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Markets and the Environment is a concise yet comprehensive introduction to a topic of central importance in understanding a wide range of environmental issues and policy approaches. It offers a clear overview of the fundamentals of environmental economics that will enable students and professionals to quickly grasp important concepts and to apply those concepts to real-world environmental problems. In addition, the book integrates normative, policy, and institutional issues at a principles level. Chapters examine: the benefits and costs of environmental protection, markets and market failure, natural resources as capital assets, and sustainability and economic development.
Markets and the Environment is the second volume in the Foundations of Contemporary Environmental Studies Series, edited by James Gustave Speth. The series presents concise guides to essential subjects in the environmental curriculum, incorporating a problem-based approach to teaching and learning.
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 naïve 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 (dirty, polluting, high-in-carbon coal) is still the dominant fuel for electric power plants in the United States, or why individuals drive Hummers 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 sport utility vehicles.
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 Snake rivers drain much of the U.S. Pacific Northwest, providing water for drinking, irrigation, transportation, and electricity generation—as well as for the support of endangered salmon populations. All of 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 carry out, 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, and one that is increasingly in the news: global climate change.
Global Climate Change
There is overwhelming scientific consensus that human activity—primarily the burning of fossil fuels and deforestation due to 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." (Surface temperatures have already increased worldwide by 0.6 degrees Celsius, or about 1 degree Fahrenheit, since the start of the twentieth century.) 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 like 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. While there has been much international discussion regarding 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. These costs, however, are invisible to the individuals 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 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 peoples' 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. Since those markets 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 emissions 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 emissions 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 emissions 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 (like malaria in the tropics and West Nile virus in North America); we would want to measure the benefits from avoiding those damages, as well.
All of these benefits (even the intangible ones like 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 relatively easy when the losses are reflected in market prices, like 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 foregone 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 by investing in pollution abatement equipment; by altering 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 is costly in its own right.
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.
There is one more question about climate change that economics can help answer: How should society address climate change? Even if the economist's prescription to maximize net benefits is ignored, economic reasoning can help improve policy design.
For example, suppose that the United States eventually signs on to a global climate change agreement, and commits to meet a particular abatement target (such as a certain number of tons of CO2 reduced each year below some baseline). This target need not be efficient from an economic point of view; it might well be shaped instead by purely political concerns. Regardless of how it is set, such a policy objective could be achieved in myriad ways—by requiring polluters to install and operate specific abatement technologies; by mandating tough energy efficiency standards for consumer appliances (and tightening fuel efficiency requirements for cars); by levying taxes based on CO2 emissions; or by capping carbon emissions in an industry sector and allowing firms to trade allowances among themselves 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 emissions 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—as well to as 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, as well as a range of 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 first discuss how economists define and measure the costs and benefits of environmental protection. We then consider benefit-cost analysis in practice, discussing how it has been employed 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. While 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 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.
Excerpted from Markets and the Environment by Nathaniel O. Keohane, Olmstead Sheila M.. Copyright © 2007 Nathaniel O. Keohane and Sheila M. Olmstead. Excerpted by permission of ISLAND PRESS.
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Chapter 1. Introduction
-Economics and the Environment
-Global Climate Change
-Organization and Content of This Book
-What We Hope Readers Will Take away from This Book
Chapter 2. Economic Efficiency and Environmental Protection
-Efficiency and Environmental Policy
-Equating Benefits and Costs on the Margin
-Dynamic Efficiency and Environmental Policy
Chapter 3. The Benefits and Costs of Environmental Protection
-Evaluating the Benefits
Chapter 4. The Efficiency of Markets
-Competitive Market Equilibrium
-The Efficiency of Competitive Markets
Chapter 5. Market Failures in the Environmental Realm
-The Tragedy of the Commons
Chapter 6. Managing Stocks: Natural Resources as Capital Assets
-Efficient Extraction in Two Periods
-A Closer Look at the Efficient Extraction Path
-The Critical Role of Property Rights
Chapter 7. Stocks that Grow: The Economics of Renewable Resource Management
-Economics of Forest Resources
Chapter 8. Principles of Market-based Environmental Policy
-Array of Policy Instruments
-Market-Based Policies Can Overcome Market Failure
-Is It Preferable to Set Prices or Quantities?
Chapter 9. The Case for Market-Based Instruments in the Real World
-Promoting Technological Change
-Marked-Based Instruments for Managing Natural Resources
Chapter 10. Market Based Instruments in Practice
-The U.S. Sulfur Dioxide Market
-Individual Tradable Quotas for Fishing in New Zealand
-Municipal Water Pricing
-Water Quality Trading
-Waste Management: "Pay As You Throw"
-Habitat and Land Management
Chapter 11. Sustainability and Economic Growth
-Limits to Growth?
-Sustainability, in Economic Terms
-Keeping Track: Green Accounting
-Are Economic Growth and Sustainability Compatible?
Chapter 12. Conclusion
-What Does Economics Imply for Environmental Policy?
-The Role of Firms, Consumers, and Governments
-Some Final Thoughts