Managerial, Institutional, and Evolutionary Approaches to Environmental Problems: Welfare and Policy Implications

1. Managerial, Institutional and Evolutionary Approaches to Environmental Problems: Welfare and Policy ImplicationsJonathan MichieUniversity of OxfordandChristine OughtonSOAS, University of London New Directions in Welfare A conference for economists and policy makers St Catherine’s College, Oxford University Oxford 29 June - 1 July 2009

2. “Climate change is the greatest challenge facing humanity at the start of the 21st Century. Failure to meet that challenge raises the spectre of unprecedented reversals in human development.” United Nations Development Programme (2008), Human Development Report 2007/08

3. Welfare Effects • Negative externalities generate social costs • In the case of environmental damage, social costs may be: • difficult to observe • greater in countries far from where they were generated • greater in the future than at the time of generation

4. The nature of the problem

5. Source: United Nations Development Programme, Human Development Report 2007/08

6. Source: United Nations Development Programme, Human Development Report 2007/08

7. “Recent observations confirm that, given high rates of observed emissions, the worst-case IPCC scenario trajectories (or even worse) are being realised. For many key parameters, the climate system is already moving beyond the patterns of natural variability within which our society and economy have developed and thrived. These parameters include global mean surface temperature, sea-level rise, ocean and ice sheet dynamics, ocean acidification, and extreme climatic events. There is a significant risk that many of the trends will accelerate, leading to an increasing risk of abrupt or irreversible climatic shifts.” The International Scientific Congress on Climate Change 10-12 March 2009 Copenhagen

8. Does standard economic theory provide an adequate framework to deal with environmental problems, their welfare implications, ethical issues and policy design? What can managerial, institutional and evolutionary approaches offer?

9. Standard Neoclassical Analysis • Based on a ‘representative’ firm or agent • Firms’ behaviour is explained by assuming instrumental rationality; decisions are reduced to calculus and marginal analysis • There is no scope for ‘managerial’ decision-making • Cost curves are assumed to be well behaved • Innovation is a ‘bolt on’ to standard analysis • Consumer preferences are exogenous

10. Standard Welfare Analysis • It is possible to identify an optimal level of pollution or abatement • For example, in the case of carbon emissions, the optimal level occurs where the marginal abatement cost equals the marginal social cost of carbon • Market based instruments e.g. carbon trading schemes can be shown to be efficient

11. Problems • Are cost curves well behaved? • The representative agent/firm: whom/what does it represent (Kirman, 1992)? • Innovation – how do firms innovate? • Is there a trade-off between abatement and social cost? • Rationality – is instrumental rationality an adequate model of business and consumer behaviour?

12. Badly-behaved cost curves? “The chief obstacle against which they [firms] have to contend when they want gradually to increase their production does not lie in the cost of production – which, indeed, generally favours them in that direction – but in the difficulty of selling the larger output of goods…” Sraffa (1926, p. 543) “at the empirical level, nobody doubts that in any economic activity which involves the processing or transformation of basic materials – in other words, in industry – increasing returns dominate the picture”. Kaldor (1972)

13. The myth of the representative firm “The question of what makes for good policies is what the business management field is all about.” “in most of economics, firms are treated as simple entities… management chooses the policies that will ‘maximize’ firm profits. The ‘question’ that is at the centre of concern in the business management field is assumed trivial to answer. And since it is, all firms in the same economic context are presumed to have the same policies – those that are best in that context – and to do the same thing.” (Nelson, 1991, p. 347)

14. Innovation “To be successful in a world that requires that firms innovate and change, a firm must have a coherent strategy that enables it to decide what new ventures to go into and what to stay out of. And it needs a structure, in the sense of mode of organization and governance, that guides and supports the building and sustaining of the core capabilities needed to carry out that strategy effectively.” “If one thinks within the frame of evolutionary theory, it is nonsense to presume that a firm can calculate an actual ‘best’ strategy. A basic premise of evolutionary theory is that the world is too complicated for a firm to comprehend, in the sense that a firm understands its world in neoclassical theory.” (Nelson, 1991, pp. 68-9)

15. Systems of Innovation “the network of institutions in the public and private sectors whose activities and interactions initiate, import, and diffuse new technologies” (Freeman, 1987, p. 1).

16. Institutions “That institutions affect the performance of economies is hardly controversial. That the differential performance of economies over time is fundamentally influenced by the way the institutions evolve is also not controversial… the institutional framework (of rules, norms, and enforcement characteristics) together with the traditional constraints (budget, technology) of economic theory determine the opportunities available at any moment in time.” (North, 1993, pp. 242-243).

17. “A central insight provided by the systems-of-innovation approach is that firms do not generally innovate in isolation, but do so in interaction with other organizational actors (such as other firms, universities, or standard-setting agencies) and that this interaction is shaped by (and shapes) the framework of existing institutional rules (laws, norms, technical standards). The approach takes into consideration the actions of both firms and governments. In short, this conceptual approach regards innovation as a process of interactive learning.” (Edquist, 2001, p. 1623)

18. Implications “A major implication of the characteristics of cumulativeness, tacitness, and partial appropriability of innovation is the permanent existence of asymmetries among firms, in terms of their process technologies and quality of output. That is, firms can be ranked as “better” or “worse” according to their distance from the technological frontier.” (Dosi, 1988, 1155-1156

19. Is there always a trade-off? The Porter Hypothesis and SEM question the trade-off between abatement and profitability If innovation and SEM are profitable why don’t all firms use them? Firms’ environmental strategies are subject to bounded rationality and/or procedural rationality Suggests a role for policy to overcome bounded rationality and lock-in to procedural rationality Strategic environmental management and regulation can become important competitive tools

20. Strategic Environmental Management “The opportunities for this kind of strategic repositioning are thought to originate in broad social and environmental trends. Hart (1997) argues that while “bottom-up pollution-prevention programs have saved companies millions of dollars” (67-68) – with increased cost savings and hence profits coming from reduced waste and energy use – the best is yet to come. He points to the smaller number of firms that have begun reorienting their long term strategies, and plans for revenue growth, around solving sustainable development problems where their basic capabilities give them expertise.” (Goldstein, 2002, p. 497).

21. Evidence and policy implications Goldstein (2002) looked at environmental projects in 17 companies, 16 increased profitability Cambridge Econometrics and AEA Technology undertook 65 case studies and found significant cost savings from increased resource productivity (both as a % of value added and as a % of profits) Role for policies to promote training in SEM

22. Rationality • Does instrumental rationality provide an adequate model of agents’ behaviour? • What about other models of rationality? • Bounded rationality • Procedural rationality • Expressive rationality • Kantian Rationality • How do we explain cooperative behaviour and trust, do institutions matter? • Do firms have an ethical or CSR dimension to their strategies?

23. The Tragedy of the Commons No Externalities Externalities Externalities (1, 1) (5, 0) No externalities (0, 5) (3, 3)

24. The Tragedy of the Commons No Externalities Externalities Externalities (1, 1) (5, 0) No externalities (0, 5) (3, 3)

25. Limits of Instrumental Rationality • Two so-called ‘irrational’ agents could do better • It’s not easy to explain cooperation under IR – it can be done (e.g. Axelrod, 1981) but it requires: • an indefinite time horizon (and therefore a belief in the possibility of one’s own immortality) and the existence of a player (or group of players) who starts by cooperating • or a finite time horizon and asymmetric information with the injection of a rogue ‘irrational’ cooperative player (e.g. Kreps and Wilson)

26. Policy Implications • Neoclassical analysis relies on market-based instruments that change monetary payoffs • Managerial approaches point to regulatory policies that rule out certain strategies and policies that catalyse innovation (possibly in combination with taxes) • Voluntary business policies rely on cooperation – depend on other models of rationality • Innovation and SEM change the structure of the game (relative payoffs) • International agreements change the game from non-cooperative to cooperative

27. Voluntary Actions, Rationality

28. Regulation, Innovation and Abatement

29. Complex Systems Theory • Views the economy as part of a complex system, made up of many different agents • Complex systems may be distinguished from simple systems by virtue of the fact that the actions of individual agents have macroeconomic or system wide effects • Allows the incorporation of different managerial strategies, institutions, innovation, diffusion, lock-in and evolution

30. Examples of System Wide Effects • Externalities – that result in system wide changes • Firms cutting back production  unemployment and recession • Lock-in to inefficient technologies • QWERTY keyboard • Petrol cars • Carbon intensive technologies

31. Sources of Lock-in • Economies of scale in production • Network externalities • System effects in education and training • Conventions in production (by firms) and transfer of inefficient technologies to developing countries • Inertia in consumption patterns

32. Policies to deal with lock-in • Market based instruments may not be effective (in isolation) at dealing with lock-in • Regulatory instruments, such as standards, conventions may be more effective and induce innovation • Training in SEM • Policies for creation and diffusion of innovation • Policies to ‘nudge’ consumer choices • International coordination

33. Conclusions • Market based instruments are good at changing financial incentives – they may induce technical change but they don’t help much with lock-in and they ignore other determinants of innovation • Managerial, institutional, evolutionary approaches offer a wider and more sophisticated set of policy instruments • We need a better theoretical understanding of firms’ behaviour and of complex systems

34. “To achieve the societal transformation required to meet the climate change challenge, we must overcome a number of significant constraints and seize critical opportunities. These include reducing inertia in social and economic systems; building on a growing public desire for governments to act on climate change; removing implicit and explicit subsidies; reducing the influence of vested interests that increase emissions and reduce resilience; enabling the shifts from ineffective governance and weak institutions to innovative leadership in government, the private sector and civil society; and engaging society in the transition to norms and practices that foster sustainability.” International Scientific Congress on Climate Change 10-12 March 2009 Copenhagen

35. Tim Foxon, Jonathan Köhler and Christine Oughton (eds) 2008, Innovation for a Low Carbon Economy, Edward Elgar. Complexity Economics for Sustainability ESRC seminar series is organised by Dr Tim Foxon (Principal), Dr Terry Barker, Professor Jonathan Michie and myself Simon Dietz, Jonathan Michie and Christine Oughton (eds) The Political Economy of the Environment, Routledge, forthcoming.

36. First seminar held at Oxford University November 2008 – papers can be found at: http://www.see.leeds.ac.uk/research/sri/projects/esrc-research-seminar-series.htm Second at University of Bolzano: http://www.unibz.it/en/economics/events/InnovationSystems_researchseminar.html Third at University of Leeds 23-24 June 2009 Next seminar: 3-4 December 2009, University of Cambridge