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Environmental Economics
Monday, January 16 2012, 11:31 PM

Development and Environmental Sustainability

Green Economy
The Market Based Approach or the Green Economy - Neoclassical Assumptions

1. It is implicitly assumed that the value of the consumption is determined by the individual consuming the
good and not by the state or some other authority. Moreover in making consumption decisions, individuals
ignore the externalities.
2. Rational consumers, producers and perfect competition. This means the economic costs are reflected in
terms of the price.
3. The outcome of the market economy shall depend on the initial distribution of economic assets. Different
distributions will give different outcomes. Thus the market based approach may not give a socially
optimum outcome.

How to Handle Externalities in a Green Economy

1. Let the above left panel show the case where a dam is being constructed. The benefits of the dam (in form
of hydro electricity etc.) will accrue to a select few people but the costs of the dam will be incurred by the
whole society. There is a threshold below which there are no SMC because the environment can absorb
certain degradation.
2. As per the neoclassical view, the optimum production (or environmental degradation) is @ point A (or X
is the amount of degradation). But there is no way the markets by themselves can impose the SMC on the
dam producers and thus if left to markets, the environmental degradation will be too high. This situation
can be corrected via 4 approaches - (a) Pigovian taxes and subsidies, (b) Coasian bargains, (c)
marketable permits, and (d) administrative action and legislation.
3. A Pigovian tax system is shown in the top right panel. Its advantage is that it is easy to implement. Just a
tax is needed. But the disadvantages are that the precise impact of a tax is difficult to
determine. The tax may be set too high or too low. And @ international level, its monitoring is difficult.
4. The Coasian bargain solution assumes that individual property rights are well established and economic

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agents can then bargain to arrive at the optimum solution. If the initial property rights are with the affected
people, the benefit receivers will have an incentive to compensate them and vice versa. But its problems
are that it is difficult to assign property rights and also transaction costs can impede bargaining process.
Moreover if there are a large number of people involved such that monitoring of contract enforcement is
difficult then there are problems of free riding.
5. The benefits of the marketable permits system are that - (a) The ceiling of the total pollution level can be
fixed while fixing the total amount of pollution credits. (b) Different industries may have different ease in
adopting green technologies. This lets market forces determine the outcome and hence is better for
economic efficiency. (c) Targets can be set for individual members and hence it can work at international
level as well. (d) Another reason for working at international level is that different countries vary in their
ability in switching over to green technologies. But its difficulties are that - (a) Initial 'Cap' allocation may
be arbitrary. (b) It may be difficult to implement in developing countries.
6. Thus we are left with administrative / legal action which though inefficient is in most cases the only
workable method.

Arguments Given in Support for and Against the Green Economy

1. As each service and resource is priced, its direct consumption may fall. Alternative technologies will be
developed that use resources more efficiently or use cheaper substitutes.
2. The neoclassical system (often advocated by green economists) believes that prices of goods will reflect
their true value. But obviously this has drawbacks. Another approach uses the belief that ecological
systems have an intrinsic value independent of any value which can be attributed to them by humans. This
approach gives rights to other species and environment as a whole.

The Concept of Discount Rate in Tackling Pollution

1. A stronger economy will be in a better position to handle the same anount of pollution. So if instead if
investing in green technologies, we invested money in conventional economy only and if the growth so
generated outpaces the increased costs of handling the pollution later then the future stronger economy will
be in a better position to tackle the pollution. Thus discount rates are important.
2. However, the critics of this argument argue that it is very difficult to monetise the pollution costs. So a near
zero discount rate should be used. This definitely is one criticism of Kyoto Protocol.

Additional Criticisms of Kyoto Protocol

1. The clean technology producng economies will benefit.

2. The choice if base year is arbitrary and will always create losers (high growth countries) and winners.

The Tragedy of the Commons in a Green Economy

1. The private marginal cost being close to zero and all costs to society being externalities, any rational
farmer would use the common land till the private marginal utility is zero. This imposes a cost on the
society in the form of lower soil fertility in the future. This is called the tragedy of the commons and in this
sense the problems of the commons is an inter temporal externality.

Renewable and non Renewable Resources in Green Economy

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1. Renewable resources are those resources which are capable of both growth and depletion. Let the above
figure show a renewable resource (say fisheries) where its growth (X) depends upon the stock level (X).
Below a particular stock threshold (Xc) the resource is not able to regenerate quickly and thus is not able
to sustain itself and the growth is negative. @ Xmsy the growth is maximum and is called the maximum
sustainable yield but beyond that the growth falls as there is competition etc.
2. Now as per neoclassical economics, an efficient use of a renewable resource means to maximize its social
value over time. The optimum consumption level will be reached when the value of the social benefit lost
by foregoing the last unit of consumption is just equal to the additional social benefit gained by the addition
of that last unit to the stock. Let the present marginal social benefit value of one unit of the resource be v.
Let also for simplicity the private marginal cost in harvesting the resource be zero. Let the social discount
rate be r.
3. Thus if we don't consume the last unit, we will lose the benefit of v in this period. But in the next period we
will have more stock to consume. This more stock will be the 1 unit we didn't consume in this period + the
additional growth in stock (in 1 period) due to the addition of this 1 unit. The addition in the stock due to
the addition of this one unit is (G(X))/X or simply G'(X). The social value of this gain is v.G'(X). The
social value of the additional unit of the resource is (v + v) where v is the change in social value
between the two periods. Thus the present value of the additional stock in the next period is [v.G'(X) + (v
+ v)] / (1+r). This has to be v for one to forego the present consumption. Thus the condition for
foregoing consumption is: G'(X) + (v/v) r.
4. The above equation implies that efficient consumption is not necessarily at the point of MSY since @ that
point G'(X) = 0. Also for species which have low marginal productivity (i.e. G'(X) ~ 0) and also whose
value doesn't increase appreciably as their stock decreases (i.e. v ~0), extinction may be the most
efficient outcome! In the above discussion there is also the inherent assumption that we are able to catch
all the externalities. But renewable resources are often commonly owned and it is difficult to define
property rights. So while the desirability of the efficient outcome itself was questionable, the outcome of
the market system is likely to be much worse. Also note the sensitivity of the sustainable development
decision to the social discount rate r.
5. In case of non renewable resources, the only modification is G'(X) = 0. So the condition of foregoing
utilization is (v/v) r (assuming extraction is costless or is already captured in v). Thus for an efficient
outcome the social value of the marginal consumption should be increasing @ a rate r. In case the marginal
cost of extraction is non zero, vt = mc + v0 * e^rt where mc is the constant marginal cost of extraction. The
exponential term is also called the discounted rental premium. If all externalities are captured in the private
costs, a market system can generate an efficient solution. To prevent depletion, the social cost (v) should
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also reflect the option value, quasi-option value and the bequest values.

Environmental Degradation
What constitutes social value (or social cost)?

1. Social cost = private cost + external cost + rental premium (this is the economic rent commanded by the
resource) + option value (the value of an option that this resource may be used in the future, for example,
option value of biodiversity) + quasi option value (the value of an option that this resource may be used in
the future with new possibilities being opened by the future knowledge) + existence value (this is the value
placed on the resource independent of any possible future consumption) + bequest value. An efficient
consumption must be able to capture all above costs.

Measuring Environmental Value

1. Once the environmental effects are captured then one way of valuing it is to use market prices. But this
may not capture all the constituents of social cost as well as markets may not exist for many services and
the scale of proposed use may alter these market prices themselves.
2. So another approach (specially for the services where market prices are not observable) is to asses the
social values indirectly by observed economic behavior. This approach also covers the method of hedonic
prices. Then another method within this approach is travel cost method i.e. the amount of time and costs
people are willing to incur to travel to the areas with more pleasant environments.
3. A third approach to value the environmental effects is that of contingent valuation. Direct surveys are
conducted where individuals may be asked about their willingness to pay for a particular environmental
service or the compensation they would seek for the loss of such service. But it has obvious limitations.

National Income Accounting

1. Certain expenditures like soil erosion checking are incurred to prevent environmental degradation. Current
practice is to include even these in the GDP as if they increase the welfare rather than maintain
environment. These are actually defensive expenditures and should be excluded from GDP. Instead their
environmental effects should be taken in the GDP.
2. Environmental degradation affects numerous services which are valuable but for which there is no market.
For instance pollution affects the clean air, deforestation increases soil erosion. Such effects are not
captured in GDP currently. Similarly the depletion of renewable and the non renewable resources is not
captured currently.
3. A method to measure whether the development is sustainable or not follows the weak sustainability view
(that the total capital should at least be maintained). It calculates the savings and then subtracts the
depletion of natural, manmade and other forms of capital. If the resulting number is negative then it means
the development is not sustainable. A variant of this method is to use physical and not monetary values for
various forms of capital. The accounts are divided into various sectors and changes in each are estimated.

Natural Capital, Equity and Environmental Values

1. The weak sustainability view considers all the different forms of capital (like manmade, human, natural,
social) to be substitutes and aggregates them. The condition then for sustainable development is that the
aggregate capital levels should be maintained. In support of substitutability they argue that for example
degradation in soil fertility can be checked with increased use of fertilizers.
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2. An alternative view of strong sustainability is that each of the capital is distinct and can't be aggregated.
Thus a development is sustainable if each of the individual capital levels are maintained. This view is more
conducive to preserving inter generational equity. Even natural capital is made of different resources and it
can be argued whether each of them needs to be conserved or the aggregate of natural capital only needs
to be conserved. The WB currently disagrees with the view that the economic development should take
place under the constraint that the stock of natural capital should not be depleted.

Q. Why do energy elasticities tend to unity in industrially advanced countries? (2011, I, 20)

Q. What are the negative externalities of high energy coefficients? (2011, I, 20)

Q. Outline the global efforts to check the environmental degradation. Do you think that the advanced countries
are cooperating in the effort? (2006, I, 20)

Intergenerational Equity Development

Choice of Discount Rate - Why Social Discount Rate is Needed

1. Individuals are said to suffer from myopia so that arranging their private affairs they tend to place more
emphasis on present consumption. Thus they don't care about the welfare of the generations to follow
them. But as a society it has to care and hence private discount rates may fail.
2. Even if we assume that people care about the future generations, AK Sen shows it may lead to two types
of market failure - (a) the assurance problem i.e. savings by one individual for the future generations
benefits all other individuals in the present who place a value on the consumption of future generations and
hence a positive externality. (b) the isolation paradox i.e. the value which individuals place on their
descendants' consumption compared with that of the rest of the future generations. If the return from the
saving can't be captured entirely by the individual's descendants then again there will be an externality.
3. Distributional aspects have to be borne in mind. Welfare of the future generations is a distributional issue.
Hence a social discount rate is needed. The impact of a lower discount rate on environmental degradation
is unclear though. A lower rate means placing high value on the future. But most developmental projects
incur costs in the beginning and benefits accrue in the end and thus a lower rate will sanction more projects
and hence may harm the environment.
4. Another view which calls for intergenerational equity calls for the savings rate to be set such that the
equilibrium growth path of the economy produces the maximum level of consumption for all generations.
Each generation should do for the successor what it expects its predecessors to do for itself. This 'golden
rule' requires that in equilibrium the rate of interest should be equal to the growth rate of economy which
equals the growth rate of population.

Q. What are the objectives of National Environment Policy, 2006?

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