204: ENVIRONMENTAL

ECONOMICS

ENVIRONMENT

The word ‘Environment’ has been derived from the French word ‘Environer’ which means to
surround. Accordingly, environment can be defined as everything that makes up the surroundings
and enables us to live on earth. Thus, it comprises all the physical, chemical and natural forces that
exist in our planet.

ECOLOGY

Ecology is a branch of environmental science that deals with the study of relationships between
living organisms, including humans, and their physical environment (soil, water and air). It aims at
understanding the vital connections between plants and animals and the world around them. It is
studied at various levels, such as organism, population, community, biosphere and ecosystem.

ECOSYSTEM

The ecosystem is considered as the structural and functional unit of ecology. It is a community
where the living and non-living components of the environment are in continuous interaction. An
ecosystem has two main components- (a) abiotic and (b) biotic. All the non-living components of
environment present in an ecosystem are known as abiotic components. This includes the inorganic
and organic components and climatic factors. On the other hand, the living components of an
ecosystem are known as its biotic components, which include plants, animals and micro-organisms.

ECOLOGICAL ECONOMICS

Ecological economics is a transdisciplinary effort to link the ecosystem and economic system,
addressing the difference between the two. Its goal is to develop a deeper scientific understanding
of the complex linkages between humans and the rest of nature, and to use that understanding to
develop policies that will lead to a world which is ecologically sustainable and has a fair distribution
of resources.

ENVIRONMENTAL ECONOMICS

Environmental Economics is a branch of microeconomics that is concerned with the impact of

environment on economy. It brings the discipline of economic analysis to environmental issues,
dealing with aspects such as negative externalities, control on pollution through cap and trade and
measuring the monetary value of resource depletion at large.

Perspective 1: Limits to growth,

Perspective 2: Optimistic approach, net effects of change in inputs, outputs, emissions

Perspective 3: Pessimistic approach, no markets, limited substitutability between natural and man-
made resources, failure of price mechanism.

Social Cost: Private Cost + External Cost

Private Cost: When user of resource directly incurs the opportunity cost.

External Cost: When this cost is borne by someone else.

EE has a static approach to resource allocation as compared to Resource economics.

Production function in EE has energy component.

NATURAL RESOURCE

Natural resources can be defined as the resources that exist on the planet independent of human
actions.

Renewable: These are resources that can be replenished in a short period of time. However,
many renewable resources do not have a rapid recovery rate and are susceptible to depletion if they
are overused.

(i) Flow Resources: A flow resource which is simultaneously used and replaced. These resources
are often indivisible and generally inexhaustible in the human span of time. Flow resources may
be storable or non-storable. Example of non-storable flow resources are Weather, Ocean
 waves, etc. Example of storable flow resources are Solar, Wind, Hydropower, Geothermal
energy, Water, etc.
(ii) Stock Resources: They are the ones which are regenerative within human use time frame and
assumes use within minimum and maximum thresholds. For ex- Timber and crops, Fish, Grazing
lands, Animals, Soil and Water quality, etc.

Renewable but exhaustible (forests, water, fisheries)

Renewable biological stock

Renewable physical stock (soil, water system, ozone layer)

Non-Renewable: A resource is considered to be non-renewable when their rate of

consumption exceeds the rate of recovery. Examples of non-renewable natural resources are
minerals and fossil fuels.

(i) Recyclable resources: A recyclable resource is one that can be used over and over, but must
go through a process to prepare it for reuse. There is no limit to the number of times these
resources can be recycles. For ex- Glass, Aluminium, etc.
(ii) Non-Recyclable resources: They are those resources which cannot be used after it has been
used once. For ex- Soil, Coal, Mineral oil, Natural Gas.

Natural resource economics focuses on the supply, demand, and allocation of the Earth’s natural
resources. In other words, it is the application of economics to manage naturally occurring resources
for human needs with efficiency as the primary goal. The main objective of natural resource
economics is to gain a better understanding of the role of natural resources in the economy.

INDIVIDUAL PREFERENCES REGARDING ENVIRONMENT

PROTECTION

 BIOCENTRISM

Biocentrism places the biologic world (primarily non-humans) at the centre of its value system.
Biocentrism firstly defines two concepts- Instrumental value (the usefulness of something) and
Intrinsic value (the value of the fact that a thing exists, even though it may have no instrumental
value).

Biocentrism is the philosophy that all living things have intrinsic values, irrespective of their
instrumental value. Thus, a virus like smallpox has no usefulness, but still holds some intrinsic value.

Biocentrism often clashes with many ecological views. While hunting may seem as a feasible option
in some cases, it is totally unacceptable to biocentrists.

Basically, Biocentrists are like ‘जै सा चल रहा है चलने दो’. Don’t disturb anything.

 SUSTAINABILITY

As defined by the Brundtland Commission, Sustainability allows for the use of natural resources,
provided the use doesn’t degrade the ecosystem. Thus, fishing is okay but overfishing is not.

Robert Solow defined sustainability in a similar way, but with the view that the use of natural
resources should be reduced by the introduction of new methods that produce the same efficiency
and output but use less of the degradable resources.

 ANTHROPOCENTRISM
This philosophy says that the environment exists only to fulfil the desires of the humans. Thus,
resources are measured only by their instrumental value. Thus, if a bird is of no use to the humans, it
has no value.

While anthropocentrism focuses only on the instrumental value, Utilitarianism focuses on any kind
of well-being that people attain from the environment. While most of us shall never visit the Amazon
rainforests, it gives us pleasure to know the rainforests still exists with all the variety of flora and
fauna. Thus, these forests may have little instrumental value for us but they do hold certain
utilitarian value.

THE UTILITY FUNCTION

Let there be N people in the society, numbered 1 to N. We have one composite good, x, with x1, x2,
….,xN representing individual consumption of the good and ‘e’ being the environment quality
(constant for everyone). Thus, the utility obtained from a bundle of material and environmental
goods for the ith person is Ui(x, e). While deciding about
trading off x and e, a person will always try to maximize
his/her utility. Pure biocentrists shall permit no
substitution of x for e, while extreme anthropocentrists
may allow no substitution of e for x.

Also, as our actions have effects on the future generation,

we have the function as Ui(x, e, Uj), where individual i
cares about x and e as well as the utility of the person j
(from the future).

SOCIAL CHOICE MECHANISMS

(a) Pareto Optimality Criterion: Given two consumption bundles a’ = (x’, e’), and a” = (x”, e”) and a
group of people i= 1,…..,N with utility functions, Ui, then for the group as a whole, a’ is Pareto
preferred to a’’ if for every individual I, Ui(a’)>=Ui(a’’), and for at least one individual, Ui(a’)>Ui(a’’).
This means that if all members of the society vote for a’ and a’’, then leaving aside the ones who are
indifferent between the two, everyone must prefer a’ to a’’ for a’ to be Pareto optimal. All it takes is
one “no’’ vote to conclude that a’ is not pareto preferred to a’’.
In the figure, Z is pareto preferred to W as it contains more of goods for both Anna and Brewster.
However, problem arises while comparing points like Z to X as Z contains more for Brewster but less
for Anna as compared to X. Similar case if for points B and Z.

(b) To avoid this, we can consider a Potential Pareto Improvement. Suppose 75% people prefer a
to b and 25% prefer b to a. While a Pareto optimality can’t be achieved in this situation, but if the
75% people can transfer some resources to the 25% people to make them better-off, then unanimity
can be reached.

In theoretical terms, the bundle a’= (xi, e) now becomes a’’= (xi, e, yi), y denoting a tradeable
resource, such as money. Given this, if a’ is preferred by most people (and others prefer a’’), then
there can some transfer among individuals, z, such that a’= (xi, e, yi-zi) is now Pareto preferred to a’’,
i.e., a’ is preferred by everyone. In other words, if the gains to those who prefer a’ exceed the losses
to those who prefer a’’, then the gainers can compensate the losers so that they too move to a’ and
Pareto optimality is achieved.

PROPER DEFINITION: Given the two bundles a’= (x, e) and a’’= (x’’, e’’), if there exists a vector of
individual payments, z, which sum to zero, such that (a’, y-z) is Pareto preferred to (a’’, y), then a’ is
potential pareto improvement over a’’.

From the above figure, we see that Brewster can transfer some payment to Anna so that she stays at
point Z. The amount can be the extent to which Anna’s utility is not declining. Thus, the vertical
difference between Z and R can be the amount that Brewster transfers to Anna so that Brewster can
enjoy more and Anna can enjoy equal utility at point Z as compared to point X. So, both are now
happy.

In the above figure, AB is the Pareto frontier, as for all allocations across AB, there are apparently no
better allocations, i.e., no pareto improvement.

(c) Kaldor-Hicks Compensation principle: Often it is not possible to determine how much
person would be willing to transfer to make the other person change his/her support. Nicholas
Kaldor and John Hicks propounded the Compensation principle in this regard, which says that if it is
possible to make transfers to achieve unanimity on a particular choice, it is enough for the choice to
be socially desirable, even if the transfers are not actually made. When a dam is built, the
government asks whether the gainers from the dam could compensate the losers. If the gainers are
ready to do so, then the dam is built, and no compensation is paid (except as required by law).
(d) Voting: Voting usually follows a majority principle wherein if the majority prefers a to b, we
conclude that the society prefers ‘a’ to ‘b’, even though some individuals may strongly oppose ‘a’
relative to ‘b’. Thus, voting ignores the intensity of preferences, but easy for undertaking projects as
it does not require unanimity like the Pareto criterion.

Given the above mechanisms, let us consider an example:

In a city with heavy air pollution being caused from public buses, if bus owners are asked to pay for
the clean-up, it will increase the transportation costs. The poor
are less concerned with pollution (as they face difficulties to
meet basic priorities) but now they have to bear the extra
transport cost. On the other hand, the rich, who are particularly
bothered with pollution, normally do not use public buses.

In this situation, Pareto optimality won’t be achieved as there is

no unanimity. However, with compensation from the rich, the
poor may be okay with the increased transport costs. In case of voting, the composition of the
population (whether the majority are rich or poor) decides the outcome.

SOCIAL WELFARE FUNCTION

Given there are i= 1, 2, 3,…….., N people in the society, each with utility function Ui. Let ‘a’ be the
consumption bundle, thus Ui(a) is the utility individual ‘i’ derives from ‘a’. Let W(u1, u2, ….., uN)
show the distribution of utilities in the society. If in comparing two bundles a and b, W[u1(a),
…..Un(a)] > W[u1(b),…..Un(b)], then a is being socially preferred to b and W is a social welfare
function.

The problem here is that it is the utility of different people that matters and not the consumption. As
a society, concern should be about people enjoying low utility due to lack of food than due to lack of
alcohol. But the social welfare function doesn’t differentiate between food and alcohol. Given social
welfare functions, we can draw social indifference curves to show societal preferences. In the
adjacent figure, we see that point Y is both socially preferred to X (as it yields more social welfare)
and pareto preferred to X (as it has more utility for both Anna and Brewster). Again, point Z is not
pareto preferred to X, but it is socially preferred.

Amidst all the above social choice mechanisms, it has basically been assumed that individual
preferences can be represented by utility functions which can been used to make societal decisions.
However, there arises some issues with this assumption, such as-

(a) Preferences change quickly in current times, so it is not possible to fix a utility function for an
individual.
(b) Not affected persons (such as people of the future) are not represented in voting, though
they have to bear the consequences in future.
(c) Instead of individual preferences, public policy and societal decisions should be based on
what is right.
CAPITAL STOCK

Capital Stock consists of Man-made capital (K M), Human Capital (KH), Natural Capital (KN).

K must be equal to or greater than zero:

dK/dt = d(Km+Kn+Kh)/dt >= 0 ------------------- (1)

Net capital accumulation can be expressed as K = S(t) – δK(t) ----------- (2) where S is gross Saving & δ
is depreciation on capital stock.

Combining 1 and 2, the condition for sustainability becomes S(t) – δK(t) >= 0 --------------------- (3)

Decomposing into three main components, S(t) – δmKm(t) – δhKh(t) – δnKn(t) >= 0 -------------(4)

Dropping time and dividing through by income Y, while assuming Kh=0 gives

S/Y – δmKm/Y – δnKn/Y >= 0 --------------(5)

Inequality 5 is our basic condition for sustainability. It is an intuitive zero order rule for determining
whether a country is on or off a sustainable development path at any point in time. Inequality 5
refers to the value of Z.

Thus, Z = S/Y - SMKM/Y - SNKN/Y >= 0, which is called the Sustainability Index. It is a measure of overall
progress towards environmental sustainability.

Inequality in eqn- 5 is also a Weak Sustainability. It assumes substitution possibilities between

different components of capital. Therefore, the running down stock of Kn may not be re-invested.