Environmental Economics and

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• Environmental Economics and
• the Cost-Benefit Analysis
• Miller (2003) Chapter 2

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Economy and Economics

• An economy a system of production,
  distribution, and consumption of goods and
  services that satisfy peoples wants or needs
• Economics the science that studies the choices
  that people make when demand (need) gt supply
• Scarcity our inability to satisfy our demand
  (need)
• All economic problems arise from scarcity

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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?

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Economic Systems

• Two major types
• Pure command economic system
• Market economic system

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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

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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

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• 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.

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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.

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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

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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
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• 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

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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?

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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?

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• 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

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Full-Cost Pricing

• 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)

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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

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• 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!

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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

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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 gt Costs
• ? Project is cost-effective

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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 gt Harmful costs of pollution
• Businesses go bankrupt
• People lose their jobs

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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))
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The Benefits Of Clean Air
Additional benefits to be derived from pollution
control tend to level off and become negligible
as pollutants are reduced.
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Cost-Effectiveness
Optimum (most favourable) cost-effectiveness is
achieved at lt100 pollution control. Spending
more to achieve maximum reduction may yield
little benefit and hence may be cost-ineffective.
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Optimum Level Of Pollution
High
Low
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))
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Limitations about CBA

• There are several controversies about CBA, one
  involves the discount rate
• Discount rate An estimate of a resources
  future economic value compared with its present
  value
• Size of the discount rate a primary factor
  affecting the outcome of any CBA

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Discount Rates
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.
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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

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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?