Environmental Economics and

the Cost-Benefit Analysis

Miller (2003): Chapter 2

Economy and Economics

An economy = a system of production, distribution, and consumption of goods and services that satisfy people’s wants or needs

Economics = the science that studies the choices that people make when demand (need) > supply

Scarcity = our inability to satisfy our demand (need) All economic problems arise from scarcity

Resource Allocation

Resource allocation: all nations and societies must allocate their resources in order to meet their needs

When allocating limited resources Need to make choices The cost of these choices = opportunity cost (the cost

associated with giving up an opportunity)

Some basic economic questions to ask when dealing with scarcity and efficiency in resource allocation: What goods and services to produce? How to produce them? How to distribute them? For whom to produce them?

Two major types: Pure command economic system Market economic system

Economic Systems

Pure Command Economic System

This theoretical ideal has no markets - government makes all economic decisions:

No person may independently decide to open and run any kind of business

The government decides what goods and services are to be produced

The government sells these goods and services

The government decides how the talents and skills of its workers are to be used

Market Economic System

This theoretical ideal has no governments - markets are used to make all economic decisions:

A nation's economic decisions are the result of individual decisions by buyers and sellers in the marketplace (all buying and selling is based purely on competition)

For example, U.S. has a market economic system: People there may go to work where they choose They are free to go into business on their own The price that the sellers charge for their goods or services will

depend on the prices charged by the competitors

In theory, economic decisions could be undertaken exclusively through markets or governments.

In reality, all economies rely on a mix of both markets and governments for economic decisions - mixed economy.

Economic Growth

Virtually all economies strive for economic growth, usually by maximising the flow of matter and energy resources by means of

More population growth (i.e. more consumers), and/or

More consumption per person

All economic goods and services have both internal and external costs.

Internal Costs

For example, the price a consumer pays for a new car reflects the costs of Factory Raw materials Labour Marketing Distribution Mark up (profit) Running costs

All these direct and indirect costs, which are paid for by the seller and the buyer of an economic good = internal costs

Hidden External Costs

However, extracting and processing raw materials to make and run cars:

Deplete non-renewable energy and mineral resources Produce solid and hazardous wastes Disturb land Pollute air and water Contribute to global climate change Reduce biodiversity

These harmful effects passed on to the workers, the public, the environment, and in some cases future generations = external costs

External costs (the harmful costs): not included in market price

People do not connect them with car ownership Still, everyone pays these hidden costs sooner or later,

in the form of Poorer health Higher costs for health care and health insurance Higher taxes for pollution control

Internalizing External Costs

For most economists, the solution to the harmful costs of goods and services

= Include such costs in the market prices of goods and services

= Internalizing external costs

However, internalizing external costs will not occur unless required by government regulation.

Why?

Environmental Costs

By internalizing external costs (e.g. voluntarily install pollution controls)

Need to sell goods and services at higher price (compared to competitors who do not care about external costs of their goods and services)

At competitive disadvantage Profits decline

How can the government help about this?

Government can: Impose taxes Pass laws Provide subsidies Use other strategies that encourage or force

producers to include external costs in market prices

Market price = full costs of goods and services

Full-cost pricing = Internalizing external costs

At full-cost pricing,Market price = Internal costs + External costs

(short- and long-term)

Must have government action: few companies will willingly increase their cost of business and raise consumer prices (competitive disadvantage)

Full-Cost Pricing

Good News about Internalizing External Costs

Internalizing external costs of pollution and degradation would make:

Preventing pollution more profitable than cleaning it up

Waste reduction, recycling, and reuse more profitable than burying or burning most of the waste produced

Consumers accessible to information about environmental and health effects of goods and services

To internalize external costs, governments must also: Reduce income, payroll, and other taxes Withdraw subsidies and tax breaks that encourage

environmentally harmful businesses

(e.g. the government subsidies for unsustainable forestry, for overfishing, and for using non-renewable fossil fuels, which discourage energy conservation and development of less harmful renewable energy alternatives)

Otherwise, consumers will have to pay higher market prices without tax relief policy guaranteed to fail!

More Good News about Internalizing External Costs

Some goods and services may cost less because internalizing external costs encourages producers to:

Find ways to cut costs by inventing more resource-efficient and less-polluting methods of production

Offer more environmentally beneficial (sustainable) products – i.e. “green” products

What is Cost-Benefit Analysis (CBA)?

A widely used tool for making economic decisions about how to control pollution and manage resources

Comparing the estimated short- and long-term costs (losses) with the estimated benefits (gains) of a proposal (e.g. whether a wetland should be filled)

Often used to decide whether to proceed with a given project All costs and benefits are given monetary values and

compared by means of a cost-benefit ratio A favourable ratio for a project

Benefits of project > Costs Project is cost-effective

“Zero Pollution”

For more extreme environmentalists “Zero pollution” Ideally, yes – but in the real world, not necessarily!

Natural processes can handle some of our wastes We can tolerate low air pollution levels

Pollution control costs money We cannot afford to get to zero pollution!

Beyond a certain point Clean-up costs > Harmful costs of pollution Businesses go bankrupt People lose their jobs

25 50 75 1000

As more pollutants are removed, cost of removing each additional unit increases.

Increasing cost of cleaning upC

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it o

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Percentage of pollutants removed (%)

Very expensive to get to zero pollution

Case Study: Cleaning Up Air Pollution

The cost of removing each additional unit of pollution rises exponentially Cheaper to prevent it than to clean it up (See Fig 2-6, Miller (2003))

Additional benefits to be derived from pollution control tend to level off and become negligible as pollutants are reduced.

The Benefits Of Clean Air

25 50 75 1000

Be

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its

($

va

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Percentage of pollutants removed (%)

Cost-Effectiveness

Optimum (most favourable) cost-effectiveness is achieved at <100% pollution control. Spending more to achieve maximum reduction may yield little benefit and hence may be cost-ineffective.

Area of optimum cost-effectiveness

25 50 75 1000

Be

nef

its

($

va

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)

Percentage of pollutants removed (%)

Value of benefits derived Cost of

pollution control

Costs > benefits

Optimum Level Of Pollution

255075100 0

Co

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($

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Pollutants remaining (%)

Minimal effort

Better effort

Most cost-effective

effort

Costs to society Clean

up c

osts

This curve is the sum of the two bottom curves = total costs

To find the break-even point, economists plot (1) estimated costs of cleaning up and (2) estimated social costs of pollution (harmful external costs of pollution to society), then add the two curves to get a third curve - the total costs. Lowest point on the third curve (the breakeven point) = optimum level of pollution. This graph shows the optimum level at 50%, but the actual level varies with the pollutant. (See Fig. 2-7, Miller (2003))

Low

High

Limitations about CBA

There are several controversies about CBA, one involves the discount rate:

Discount rate = An estimate of a resource’s future economic value compared with its present value

Size of the discount rate: a primary factor affecting the outcome of any CBA

At a zero discount rate, a forest of redwood trees worth $1 million today will still worth $1 million in 50 years – so no need to cut them down.

However, at a 10% annual discount rate (typically used by businesses, U.S. Office of Management and Budget, World Bank), the same trees = $10,000 in 50 years.

Makes sense from short-term economic standpoint to cut the trees down as quickly as possible and invest the money in something else.

Discount Rates

High Or Low Discount Rates?

Supporters of high discount rates (5-10%) argue that inflation will reduce the value of their earnings Encourage rapid exploitation of resources for immediate profits Impossible for sustainable use of potentially renewable resources

Critics suggest

0% (or negative) discount rate Should be used to protect unique and scarce resources 1-3% discount rates

Encourage more sustainable use of resources

Who Benefits And Who Is Harmed?

In U.S.: ~100,000 people die each year from exposure to hazardous chemicals and other safety hazards at work

In many developing countries: even worse

Critical Thinking:

(1) Is it a necessary or unnecessary cost of doing business?

(2) How do you put a value (price tag) on good health, clean air and water, wildlife habitats, endangered species?