Economics of Sustainability

Sudhir Chella Rajan

Fundamental Economic Issue
 Economics is the study of how society manages
its scarce resources

 Demand for resources far exceeds supply of

resources

 Therefore, allocation of resources poses the

fundamental problem: “efficient ways of
utilising resources” and “equitable (fair)
allocation of resources” among competing
ends

 Time scale: short run versus long run

Economic principles
 Markets will help maximise social well-
being by allocating resources efficiently
unless…
 There is Market Failure…when the
allocation of goods and services by a
market is not efficient
 Two main sources of market failure:
Externalities and the issues associated with
allocation of public goods and common
resources
 Other reasons – market power, asymmetric
information
Externalities

 An externality refers to the impact of one agent’s

actions on the well-being of a another that is not
mediated by markets.
 Mankiw’s definition (Principles of Economics, 3rd
Edition, p 204):
◦ “An externality arises when a person engages in an
activity that influences the well-being of a bystander and
yet neither pays nor receives any compensation for
that effect.” Externalities can be positive or negative.
 Externalities can be thought of as a case of
incomplete markets.
 Examples
Positive Externalities
u Immunisations of children
benefit the elderly
u Honey-bees pollinate nearby
crops
u Research into new
technologies result in
spillovers
u Education produces benefits
for society
Negative
Externalities
u Vehicle exhaust harms
society…
u As does cigarette smoking
u Barking dogs (loud pets) and
u Loud stereo in a hostel are
annoying
u Individual car drivers clogging
up roads make life a mess for
the city
Air Quality Is a Public Good
People Have an Incentive to“Free-Ride”

 Air Quality Is a Public Good:

◦ When one person abates pollution, s/he provides clean air for
everyone
◦ No one can be prevented from consuming the clean air

 This leads to the Free Rider Problem:

“a person who receives the benefit of a
good but avoids paying for it”
◦ Each person’s abatement has a small impact on air quality, and
abatement is costly to her or him
◦ When one person abates pollution, s/he provides clean air for
everyone
◦ It is therefore to her or his advantage to let others reduce
pollution, which s/he cannot be prevented from consuming
 Implications of the Free Rider Problem

 People will not voluntarily control pollution (any

more than they will voluntarily pay taxes)

 However: Everyone is better off if all people are

required to reduce pollution

 Role of Government is to provide incentives for

people to reduce pollution:
◦ Require pollution control devices on cars
◦ Mandate that lead be removed from gasoline
◦ Require that buses run on CNG
◦ Tax emissions from power plants
Individual vs. collective rationality
 Problems of collective action: Individual
rationality may often not lead to socially
optimum (collectively rational) outcomes
 Institutions (laws, regulations, policies,
cultural norms, etc) are required to
produce socially optimum solutions
Prisoner’s Dilemma (Albert Tucker,
1950)
 Two burglars, A and B, are captured and
separated by the police
 Each has to choose whether or not to
confess and implicate the other
 If neither confesses, they both serve one
year for carrying a concealed weapon
 If each confesses and implicates the other,
they both get 10 years
 If one confesses and the other does not, the
confessor goes free, and the other gets 20
years
 Prisoner’s Dilemma
Prisoner A
Confess Don’t Confess
Confess 10,10 0,20
Prisoner B Don’t Confess 20,0 1,1

•Each prisoner chooses one of the two strategies.

•A chooses a column and B chooses a row
Example of Free-riding and Common Goods: Fishing in
International Waters
Year of Peak Fish Harvest Pre-peak
Harvest peak
Post-peak

Source: Millennium Ecosystem Assessment and Sea Around Us project

The Tragedy of the Commons

 Consider a grazing area owned “in

common” by all members of a village.
 Villagers graze cows on the common.
 When n cows are grazed, total milk
production is f(n), where f’>0 and f”<0.
 How should the villagers graze their
cows so as to maximize their overall
income?
The Tragedy of the Commons

 The economic profit from introducing

one more cow is positive.
 Entry continues until the economic
profit of grazing another cow is zero.
 Since nobody owns the common,
entry is not restricted.
 The commons are over-grazed,
tragically.
The Tragedy of the Commons

 The reason for the tragedy is that

when a villager adds one more cow
his income rises but every other
villager’s income falls.
 The villager who adds the extra cow
takes no account of the cost inflicted
upon the rest of the village.
Tragedy of the Commons

 The free access and unrestricted

demand for a finite resource ultimately
dooms the resource through over-
exploitation

 “When people have open access to

forests, pastureland, or fishing grounds,
they tend to overuse them.” (World
Development Report 1992: Development
and the Environment, p 12)

 Why it occurs: Because social and

private incentives differ.
HDI versus electricity use
Life-expectency and GDP
India GDP vs HDI

$600 0.7
0.6
GDP per capita

$500
$400 0.5
(2000$)

0.4

HDI
$300
0.3
$200 0.2
$100 0.1
$0 0
1975 1980 1985 1990 1995 2000 2005
Year

GDP (2000 $) HDI

Environmental Kuznet’s Curve
Hypothesis
Costanza et al (2014)
Standard Circular Flow Model

Harris 2004
Expanding the Circle

Harris 2004
 Habitat Loss to 1990

Mediterranean Forests

Temperate Grasslands &

Woodlands
Temperate Broadleaf Forest

Tropical Dry Forest

Tropical Grasslands

Tropical Coniferous Forest

Tropical Moist Forest

0 50 100
Source: Millennium Ecosystem Assessment Percent of habitat (biome) remaining
 Scale of Change

 20% of the world’s

coral reefs were lost
and more than 20%
degraded

 35% of mangrove
area has been lost
in the last several
decades
300
Teragrams of Nitrogen per Year
250

200
Total Human
150 Additions
Natural Sources Fertilizer
100

50 Agroecosystems
Fossil Fuels
0
1875 1925 1975 2025

Source: Millennium Ecosystem Assessment

 Percent Increase in Nitrogen Flows in Rivers

Source: Millennium Ecosystem Assessment

 Trade-offs among ecosystem services

Mangrove Services:
• nursery and adult
fishery habitat
• fuelwood & timber
housing
• carbon sequestration
• traps sediment
• detoxifies pollutants
• protection from
erosion & disaster
shrimp

Mangrove ecosystem
crops
 1987

Mangrove Conversion

Source: Millennium Ecosystem

Assessment; Sathirathai and Barbier 2001
 1999

Source: UNEP

Mangrove Conversion

Source: Millennium Ecosystem

Assessment; Sathirathai and Barbier 2001
 $4000

Private Net Present Value per

hectare
Value Mangrove: $91
(per hectare)
Shrimp Farm: $2000

$2000
Net: $2,000
(Gross $17,900
less costs of
$15,900)

Fishery nursery ($70)

Source: UNEP

Timber and Non-

timber products ($90)
0
Source: Millennium Ecosystem Mangrove Shrimp Farm
Assessment; Sathirathai and Barbier 2001
 $4000
Public Net Present Value per
hectare
Mangrove: $1,000 to $3,600
Value Shrimp Farm: $-5,400 to $200
(per hectare)

Coastal Protection Shrimp Farm Source: UNEP

$2000 (~$3,840)
Net: $2,000
(Gross $17,900
less costs of
$15,900)

Fishery nursery ($70)

Less subsidies (-$1,700)
Timber and Non-
timber products ($90) Pollution Costs (-$230)
0
Restoration (-$8,240)
Source: Millennium Ecosystem Mangrove
Assessment; Sathirathai and Barbier 2001
 Many ecosystem services and are difficult to value in
economic terms
Spiritual & religious ?

Economic Private Benefit

Aesthetic ?
Valuation Capture
Flood/Fire regulation ?
Difficult or Difficult
impossible
Disease regulation ?

Water purification ?

Climate regulation ?

Freshwater ?

Genetic Resources ?

Recreation & tourism ?

Fiber ? Easy Easy

Food ?

Economic Value ($)