Economy and

2.1 INTRODUCTION Environment

Environmental resource service is scarce with many conflicting demand placed for it by
various human interactions. Since much of economics is concerned with allocating
scarce resources to conflicting demands, it has an important role to play in this respect.
However, the market system works very poorly in allocating environmental resources.
This market failure is largely on account of imperfect specification of property rights,
resulting in a set of prices which sends wrong signals to all stake holders (i.e. the
producers, consumers and the government). Further, the individual incentive to preserve
the environment is often understated in relation to the collective benefit of preservation
of environmental resources.
The linkage between economy and natural environment is, however, integral. Every
economic action can have some impact on environment, and every environmental change,
in turn, can have an impact on the economy. By ‘economy’ we refer to the entire set of
economic agents (including firms and governments) and the inter-linkages between the
agents and the institutions such as the markets. By ‘environment’we mean the biosphere
[i.e. the earth surface on which life exists (Nisbet, 1991)], the atmosphere, the
geosphere (i.e. the part of the earth lying below the biosphere) and all flora and fauna.
Thus, the definition of environment includes all life forms, energy, material resources,
the stratosphere (high atmosphere) and the troposphere (low atmosphere). These
constituent parts of environment interact with each other resulting in changes in
environment (an example is the effect of changes in biosphere on the composition of
atmosphere). Another example is generation of electricity (the source of energy) from
fossil fuel. This type of energy production depletes the stock of fossil fuel from the
geosphere besides releasing carbon dioxide (CO2) and sulphur dioxide (SO2), both of
which result in adverse environmental impact on the quality of life in the long run. The
unit deals with these issues by focusing on the relationship between market, market
failures and sustainable development.

2.2 ECONOMY-ENVIRONMENT INTERACTION

In economics, environment is viewed as a composite asset that provides a variety of
services. Specifically, the environment provides us the life support through three critical
services viz. supply of raw materials for production and direct consumption, by acting
as sink in absorbing and transforming the economic wastes, and by providing amenities
of aesthetic value to the society.
2.2.1 Circular Flow/Material Balance
The inter-linkage between environment and economy can be depicted by a Circular
Flow diagram (also called the Material Balance Model) (Figure 2.1). For simplicity,
we define the economy as broadly consisting of two sectors: production and
consumption. Exchange of goods and services and factors of production are assumed
to take place between these two sectors. Environmental services are primarily rendered
through the three interlinked circles E1, E2, E3 and all encompassing boundary labelled
as E4. The production sector extracts energy resources (like crude oil, coal) and
material resources (like iron ore) from the environment. These are transformed into
outputs of goods and services for the consumption as well for further production
purposes. Along with these, there is recycling of resources within the production as
well as the consumption sectors. Waste material arise at each stage of production as
well consumption process. Production process creates waste in the form of industrial
effluents, air pollution, water pollution and solid waste while consumption creates wastes
by generating sewage, litter and municipal refuse. Thus, the environment’s first role is
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Society, Environment
and Economy

Goods and Services

Production Consumption

Factors of Production

G
Energy & Material
Waste Sink
E1
E2
Amenity

E3

E 4 Global Life Support

Services

Figure 2.1: Circular Flow Diagram

as a supplier of resources where it provides the economy with raw materials, which
are then transformed into consumer products by the production process with energy
fuelling the transformation. Its second role is as a sink or receptor for waste products.
The natural environment functions as the ultimate repository of waste products generated
in which gaseous substances like CO2 and SO2 go to the atmosphere, industrial and
municipal sewage go into rivers and seas, solid waste goes to landfill, chlorofluro-
carbons go to the stratosphere and so on. Besides these, the natural systems themselves
generate waste like trees shedding off their leaves. However, the basic difference
between the waste generated by the two systems (natural and man-made) is that while
the natural system tends to recycle their waste (like the dried leaves naturally decomposed
in the soil and converted into organic fertilizer for plants and the trees), the waste generated
by the economic systems does not have such inbuilt system to absorb the waste by
recycling. So the wastes are released into the environment. The environment, however,
has a capability limit to absorb the waste and convert them back into harmless or
ecologically useful products. This is called the environment’s assimilative capacity
or the carrying capacity, which is the second major function of natural environment.
The assimilative capacity of the environment is thus a resource which is finite. So long
as we dispose of waste in quantities (and qualities) that are commensurate with the
environment’s assimilative capacity, the economic system will function just like a natural
system. But if the disposal exceeds the assimilative capacity we begin witnessing its
external manifestation broadly called as pollution. We thus have air pollution, water
pollution, forest degradation, soil contamination, etc. Excessive waste, when it crosses
the assimilative capacity of nature, depreciates the assets or resources by way of reducing
their efficiency of service that they otherwise provide. It then starts yielding negative
externalities like respiratory problems (caused by air pollution), gastrointestinal diseases
(caused by drinking polluted water), nature’s beauty getting restricted by smog, etc.
The smog effect on nature relates to the third service the environment provides us by
way of a wide range of aesthetic amenity of spiritual and educational value to
the society (e.g. majestic mountains, serenity of the wilderness trek, adventure of the
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wild life sanctuary, mesmerizing view of sunset in the sea) for which no substitutes exist. Economy and
Environment
If we generate more waste, in excess of assimilative capacity of the environment, it will
degrade this important function of the environment (e.g. polluted river detracting the
amenity value of water flow in the environment). We can look at this from the ‘utility-
environmental resource-goods/service’ perspective as follows.
Individuals derive utility from consuming goods and services and from the state of natural
environment. This is by using the natural environment to produce goods and services.
To depict this in notation, a representative individual’s utility function can be expressed
as:
UA=U(X1, X2, ... ... Xn, Q1, Q2,... ... Qm), where,

UA is the utility, (X1 , X2 , … … . Xn ) is the vector of goods and services produced and
( 1, 2 , … . ) are environmental assets consumed in the production of the above
goods. Q1 can be local air quality, Q2 can be local water quality, and Qm can be the
stock of animal population. The environment thus supplies utility directly (to individual
A) through the vector of assets and indirectly through its role in the production of
‘goods and services’. Clearly, any increase in the output of any element of the X
vector will result in the decrease in the quantity or quality of an element in the Q vector.
Thus, extracting environmental resources for one purpose (as a supplier of material
resource) can reduce its ability to supply for other services (such as the ability to breathe
clean air with the reduction in the number of trees). This is the reason why in Fig 2.1,
the three circles E1, E2 and E3 are shown as overlapping, indicating the conflicts in
resource use. Thus, for instance, using river for waste disposal means its amenity value
is reduced besides restricting the scope of fish harvests. Similarly, too much extraction
of timber would reduce the electricity generating capacity of a dam, owing to increased
soil erosion and reduction in the amenity values due to forest degradation and
displacement of wild life.

2.2.2 Laws of Thermodynamics

The inter-linkages portrayed in the circular flow diagram (in Figure 2.1) are governed
by the physical or natural laws called the ‘laws of thermodynamics’ – a branch of
science concerned with the relations between ‘heat’ and ‘energy’. Both laws hold
true in a strictly closed system with no external inputs. It is grounded in the fact that
‘energy’ is the basic input on which any economic activity can sustain.
The first law of thermodynamics, also known as the law of conservation of energy
(or the material balance principle) states that ‘energy’ can neither be created nor
destroyed i.e. it can only be transferred (or changed) from one form to another. Hence,
whatever we use up by way of resources must end up in some other form in the
environmental system. For instance, coal consumption must be equal to the amount of
‘energy generated’ plus the waste in the form of gases and solids produced by coal
combustion. Boulding (1966) construed earth as a closed economic system where
economy and environment are characterised by a circular relationship. Hence, we
cannot ignore the fact that a closed system sets limits (or boundaries) within which the
task of achieving utility for human consumption needs to be considered. The first law
has thus two important implications in addition to conveying the significance of limits on
matter (i.e. solid, liquid, gas) for supplying energy. One is that, as more matter is
extracted by the production process, more of waste is generated. Thus, economic
growth which results in increased extraction of material resources (like coal, water,
wind, etc.), for generation of energy, is also accompanied by increased residual wastes. 31
Society, Environment Second, there are limits on the degree to which resources can be substituted for each
and Economy
other in production. The degree of substitutability that can be derived from the
environment is a very important parameter referred to in literature on economics as the
‘limits to growth’.
The second law of thermodynamics is known as the Entropy Law. The word
Entropy refers in general to the ‘degree of disorder’, and in the context of energy
generation for consumption, its ‘unavailability (once used) for new work’. Consider an
example of a room cluttered with waste which reduces the utility of the room by its
disorderliness. This can be restored only by cleaning up the room which in turn creates
more accumulation of waste outside the room. Cleaning up the room makes it transform
from a state of high entropy (disorder) to a state of low entropy (order). Linking this to
production/consumption of energy in a closed system, which is inevitable and important
for economic growth, the use of matter causes a one way flow of energy i.e. from the
low entropy resource to high entropy resource (from order to disorder). In a larger
perspective, the material that is used in the economy tend to be used entropically i.e.
the residual gets generated and dissipated within the economic system. In relation to
the energy process, this law implies that no conversion of energy, from one form to
another, is completely efficient and the conversion process is irreversible. Some energy
is lost (i.e. used-up) in conversion and the rest once-used is no longer available. For
example, consider a discarded car. Out of the many hundreds of components of car, it
is possible to recycle only a few (e.g. aluminium, steel, lead) with a major part not
technologically feasible to recycle. In the same way, the carbon dioxide released in the
burning process, does not create another useful substance. Entropy therefore creates
a physical obstacle. Thus, if the earth is a closed system, with a limited stock of low
entropy energy resource (fossil fuel), then the system is unsustainable if the economic
activity degrades the energy resources beyond a point (referred to as the ‘limit to growth’)
where no potential for its further use remains.
Although the earth is not a closed system, since we obtain energy directly from the sun
too, we have a limited capacity of other energy resources to utilise. Thus, entropy law
suggest that the flow of solar energy establishes an upper limit on the flow of energy that
can be sustained. And once the stock of stored energy (such as fossil fuel and nuclear
energy) is exhausted, the amount of energy available for useful work will be determined
solely by the flow of solar energy and further by its amount that can be stored. In other
words, over the very long run, the growth process will be limited by the availability of
solar energy and our ability to store and use it.

2.2.3 Life Support System and Sustainability

Thus, the natural environment is a very special asset, since it provides life support
system that sustain our very existence. The three economic functions i.e. (i) resource
supply; (ii) waste assimilation; and (iii) amenity and aesthetic value can be regarded as
components of one general function of natural environment i.e. the function of life
support. The environment also provides services directly to the consumers (e.g. the
air we breathe, the nourishment we receive from food and drink, the protection we
derive from shelter and clothing) which are all benefits we derive directly or indirectly
from environment. The problem we face with the economic designs or systems – whether
free, planned, or mixed – offers no guarantee that the life support functions of natural
environment will continue to last undisturbed. The working of economic system, under
any set-up, risks the running down, depreciation and depletion of natural environment’s
functions. We, thus, do not have an ‘existence theorem’ that relates the scale and
configuration of an economy to the set of environment-economy interrelationships
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underlying the economy. But if we are interested in sustaining an economy, it is important Economy and
Environment
to establish the sustainability conditions for the compatibility of economies and their
environments.
Check Your Progress 1 [answer the questions in about 100 words in the space given]
1) State the three important functions performed by environment. What, in particular,
distinguishes the natural wastes from man-made wastes?
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2) What, in essence, are the implications of the first law of thermodynamics?
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3) What is the implication of the entropy law to the process of energy generation/
consumption? What does this law suggest in respect of this energy issue from a
long term perspective?
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4) What is meant by ‘function of life support’? What actually is needed to ensure the
compatibility of environment with an economic system?
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2.3 MARKET FAILURE IN THE CONTEXT OF

ENVIRONMENTAL GOODS
A market is an institution which help agents (buyers and sellers) to exchange goods,
services and information through price mechanism. It is a process by which the prices
of goods and services are established. Markets facilitate the distribution and allocation
of resources in a society. Markets thus use prices to communicate the wants and limits
of a diffuse and diverse society so as to bring about coordinated economic decisions in
the most efficient manner. The power of perfectly functioning market rests in its
decentralized process of decision making and exchange with no omnipotent central
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