ENVIRONMENTAL ECONOMICS

Spring 2015Assoc. Prof. Mahmut Tekçemtekce@marmara.edu.tr

primary focus is how to use or manage primary focus is how to use or manage the natural environment (air, water, the natural environment (air, water, landmass) as a valuable resource for landmass) as a valuable resource for

the disposal of waste.the disposal of waste.

Environmental EconomicsEnvironmental Economics

Environmental Economics

• originated in the 1960s

• one of the fastest-growing fields of study in economics.

• increasing recognition of the significant roles that nature plays in the economic process as well as in the formation of economic value.

Environmental Economics

• Dates back to the Classical economists.– Analysis of limited land and natural resources by

Smith and Ricardo– Mill: land not only has agricultural and extractive

uses, but it is also a source of amenity values.– Analysis of externalities and market mailures by

Marshall, Pigou, etc.

• Natural resource economics• Environmental economics• Ecological economics

• The modern sub-disciplines of natural resource economics and environmental economics have largely distinct roots in the core of modern mainstream economics.

• NNatural resource atural resource economics emerged mainly out of neoclassical growth economics

• Environmental economics out of welfare economics and the study of market failure.

• Ecological economics is a relatively new (1980s) and interdisciplinary (ecology and economics) field

• ‘Eco’ comes from ‘oikos’ (household)• Ecology is the study of nature’s housekeeping,

while economics is the study of human housekeeping.

• Ecological economics: study of how these two sets of housekeeping are related to one another.

Fundamental issues in the economic approach to resource and

environmental issues• Property rights, efficiency and government

intervention• The role, and the limits, of valuation, in

achieving efficiency• The time dimension of economic decisions• Substitutability and irreversibility

Economy and Environment

economy is assumed to depend on the natural environment

• the extraction of nonrenewable resources and the harvest of renewable resources

• the disposal and assimilation of wastes

• the consumption of environmental amenities

Economy and Environment

• Economic activity draws resources from the environment, and provides flows back into the environment.

• These flows must satisfy the laws of thermodynamics:• First law: Conservation of mass/energy (materials

balance principle)

• Second law: Entropy is non-increasing

Economy and Environment

Natural Resources

all the ‘original’ elements that comprise the Earth’s natural endowments or life-support systems: air, water, the Earth’s

crust, and radiation from the Sun.

Arable land, wilderness areas, mineral fuels and nonfuel minerals, watersheds, and the ability of the natural

environment to degrade waste and absorb ultraviolet light from the Sun.

• Renewable resources

Natural ResourcesNatural Resources

Non- renewable Non- renewable resourcesresources

Renewable Resourcescapable of regenerating themselves

within a relatively short period.

plants, fish, forests, soil, solar radiation, wind, tides, etc.

Stock (Biological) resources

various species of plants and animals

can be irreparably damaged if they are exploited beyond a certain critical threshold

Flow resources

solar radiation, wind, tides, and water streams

Renewable Resources

Nonrenewable Resourceseither exist in fixed supply or are renewable only on a geological

timescale, whose regenerative capacity can be assumed to be zero for all practical human purposes.

Recyclable Recyclable resourcesresources

metallic minerals metallic minerals (iron, aluminum, (iron, aluminum, copper, and uranium)copper, and uranium)

Nonrecyclable Nonrecyclable resourcesresources

fossil fuelsfossil fuels

Nonrenewable Resources

Neoclassical Approach

• Natural resources are ‘essential’ factors of production

• Natural resources are scarce.• The economic value of natural resources is

determined by consumers’ preferences, and these preferences are best expressed by a freely operating private market system.

Neoclassical Approach

• Market price can be used as an indicator of resource scarcity.

• Natural resources can always be replaced (partially or fully) by the use of other resources that are manufactured or natural.

• Technological advances continually augment the scarcity of natural resources.

• natural ecosystem is treated as being outside the human economy and exogenously determined

Neoclassical ApproachKey issues:

• the market as a provider of information about resource scarcity

• resource (factor) substitution• scarcity augmenting technological advance• the nature of the relationships between the

human economy and the natural environment

Neoclassical Economics

• “Invisible Hand” theorem: idealized capitalist market economy

• Freedom of choice based on self-interest• Perfect information• Competition• Mobility of resources• Ownership rights

Price signals

– Free good – no price– Scarce good – positive price

Price as a signal of emerging resource scarcity

decreasing resource scarcity over time

• Factor substitution– one kind of resource can be freely replaced by another in

the production process.

• Input substitutability– Constant factor substitution possibilities

– Diminishing factor substitution possibilities: the opportunity cost of using natural capital increases at an increasing rate as natural capital becomes scarce

– No factor substitution possibilities: to produce a given level of output a certain minimum of natural capital input is needed

• Technological Advance

– the ability to produce a given amount of output by using less of all inputs

– conservation of resources

– the amount of resource conservation depend on the impact that technological advance has on the relative productivity of each of the inputs

The human economy and the natural world

• the human economy is composed of three entities: people, social institutions and commodities

• the value of resources is assumed to emanate exclusively from their usefulness to human

• matter and energy from the natural environment are continuously transformed to create an immaterial flow of value and utility

Ecological Perspective

• Environmental resources of the biosphere are finite

• Mutual interdependencies: everything is related to everything else

• Biosphere is characterized by a continuous transformation of matter and energy

Ecological Perspective

• Material recycling is essential for the growth and revitalization of all the subsystems of the biosphere

• Nothing remains constant in nature

• The human economy is a subsystem of the biosphere

• the human economy is completely and unambiguously dependent on natural ecological systems for its material needs

• the growth of the economic subsystem is ‘bounded’ by a nongrowing and finite ecological sphere

• nature acts as both a source of and a limiting factor on the basic material requirements for the human economy

Ecology

systematically studies the

relationships between living

organisms and the physical and

chemical environment in which they live.

Ecosystem

• living organisms in a specified physical environment,

• the interactions among the organisms,

• the nonbiological factors in the physical environment that limit their growth and reproduction.

Atmosphere Hydrosphere

Litosphere Biosphere

Components of the

Ecosystem

Dynamic interaction between abiotic and biotic components

Abiotic components

• habitat for organisms.

• reservoir of the six most important elements for life (C, H, O, N, S, P).

Biotic components

• Producers: organisms capable of photosynthesis.

• Consumers: organisms whose survival depends on the organic materials manufactured by the producers.

• Decomposers: micro-organisms and many other small animals that rely on dead organisms for their survival

• A functioning natural ecosystem is characterized by a constant transformation of matter and energy.

• Material recycling is essential for the growth and revitalization of all the components of the ecosphere

Energy and thermodynamics

• The first law of thermodynamics: principle of conservation of energy - matter and energy can neither be created nor destroyed, only transformed.

• The second law of thermodynamics: energy transformations – in every energy conversion some useful energy is converted to useless (heat) energy (entropy)

• In all conversion of energy to work, there will always be a certain waste or loss of energy quality.

• Useful energy cannot be recycled

• Natural ecosystems require continual energy flows from an external source

Ecology and the human economy

• The human economy is a subsystem of the biosphere

• Natural resources cannot be viewed merely as factors of production

• Humans lead to;– Simplification of ecosystems– Creation of industrial pollution (waste)

• waste-absorptive capacity of the natural environment: ecological threshold

• trade-off between economic goods and environmental quality

Assimilative capacity of the natural environment

• the assimilative capacity of the environment is limited.

• the assimilative capacity of the natural environment depends on the flexibility of the ecosystem and the nature of the waste.

• pollution reduces the capacity of an environmental medium to withstand further pollution

Assume a linear relationship between waste and economic activity

W = f (X, t)

W : level of waste generatedX : production of goods and servicest : technological and ecological factors

if t assumed constant;

W = βX

Market Economy andAllocation of Environmental Resources

Ownership of a resource:• ownership rights are completely specified• the rights are completely exclusive• the ownership rights are transferable• ownership is enforceable

• When these four conditions are met, self-interest based behavior of individuals will ensure that resources are used where they are most valued.

• Environmental resources tend to be common property resources.

• The ownership of environmental resources cannot be clearly defined.

• for the common property resources, economic pursuit on the basis of individual self-interest would not lead to what is best for society as a whole

• the use of commons needs to be regulated by a ‘visible hand’

Externalities• Positive and Negative

• In the presence of real externalities, there will be a divergence between private and social evaluations of costs and benefits

NNegative egative EExternalityxternality

• A negative externality is a cost that is suffered by a third party as a result of an economic transaction. In a transaction, the producer and consumer are the first and second parties, and third parties include any individual, organisation, property owner, or resource that is indirectly affected.

Positive Externality:

Social benefits = Private benefits + External benefitsExternal benefits > 0

Social benefits > Private benefits

Negative Externality:

Social costs = Private costs + External costsExternal costs > 0

Social costs > Private costs

Market Economy andMarket Economy andEnvironmental ResourcesEnvironmental Resources

Fundamental question:Why may markets fail to allocate environmental Why may markets fail to allocate environmental

resources optimally?resources optimally?

– Externalities

Macroeconomic Effects of Environmental Regulations

• Environmental externalities cause a misallocation of resources.

• Policies needed– Taxes, penalties– Risk of inflation and unemployment– Job destroying and job creating effects– “cleaning up the environment creates more jobs

than it destroys”

Macroeconomic Effects of Environmental Macroeconomic Effects of Environmental RegulationsRegulations

‘Porter hypothesis’

Strictly enforced environmental policy could have the effect of forcing firms to adopt more efficient production technologies.

In the long run, the effect of this would be a reduction in production costs and a further stimulus to the economy

Macroeconomic Effects of Environmental Macroeconomic Effects of Environmental RegulationsRegulations

Debate: Regulation vs Deregulation

• Effect of environmental regulations on long-run economic performance

• Expenditure on pollution control limited