The Economy in the Environment

– basic concepts

The Holistic View

 The Cowboy Economy
• Circular flow between
firms and consumers
• Seemingly perpetual
• Success measured by
the amount of stuff
moving through
• Reckless, romantic,
not realistic
 The Spaceship Economy
• Expanding system
boundaries
• Limited reservoir of
materials on earth
• Economy uses inputs
from the environment
and emits waste
• Must limit throughput
• Limits to growth?
 The Big Picture
Input from the environment

• Resources
• Life support services
• Amenities
• Waste-sink

• Last time established

the economic
importance of
environmental input
 The Big Picture
• Continually trying:
– Not to overwhelm regenerative capacity of the
environment
– Not to overwhelm the waste-assimilative
capacity of the environment
 First - a few concepts
• Thermodynamics
• Matter = energy and materials
• Energy = ability to do work
• Entropy = unavailable bound energy -
represents level of chaos or disarray. Can also
measure the quality of energy.
 First - a few concepts
• Systems: Two or more entities that interact

• Open system: Exchanges energy and

materials with its surroundings

• Closed system: Exchanges only energy

with its surroundings.
Is the earth open or closed?
Is the economic system open or
closed?
 Laws of Thermodynamics
The first law:
• Matter (energy or materials) can neither be
created nor destroyed
Implications:
• Whatever comes in will come out (implies
waste)
• Economic processes simply rearrange
things
 Laws of Thermodynamics
Second law:The entropy law
• All processes require energy - and as they
do they reduce the quality of the energy
used - increasing entropy in the universe
• The arrow of time: over time we always
will see an increase in entropy
• Energy cannot be recycled - continually
goes from a high quality state to a low
quality state
 Laws of thermodynamics
• Implications for the earth
as a whole
– A closed system, and thus
quantity of materials is
constant
– Constant flux of energy into
the system
– Energy cannot be recycled
but materials can
– No process is 100%
efficient
– Implications for economic
systems?
 Natural Capital
• Capital: A stock that yields a flow of goods
and services into the future
• Natural capital: Those stocks in nature that
provide goods and services into the future

• Example: A fish stock (capital) yields a

flow of goods (harvested fish) into the
future
 Natural Capital
• Two types:
– Renewable or active capital
• Providing extractable renewable resources, and
provide services without being extracted (ex.
Waste assimilation).
– Nonrenewable or passive capital
• Inactive (passive). Provide no services until
extracted. Ex. Fossil fuels

– Perpetual resources - only provide flow

services and have no stock counterpart
Stocks and flows
 The Big Picture
• Resources:
– Flow resources
– Stock resources
• Nonrenewable
• Renewable
 Stock resources
• Non-renewable
• Depletable, scarce (if used)
• Resources vs. reserves
– Economic feasibility
• Provide services only if extracted
Non-Renewable Resources
 Non-Renewable Resources
• Rate of regeneration is slower than
extraction
• St = St-1 + Gt - Et
Where:
Gt = 0
• Example: Fossil fuels - Others?
 Economic theory of
nonrenewable resources
• Describes the optimal extraction path for
non-renewable resources
– Hotelling principle
• By definition scarcity increases as
extracted which should increase price
– Has it?
 Economics of non-renewable
resources
• Optimal extraction
rule: Extract such that
rent rises at the rate
of interest
• What happens if
interest rates
increase? Extract
more? Less?
 Economic theory of non-
renewable resources
– Prices increase over
time
– Extracted quantity
declines over time
– Total size of the
resource declines over
time
– All true in reality?
 Economic theory of non-
renewable resources
• More realistic picture
• U-shaped price path
– Technology
– Scarcity
– Shown by Slade 1982
 Economic theory of non-
renewable resources
• Is it possible to use non-renewable
resources and be sustainable?
• Why/why not?
• If yes, how?
 Renewable Resources
• Rate of regeneration faster than rate of
extraction
• Are all active
• Provide services when extracted and also when
left in place
• St = St-1 + Gt - Et
Where:
Gt >0

Example: fish stocks

 Renewable resources -
Population dynamics
• Population: a group of individuals
belonging to the same species
• Population dynamics: The dynamics of
population growth and how populations
interact
• Crucial for the management of renewable
resources
 Renewable Resources
Population growth
• Focus on G
• Exponential growth
• Characterizes
anything that can
grow without limit
• Pt = Pt-1*(1+r)
• Doubling time:
LogN2 =r*DT
0.693 = r*DT
DT = 70/r
 Renewable Resources
Population growth
• Logistic or density
dependent growth
• Upper limit to the
ultimate size
• Determined by carrying
capacity
– What defines CC?
• Growth curve u-shaped

Growth determined by:

Pt = Pt-1 + r*(CC - Pt-1)/CC
 Renewable resources
Original Equation
• St = St-1 + Gt - Et
• Extraction affects
stock size.
• Sustainable yield:
extraction equal to
growth
• G=E
 Renewable resources
• Maximum sustainable
yield (MSY)
• Complex dynamics -
stock possibly grows
drastically with
decreased harvest
 Renewable Resources
Equilibrium and
stability
• Do populations ever
reach an equilibrium?
• Are growth curves
ever smooth?
• Can populations be
stable without an
equilibrium?
 Renewable Resources
• A) Dampened oscillations
- falling amplitude
• B) Constant oscillations -
constant amplitude
• C) Exploding oscillations -
increasing amplitude -
collapse
 Renewable resources
Population interactions
• No species lives in isolation
• Predator prey (Lotka Volterra)
• Competition
• Symbiosis
 Renewable resources
• Resiliency - ability of
a system to bounch
back after a
disturbance
• What determines
resiliency?
– Diversity?
– Keystone species?

• The rivets analogy

 The Big Picture
• Waste: definition
“Unwanted” byproducts
of economic activity
• Conservation of
matter - always waste
into the environment
 Waste
• Accumulation of waste
• St = St-1 + W - D
– W: inflow
– D: assimilation
• Function of S
• D = d*S
• With d from 0-1
• Recycling or reuse
possible, intercepts flow
• Industrial symbiosis
 Waste
Damage relationships
• Biomagnification
– Increasing
concentration as going
up food-chain
– DDT
• Synergy: Two
pollutants interact and
create something
worse - e.g. smog
 Waste
Damage relationships
• Dose response
curves
– Relationship between
exposure and damage
• Thresholds
• Lagged response
 Amenity services
• Pleasure of going to a
park
• Pleasure to run in a
forest
• Simply knowing that
nature exists
 Amenity services
• Sustainable amenity
service
• Relationship between
the quality of the
service and the
number of visitors
 Life Support Services
• Services that make
human life possible
– Purification of air and
water
– Stabilization and
moderation of climate
– Nutrient cycling
– Pollination of plants
 Interactions
• Various services
interact e.g.
– Inflow of fossil fuels
creates an outflow of
carbon
– Increasing
temperatures,
affecting other
services
 Summary
• Various services received from nature
• Valuable (33 trillion $)
• Very complex dynamics
– Non-linear movements
– Lags
– Thresholds
– Interactions
• Creates massive Uncertainty
 Threats to Sustainability
• Resource depletion
• Waste accumulation
• Loss of resiliency

• What to do?
• Why those threats?
 Classical causes of
Environmental degradation!
 Markets and efficiency
• Market:
• Is a system in which buyers and sellers of
something interact.
• Something is exchanged in return for
money

• Illustrates individual preferences

 Demand and Supply

Demand function:
• Describes the relationship
between the quantity the
buyers buy and price of
the product
• Inverse relationship
• Qd = 30 - 6P
• Maximum price – choke
price
• Usually not linear
 Elasticity
• Describes how
quantity changes as
price changes.

1=elastic
0=inelastic
 Elasticity
• Elasticity of demand (Ed)
• Elasticity of supply
• Cross elasticity of demand or supply
• Income elasticity (IE)

• Inferior goods (IE negative, Ed negative)

• Normal goods (IE positive, Ed negative)
• Luxury goods (IE positive, Ed positive)
 Supply function

• Describes the
relationship between
the quantity that
sellers are ready to
sell and price
• Upward sloping
 Market equilibrium
• Bringing together
buyers and sellers
• At the market
equilibrium D=S, and
giving the market
price
• Illustrates efficient
allocation of
resources
 Markets and Efficiency
• Economics: Allocation by economic agents of
scarce resources among alternative competing
ends.
• Three questions:
– What ends to economic agents desire
• (what to produce and how much)
– What limited scarce resources do economic agents
need to attain those ends
• How to produce this?
– What ends do get priority and how to share this
among society
 Welfare economics
Answer: Maximize utility
Utility
• What people want, and the benefit from
getting it, expressed via preferences
• Increases via ever increasing provision of
goods and services

Maximum utility = maximum social welfare

 Preferences
• Expressed through the market by what
goods and services people are willing to
give up (read money) to get sth else
• Willingness to pay
 Allocative Efficiency
• Adam Smith – Invisible hand
• First theorem of welfare economics
– Pareto efficient allocation (optimality)
• Efficient allocation when noone can be made
better of at the cost of others
• Noone can gain at the cost of others+
• Only holds under “perfect markets”
 Conditions for efficient allocation
(“perfect markets”)
• Competitive market
– Price takers
• Rational behavior
• Full information
• Full inclusion

• Marginal benefit (MB) = marginal cost

(MC)
MC = MB, D = S
 Market failure
• When allocative efficiency is not achieved
• Conditions for a perfect market:
– Full (complete) inclusion of all goods and services (all
traded in markets), nothing external
– Full (complete) information
– Rational behavior
– Competitive markets (price takers)
– Property rights allocated – consumer sovereignty
 Public goods
• Public vs private goods
• Public goods: Used collectively by society
• Pure PG are non-rivalrous and non-excludable
(pure vs. impure)
– Non-rivalrous: consumption by one does not affect
consumption by another
• Crowding
– Non-excludable: agent cannot be prevented from
consuming and using it
– Market does not handle allocation of such goods
 Management concepts
• Open access
• Private property
– Exclusive
– Functional ownership
• Common property
– “the commons”
 Externalities
• Externality
– The unintended and uncompensated side-
effects of one agents activities on another
– Beneficial, or harmful
• Positive externality (beneficial)
– Ex. Orchards and the bee farmer
• Negative externality (harmful)
– Ex. Pollution affects a surrounding community
Internalizing Externalities
 How to intervene to ensure
effective allocation?
• Coase theorem
– Private property rights
– Issues
• High transaction costs
• Number of agents
• Intervention
– Piguvian taxes (e.g.)
– Subsidies
Application of the Coase Theorem
External costs in the Automobile
industry
External costs with tax
 Enter the Environment
• Nature/natural services
– Non-market good
• Rarely enter welfare functions, often excluded from
economic decision-making
• Services received free of charge
– External to the market
• Provide positive externalities
• Affected by negative externalities
– Property rights hard to define
• Many cases considered public goods
Classical Causes of Environmental
Degradation
• Exclusion of the environment indicates
market failure
– Markets cannot allocate the environment
efficiently
– Agents (that operate based on price), do not
have the means to allocate this resource
effectively
• Result: We overuse natural capital, extract
too much and emit too much waste
 Tragedy of the Commons
• A group of herdsmen that all have to use
common grazing lands. That is the grazing
lands are all used in common and are the
resource in question.
• The herdsmen must use the grazing-lands to
fatten their cattle - and thus they want to keep as
many cattle on the grazing lands as possible.
• Grazing lands are a renewable resource =
overuse means degradation.
 Tragedy of the Commons
• Assume:
– Profit maximization
• Based on weight of each cattle times N
– Rational behavior
• Maximize profits, (minimize cost)
 Tragedy of the Commons
• Profits = P*Q
• Costs = C*Q/N

• Profits private
• Costs are shared by all

=> More cattle added until Commons are

ruined
 Tragedy of the Commons

• Can “Commons” Management ever work?

– Strength of norm
• Technology
• Prices
• Outsiders
 What to do?
• Get the market to internalize the
environment
• When?
– In the presence of market failure
• How?
– Property rights
– Market intervention
• Policy
 Sustainability = efficient markets?
• Correcting market failure does not
guarantee sustainability

• Intergenerational equity
• Exclusion of “non-productive” natural
capital
• Neoclassical perspective vs. Sustainability
perspective
The Economy and the Environment
• Economic Planner – maximize economic
utility, economic growth, income
• Environment excluded from framework
• Relationship between the environment and
income e.g.the EKC (later)

• But, what is economic growth? (next

time)
 Next time

What is economic growth?