policy on the Environment and Environmental Policy • The Appellate Body of the Dispute Resolution Understanding (WTO) has begun to develop a set of precedents related to trade-environment issues. • A series of precedents have been used. • The Tuna-Dolphin dispute between the US and Mexico involved a situation where the US implemented an embargo against Mexican tuna charging that Mexico was not taking sufficient steps to protect dolphins in the harvest tuna. The WTO ruled against the US.

The Impact of International Trade Policy on the Environment and Environmental Policy • In a separate dispute, shrimp exporting countries charged the US with unfair exclusion because the US placed an embargo on the importation of shrimp that were harvested in a fashion that led to sea turtle mortality. • The Appellate Body recognized that the protection of sea turtles anywhere in the world represents a legitimate environmental concern. • After an initial ruling against the US, US policy was modified and the basic structure of the embargo was accepted as legitimate.

NAFTA, Trade and the North American Environment • There has been much discussion about the potential effect of NAFTA on environmental quality in the US and Mexico. • The primary fear has been that NAFTA would lead to relocation of industry, lost jobs in the US and increased pollution in Mexico. • Ten years after implementation of NAFTA, the worst fears have not come to pass. • The implementation process say trade and environment woven together in an integrated policy, with US responsibility shared between the office of the US Trade Representative and the US EPA.

Summary • Both microeconomic and macroeconomic methodologies are important in helping to guide the development of environmental policy. • Environmental policy can have both negative and positive impacts on the economy. • Previous models have concluded increasing environmental quality will have a negative impact on the economy, but these failed to include potential positive impacts. • While macroeconomic policies are important, they should not be the only determinant of environmental policy.

The Economic Approach to Environmental and Natural Resources, 3e