Introduction: Meaning of Environmental Economics, Basic Concepts & Tools

Meaning

Environmental economics is a nascent sub-discipline of economics. It is

concerned with the efficient allocation of environmental resources. The environment
provides both a direct value as well as raw material intended for economic activity, thus
making the environment and the economy interdependent. For that reason, the way in
which the economy is managed has an impact on the environment which, in turn, affects
both welfare and the performance of the economy.

It would therefore be in order if we first define its parent discipline. Economics is

a social science that deals with the explanation and prediction of economic behaviour of
rational individual or other economic decision making entities. Economic behaviour is
revealed in terms of choices that people or group of people made. So, economics is called
a science of making choices. It is the science which studies human behaviour as a
relationship between ends and means which have alternative uses. In brief, it is the
multiplicity of ends and limited availability of resources that give rise to the problem of
choice.

Environmental economics deals with the application of the principles of

economics to study why and how human beings interact with their environment the way
they do, how they use and manage the environmental resources, and what are the impacts
of human activities on environment. It draws from all sub-disciplines of economics such
as microeconomics, macroeconomics, and welfare economics, as well as, from natural
science, including environmental science. It attempts to explain the economic aspects of
attitudes and behaviour of people with regard to natural environment. It is also concerned
with how economic institutions and polices can be changed to bring the environmental
impacts of human activities into balance with human desires and the needs of ecosystems.
Several economic concepts and tools such as marginalism, consumer surplus, producer’s
surplus, and opportunity cost, externalities, subsidies, taxes, social welfare, Pareto
optimality and cost-benefit analysis have relevance and applications in analyzing
environmental problems.

Environmental economics deals with economic aspects of interdependence and

interaction between human being and the environment. Since many environmental assets,
goods and services have no markets and hence either have no prices or have prices that
are distorted; most environmental problems could be considered as problems of non-
optimal pricing. In other words, environmental problems arise either due to non-existence
or failure of market. Environmental economics deals with non-market goods, amenities
and services provided by Mother Nature.

The definition of environmental economics as a discipline dealing with the

relationship between economic activities and environment focuses attention on economic
development and its effects on environment. Man has been tampering with the ecosphere

1
since a long time. But now is being realized that environmental goods and services are
also scarce and exhaustible. Therefore, society can have more of them only by giving up
significant quantity of other goods and services, that is, there is a trade-off between
environmental goods and other goods.

Environmental economics (EE) takes into consideration issues such as the

conservation and valuation of natural resources, pollution control, waste management and
recycling, and the efficient creation of emission standards. Economics is an important
tool for making decisions about the use, conservation, and protection of natural resources
because it provides information about choices people make, the costs and benefits of
various proposed measures, and the likely outcome of environmental and other policies.
Since resources – whether human, natural, or monetary – are not infinite, these public
policies are most effective when they achieve the maximum possible benefit in the most
efficient way. Therefore, one job of policymakers is to understand how resources can be
utilized most efficiently in order to accomplish the desired goals by weighing the costs of
various alternatives to their potential benefits.

EE has two braches—positive EE and normative EE. The positive EE draws

heavily upon microeconomic and macroeconomic theories to describe and explain the
way in which economic factor influence the consumption and production of
environmental goods and services. It is largely descriptive and predictive. Normative EE
is largely prescriptive, that is, it attempts to prescribe what ought to be done to protect
and conserve the environment. It applies the principles of welfare economics to
determine the socially optimum allocation of environmental goods and services currently
and overtime that maximize the net social welfare of present as were as future
generations.

The Rationale of Environmental Economics

Because humans interact with the environment and because humans allocate
scarce resources applying economic principles and tools, study of EE can lead to greater
insights about why environmental problem exists and what the best solution to the
problem is. Why is the air polluted? Why are rivers and lakes polluted? What is the right
amount of carbon dioxide in the atmosphere? Answers to these and similar questions can
serve as the basis of sound policies that can eliminate or at least lessen the severity of the
problems.

All environmental problems can be traced to the fundamental economic problem

of ‘scarcity’. Environmental problems arise when the use of environment for one set of
functions interferes with, or prevents, the operations of other functions. For example,
using the atmosphere as a dumping ground for chlorofluorocarbons (CFCs) or carbon
dioxide (CO2) damages the ozone shield and reduces climate stability; damming a river
to provide hydropower, destroys habitations and agriculture and possibly a whole range
of associated cultural and recreational activities. It can be seen from these example that
environmental problem occurs mainly when the use of the environment to supply
resources to or disposal of waste from, economic activity reduces its ability to supply

2
other environmental services. In addition, the environmental problems have a negative
impact on economic activity.

Determining the most reasonable trade-offs among various uses of the

environment is where the study of environmental economics is important. Solving
environmental problems requires an understanding of fundamental economic concepts
such as scarcity. Traditional economics begins with the interaction of supply and demand.
With the help of these, it can be explained how well-established markets functions. But
for many environmental goods and services, such as, clean air, there is ‘not a direct
market’ that can mediate between buyers and sellers. No one has distinct ownership of
clean air supplies (all of us—and none of us—on the atmosphere). But the principles that
determine the price of economic goods can also apply to non-market goods like clean air,
which like apples, requires resources to produce. As apple production needs land, water,
fertilizers, and labour, among others ‘clean air’ production requires that the atmosphere
not be used as waste dump or at least used less so. That means waste must be diverted
elsewhere which also requires scarce resources. One solution, at least for some
environmental problems, is to introduce some market interactions where none had existed
previously. That is one key goal of environmental economics.

Much of environmental economics has focused on the relative merits and

demerits of different policy responses to various flaws of market mechanism in the areas
of environmental degradation and pollutions, for example, should emissions be stopped
by regulation or should be taxed? In fact, environmental economics provides solid
foundation for most of the policy measures designed to address environmental problems.
It seeks to compare the expected social costs and benefits of policy measures and
advocates the promulgation of only those measures which promise to enhance the net
social welfare.

Evolution and Growth of Environmental Economics

Classical economist such as Adam Smith, Malthus, Ricardo and J.S. Mill did not
explicitly address the environmental aspects of economic growth but they left a legacy of
ideas many of which are relevant to, and have been re-introduced into, contemporary
environmental debates. For instance, Ricardo argued that economic growth would peter
out in the long run because of scarcity of natural resources and diminishing returns to
land. Classical theory of political economy highlighted the importance of market as an
instrument of stimulating both growth and innovation, but remained pessimistic about
long term economic growth prospects.
Neo-classical economists introduced a new methodology of marginal analysis that
dealt with the study of the relationships between small or incremental changes in inputs
and outputs. According to the neoclaasical system of thought the economic value of
marketable commodities, unpriced environmental goods and services or sympathy for
future generations is determined based on the amount of personal utility yielded.
With the emphasis on government intervention and deficit spending, post-war
Keynesian economics got the discipline into economic and political agendas.
Subsequently, during 1960s, environmental pollutions caused mainly rapid economic

3
growth in developed countries intensified and became wide-spread. This led to the
emergence of new environmental ideologies and mass awareness about the need and
importance of keeping the quality of the environment intact.

Since 1970s, a number of ‘work views’ have crystallized within

environmentalism, providing a rationale for the emergence of environmental economics
as a sub-discipline of economics. Four basic wolrld views can be distinguished, ranging
from support for a market and technology-driven growth process which is environmental
damaging, through a position favouring managed resource conservation and growth, to
‘eco-preservationist’ positions which explicitly reject the economic growth paradigm.
The need of the 21st century and beyond is self-sustaining development. In this context, it
is of vital importance to allocate the plant’s scarce resources such that the goal of
sustainable development is attained.

By the late 1970s, the late economist Julian Simon began countering arguments
against economic growth. His keystone work was The Ultimate Resource, published in
1981 and updated in 1996 as The Ultimate Resource 2, in which he concludes there is no
reason why welfare should not continue to improve and that increasing population
contributes to that improvement in the long run. His theory was that population growth
and increased income puts pressure on resource supplies; this increases prices, which
provides both opportunity and incentive for innovation; eventually the innovations are so
successful that prices end up below what they were before the resource shortages
occurred. In Simon's view, a key factor in economic growth is the human capacity for
creating new ideas and contributing to the knowledge base. Therefore, the more people
who can be trained to help solve arising problems, the faster obstacles are removed, and
the greater the economic condition for current and future generations.

One reason for the recent emergence of environmental economics is the change in
our society’s attitude towards the environment overtime. Under the ‘laissez-faire’
economic system, only economic development was emphasized upon and no questions
were asked, whether trees were felled or mines quarried, rivers demanded as long as it
was in the interest of economic growth. Until 1960s, economists concentrated on
reallocation of scarce land and labour and did not consider environment as a scarce
resource. Then, there began a widespread shift in values and expectations that represented
a sort of return to the pre-revolutionary colonial tradition of social control. We began to
notice the effects of our economic actions on the environment. We noticed that our air
and water had become filthy. Our society then started looking for its response towards
environmental protection, combining every thing from legislation, mandating
improvements in air and water quality, to agitations protesting against wasteful and
profligate use of our natural resources and the environment. Economists responded by
studying the causes of degradation of the environment and seeking alternatives for
preserving the quality and integrity of the environment.

To sum up, the major landmarks in the growth and development of the discipline
are as follows:

4
 • 1972: the Stockholm conference on Human Environment created formal
international awareness of the need for maintaining the quality and integrity of
the environment.
• 1987: Brundtland Commission’s report , Our Common Future, popularized the
concept of sustainable development.
• 1992: The world Bank’s the world development report highlighted the links
between development and environment.
• 1992: Agenda 21 of the United Nations conference on Environment and
development (earth submit) in Rio de Janeiro.
• 1992: Convention on Biological Diversity highlighted the need for biodiversity
conservation.
• 2002: The second Earth Summit, held in Johannesburg , was an attempt by the
UN to review the progress of the expectations raised in Rio and to reaffirm the
commitment of world leaders in continuing to pursue actions towards sustainable
development

• 1990s and beyond: Growth and development of theoretical and applied economic
analyses of environmental issues.

These and other related developments led to the setting up of several specialized
institutes, departments and professional bodies including the IIED, Swedish Royal
Academy’s Beijer Institute, International Society for Ecological Economics and
Indian Society for Ecological Economics. Besides, several professional journals have
also been launched and national and international conferences and training courses in
environmental economics organized. This trend is continuing and is likely to gain
momentum as awareness about the need to protect and conserve the environment
grows in developing countries.

Basic Concept

1. Carrying Capacity

Changes in population can have a variety of economic, ecological, and social

implications. One population issue is that of carrying capacity – the number of
individuals an ecosystem can support without having any negative effects. It also
includes a limit of resources and pollution levels that can be maintained without
experiencing high levels of change. If carrying capacity is exceeded, living organisms
must adapt to new levels of consumption or find alternative resources. Carrying capacity
can be affected by the size of the human population, consumption of resources, and the
level of pollution and environmental degradation that results. Carrying capacity,
however, need not be fixed and can be expanded through good management and the
development of new resource-saving technologies.
The relationship between carrying capacity and population growth has long been
controversial. One of the original arguments appeared in 1798 by English economist
Thomas Malthus who stated that continued population growth would cause over-
consumption of resources. Malthus further argued that population was likely to grow at

5
an exponential rate while food supplies would increase at an arithmetic rate, not
keeping up with the exponential population growth. Malthus believed that an ever
increasing population would continually strain society's ability to provide for itself and,
as a result, mankind would be doomed to forever live in poverty.

Over a century later, American economist Julian Simon countered Malthus'

arguments, asserting that an increase in population would improve the environment rather
than degrade it. He believed human intellect to be the most valuable renewable natural
resource that would continue to find innovative solutions to any problems that might arise
–environmental, economical, or otherwise Simon was also one of the founders of
freemarket environmentalism, finding that a free market, together with appropriate
property rights, was the best tool in order to preserve both the health and sustainability of
the environment.

2. Sustainable Development

Over the past few decades, many definitions of sustainable development have
been suggested and debated, resulting in a concept that has become broad and somewhat
vague. In recognition of the need for a clearer understanding of sustainable development,
the United Nation's World Commission on Environment and Development commissioned
a study on the subject by what is now known as the Brundtland Commission. The
resulting report, Our Common Future (1987), defined sustainable development as
"development that meets the needs of the present without compromising the ability of
future generations to meet their own needs," which has become the accepted standard
definition. The report also identified three components to sustainable development:
economic growth, environmental protection, and social equity, and suggested that all
three can be achieved by gradually changing the ways in which we develop and use
technologies.
The United Nations attempted to reconcile these views in 1992 by convening the
first Earth Summit in Rio de Janeiro. It was here that the international community first
agreed on a comprehensive strategy to address development and environmental
challenges through a global partnership. The framework for this partnership was Agenda
21, which covered the key aspects of sustainability – economic development,
environmental protection, social justice, and democratic and effective governance.

3. Externalities
Externalities are unintentional side effects of an activity affecting people other
than those directly involved in the activity. A negative externality is one that creates side
effects that could be harmful to either the general public directly or through the
environment. An example would be a factory that pollutes as a result of its production
process. This pollution may pose health risks for nearby residents or degrade the quality
of the air or water. Either way, the owner of the factory does not directly pay the
additional cost to address any health issues or to help maintain the cleanliness of the air
or water. In some cases, however, the harmed parties can use legal measures to receive
compensation for damages. A positive externality, on the other hand, is an unpaid benefit
that extends beyond those directly initiating the activity. One example would be a

6
neighborhood resident who creates a private garden, the aesthetic beauty of which
benefits other people in the community. Also, when a group voluntarily chooses to create
a benefit, such as a community park, others may benefit without contributing to the
project. Any individuals or groups that gain additional benefits without contributing are
nown as "free riders".
Traditionally, both negative and positive externalities are considered to be forms
of market failure - when a free market does not allocate resources efficiently. Arthur
Pigou, a British economist best known for his work in welfare economics, argued that the
existence of externalities justified government intervention through legislation or
regulation. Pigou supported taxes to discourage activities that created harmful effects and
subsidies for those creating benefits to further encourage those activities. These are now
known as Pigovian taxes and subsidies.

4. Marginal Costs and Benefits

Marginal costs and benefits are essential information for economists,

businesses, and consumers. Even if we do not realize it, we all make decisions based on
our marginal evaluations of the alternatives. In other words, “what does it cost to produce
one more unit?” or “what will be the benefit of acquiring
one more unit?”

When necessary, individual and social marginal cost and benefit curves can be
drawn separately in order to understand different effects that a given action or policy
might have. In the case of pollution, the social cost is generally higher than the individual
cost due to externalities. However, as a whole, an economic system is considered
efficient at the point where marginal benefit and marginal cost intersect, or are equal.
Similar to the production of goods and services, we can utilize the same information in
order to analyze pollution abatement – in terms of the production or reduction of
pollution – within the market. In order to assess environmental improvement, we must
take cost into consideration. The cost of these improvements is often thought of as the
direct cost of any action taken in order to improve the environment.

Marginal cost measures the change in cost over the change in quantity. For
example, if a company is producing 10 units at $100 total cost, and steps up production to
11 units at $120 total cost, the marginal cost is $20 since only the last unit of production
is measured in order to calculate marginal cost.
Mathematically speaking, it is the derivative of the total cost. Marginal cost is an
important measurement because it accounts for increasing or decreasing costs of
production, which allows a company to evaluate how much they actually pay to
‘produce’ one more unit.

Marginal cost will normally initially decrease through a short range, but increase
as more is produced. Therefore the marginal cost curve is typically thought of as upward
sloping. The marginal cost curve can represent a wide range of activities that can reduce
the effects of environmental externalities, like pollution. The key point is that most

7
environmental improvements are not free; resources must be expended in order for
improvement to occur. For example, take an environment that has been polluted – while
the initial unit of cleanup may be cheap, it becomes more and more expensive as
additional cleanup is done.

Marginal benefit is similar to marginal cost in that it is a measurement of the

change in benefits over the change in quantity. While marginal cost is measured on the
producer’s end, marginal benefit is looked at from the consumer’s perspective – in this
sense it can be thought of as the demand curve for environmental improvement.

The marginal benefit curve represents the tradeoff between environmental

improvements and other things we could do with the resources needed to gain the
improvement. Again take an environment that has been polluted, the first unit of this
pollution that is cleaned up has a very high benefit value to consumers of the
environment. Each additional unit that is cleaned up is valued at a somewhat lower level
than each previous one because the overall pollution level continues to decrease. Once
the pollution is reduced below a certain point, the marginal benefit of additional pollution
control measures will be negligible because the environment itself is able to absorb a low
level of pollution. Taking a look at the graph above, the total consumer benefit that is
represented as the dark grey area, the net benefit is greatest when the quantity – “Q” –
reaches the marginal benefit curve. We could increase total benefit by adding pollution
controls beyond Q, but only with marginal costs (MC) greater than marginal benefits
(MB), so it is no longer efficient to further increase the benefits.

Oftentimes, benefits are more difficult to measure because they are not always
monetary. In cases such as these the measurement may involve utilizing revealed
preferences, through a survey or another mechanism, in order to discover the maximum
price consumers are willing to pay for a particular quantity of a good. An average benefit

8
is used when considering society as a whole because each individual’s willingness to pay
is different.

Marginal costs and benefits are a vital part of economics because they help to provide
the relevant measurement of costs and benefits at a certain level of production and
consumption. If measured marginal costs and benefits are provided, it is much easier to
calculate the ideal price and quantity. It is where the two intersect that will always be the
most economically efficient point of production and consumption. When considering
environmental issues, the efficient point at which marginal costs and marginal benefits
are equal is an important economic concept because it captures the essence of tradeoffs.
Often, environmental improvement concerns often revolve around whether we are above
or below this point –whether any additional environmental improvement can provide
more benefit than it will cost; this becomes an essential component in cost-benefit
analysis

5. Positive and Normative Economics

Positive economics is more value free, aiming to explain why markets and
institutions have evolved as they have and how they work. Examples are to understand
why the price of petrol increases when OPEC meets to restrict the output and how the
spatial distribution of pollution emissions changes when a marketable permit system is
established to regulate sulfur emissions. Normative economics, on the other hand,
attempts to use economic tools to design government policies to intervene in the market
place. Inevitably the question arises as to the ‘best’ way of intervening in the
marketplace. Clearly, this requires a way of defining what is best—a much more value-
laden process than why the economy works as it does.
When working in the environmental problems it is not possible to restrict
attention solely to positive economics. Fundamental to environmental economics is the
notion of market failure. Repairing the market failure typically requires government
interventions. What kinds of government interventions? That is a normative question. In
developing the normative theory of regulation to correct market failure or the public
provision on non-market goods, value judgment may enter the process of policy
formulation.

6. Opportunity Cost

The Australian School of economics and its followers gave an alternative concept
of real cost. According to them, the real cost of production of a given commodity is the
next best alternative sacrificed in order to obtain that commodity. It is called opportunity
cost or displacement cost. The opportunity cost of a resource can be defined as the value
of the resource in its next best use, i. e, if it were not being used for the present purpose.
Thus, it is the value of the best alternative that was not chosen in order to pursue the
current endeavour--i.e., what could have been accomplished with the resources expended
in the undertaking. It represents opportunities forgone. If a person has a job offer that
pays Rs.75 for an hour's work, and instead chooses to take a nap, then the accounting cost

9
of the nap is zero; the person did not hand over any money in order to nap. However, the
opportunity cost is the Rs.75 that could have been earned by him by working.

Opportunity cost is the value of what is foregone in order to have something else.
This value is personal to each individual. You may, for instance, forego ice cream in
order to have an extra helping of mashed potatoes. For you, the mashed potatoes have a
greater value than dessert. But you can always change your mind in the future since there
may be some instances when the mashed potatoes are just not as attractive as the ice
cream. The opportunity cost of an individual's decisions, therefore, is determined by his
or her needs, wants, time, and resources (income).

7. Subsidy

Subsidies are used by the government to promote social objectives. It is a direct or

indirect payment by a government to households or firms and may also includes
grants or other aids from a central government to local governments.

8. Production Possibility Frontier (PPF)

Under the field of macroeconomics, the production possibility frontier (PPF)

represents the point at which an economy is most efficiently producing its goods and
services, and therefore allocating its resources in the best way possible. If the economy is
not producing quantities indicated by the PPF, resources are being managed inefficiently,
and the production of society will dwindle. The production possibility frontier shows
there are limits to production, so an economy, to achieve efficiency, must decide what
combination of goods and services can be produced.

Let's turn to the chart below. Imagine an economy that can produce only wine and cotton.
According to the PPF, points A, B and C—all appearing on the curve—represent the
most efficient use of resources by the economy. Point X represents an inefficient use of
resources, while point Y represents goals that the economy cannot attain with its present
levels of resources.

10
 As we can see, in order for this economy to produce more wine, it must give up
some of its resources used to produce cotton (point A). If the economy started producing
more cotton (represented by points B and C), it would have to divert resources from
making wine and consequently produce less wine than it is at point A. As you can see, by
moving production from point A to B, the economy will have to decrease wine
production a small amount in comparison to the increase in cotton output. Point X means
that the country's resources are not being used efficiently, or, more specifically, given the
potential of its resources, the country is not producing enough cotton or wine. Point Y, as
we mentioned above, represents an output level that is currently unreachable by this
economy. However, if there were a change in technology whiles the level of land, labor,
and capital remained the same, the time required to pick cotton and grapes would be
reduced. Output would increase, and the PPF would be pushed outwards. A new curve,
on which Y would appear, would represent the new efficient allocation of resources:

11
 When the PPF shifts out, we know there is growth in an economy. Alternatively,
when the PPF shifts inwards, it indicates that the economy is shrinking as a result of a
decline in its most efficient allocation of resources and optimal production capability. A
shrinking economy could be a result of a decrease in supplies or a deficiency in
technology.

9. Pareto Optimality

Named after Italian sociologist and economist Vilfredo Pareto, Pareto optimality
is a situation which exists when economic resources and output have been allocated in
such a way that no-one can be made better off without sacrificing the well-being of at
least one person. It refers to the "best that could be achieved without disadvantaging at
least one group”. A typical definition of Pareto efficiency would he: "A given economic
arrangement is efficient if there can be no arrangement which will leave someone better off without
worsening the position of others." Thus any exchange or reallocation of resources is only Pareto
optimal if the exchange or reallocation will not harm somebody.

Ten Major Challenges

1. Acid rain and regional scale air pollution

2. Ozone depletion by CFCs and other industrial and agricultural chemicals
3. Global warming and climate change due to GHGs in the atmosphere
4. Deforestation, especially in the tropics
5. Land degradation
6. Fresh water pollution and scarcities
7. Marine Treats, including overfishing
8. Threats to human health from organic pollutants and heavy metals
9. Decline in biodiversity and ecosystem, services through loss of ecosystems and
spices
10. Excessive nitrogen production and overfertilisation

Important Issues in Environmental Economics

One of the most important contributions of environmental economics to

economics generally has been in the area of measuring the demand for non-market goods.
Measuring this demand has become central to many public debates over environmental
quality. However, some methods of measuring demand have been the subject of great
controversy. Stated preference methods involve directly asking people how they value the
environment. Such methods have come under serious attack by some as at best biased
and at worst vacuous. Others argue they are valid and of tremendous importance. A very
active area of current research is the theory underlying methods for measuring demand
for environmental goods as well as empirical methods for doing so.
There is another set of issues surrounding regulation of environmental goods. The
basic problem is that economic incentives need significant refining before they can be
relied on to solve many real environmental problems. These difficulties have to do with
incentives, different amounts of information processed by polluters and the government,
and the role of technological change in determining future levels of pollution control.

12
This work takes place at various levels, including institutional design, determining
empirical properties of different regulatory mechanisms, and theoretical issues of
regulatory design.
There are a number of international issues of environmental regulation that are not
fully resolved. One major problem is in understanding how environmental regulations
interact with trade restrictions. Are differential environmental regulations compatible
with free trade? Does free trade tend to exploit the environments of developing countries
due to their less developed institutions for environmental protection?

13