ECON 310 Chapter 5 Notes
It should be quite clear, then, that there are no criteria to be laid down in general for distinguishing the real from the not real.
Jane
Austin, Sense and Sensibility, p 76
Oxford University Press
CHAPTER SUMMARY
This
chapter shows how the measures of economic value discussed in the preceding
chapter can be used to test the “economic efficiency” of a potential decision
or outcome. Additional criteria will also be introduced with a discussion of
methods for simultaneously considering these diverse criteria. While everyone agrees that it is essential to
develop decision-making criteria, there is a great deal of disagreement about
what the criteria should include.
Table
5.1 provides a partial list of factors which should be included as part of the
decision-making criteria. These include
economic efficiency, equity, sustainability, environmental justice, ecological
impact/ environmental stewardship, ethics, public participation and advancement
of knowledge.
The
criteria of economic efficiency has to do with the
maximization of the difference between the social benefit and the social cost
of an economic activity. Economic
efficiency can be examined one of two different ways. The first considers the net economic benefit,
which is generally measured as the total willingness to pay for a good or
activity, less the cost of providing the activity. This measurement was examined in Chapter
4. The second approach uses Gross
Domestic Product (GDP). GDP measures the
market value of all goods and services produced within the borders of a
nation. This is a measurement preferred
by international development and lending agencies.
While
every principles of economics text stresses that GDP is not a measure of social
welfare, because GDP does not include measures for other dimensions of quality
of life, many policy makers use it as such.
The drawbacks to using GDP as a measure of economic efficiency include
the fact that GDP does not take into account the opportunity costs of
production. As a result, GDP would not
recognize the loss of resources to a destructive storm, only the increased
spending due to recovery. In addition,
because GDP only measures market-based activity, it does not include production
in the subsistence or informal sector of the economy.
Economic
efficiency requires that benefits be compared to costs with the idea of
improving society’s well being. The
criterion employed by most economists is the Hicks-Kaldor
criterion of potential Pareto improvement.
This is different from Pareto improvement which requires resource
allocation such that some people are better off but no one is worse off. Potential Pareto improvement is a
reallocation of resources where the gain of people helped is greater than the
losses of those who are made worse off.
Potential Pareto improvement could only function as a decision rule if
economic efficiency is the only criteria.
Equity
issues or fairness may mean a different choice would be made. An equity criterion considers the
distribution aspects of costs and benefits and is multi-dimensional. These dimensions could include socio-economic
groups, differing countries and differing generations.
There
is some disagreement among economists regarding the intra-country equity impact
of environmental degradation and policy.
While one group argues that improving environmental quality may widen
the social welfare gap, others argue that dependence on subsistence
agricultural makes the poor much more sensitive to environmental
degradation. In addition, urban poor can
not escape the impact of environmental degradation of water or air.
Equity
across countries is of particular concern when wealthy countries demand the
preservation of the environmental resources in lower-income countries. The lower income countries are bearing the
cost to generate benefits for the higher income country. For the lower-income countries these costs
can be in terms of development foregone.
Because
today’s decisions may generate important costs for future generations,
intergenerational equity is an important consideration. This is particularly true because future
generations can not participate in the policies of today. Some policy-makers argue that the use of
discounting marginalizes the value of future benefits. They advocate a criterion of sustainability
rather than efficiency. The idea behind sustainability
is the improvement of the current generation without compromising future
generations. Sustainability is an
important concept when examining deforestation, global climate change, nuclear
power and diversity.
One
component of equity is income distribution.
Two measures which have been developed to examine the inequality of
income distribution are the Lorenz Curve and the Gini
Coefficient. The Lorenz Curve, as
illustrated in Figure 5.2, shows the percentage of the income received by a
given percentage of the population. The
diagonal line indicates perfectly equitable distribution of income. The further from the diagonal, the less
equitable the distribution. The Gini
Coefficient is calculated from the Lorenz Curve. Perfectly equitable distribution of income is
indicated with a Gini coefficient of zero. The closer the value of the coefficient is to one hundred,
the greater the inequity in income distribution. Table 5.2 presents Gini
Coefficients for selected countries.
An
additional component of equity is equal access to the law, education
opportunity and health. For this text,
equal access to environmental quality is of particular importance. This issue has come to be known as
environmental justice. Environmental
justice is an issue in both developed and developing countries. Studies in the US have found that minorities,
especially those of low income living in rural areas, face a disproportionate
level of exposure to environmental hazards.
The same patterns hold in developing countries. Environmental justice is an issue in rural
areas where farm workers are exposed to high levels of pesticides. One issue of global importance is that of
contaminated drinking water. Again,
lower-income populations are less likely to be able to escape the impact of the
decline in water quality.
The
next section of the chapter discusses several alternatives for assessing the
status of ecosystems and their ability to contribute to social welfare. The first question to be addressed is how to
define a desirable state of an ecosystem.
One area of measure concerns ecosystem health the other concerns
ecosystem integrity. Ecosystem health
has to do with a system’s ability to provide a flow of ecological services
while ecosystem integrity measures the closeness of the system to a
hypothetical reference system that is completely undisturbed by humans.
Measurement
of ecosystem health is controversial. Schrade-Frechette argues that ecosystem health can be
measured with an extension of the traditional ecological risk assessment
paradigm. She focuses on the “wholistic[sic]
health approach” to ecosystem management and risk assessment. Proponents of this concept believe that
ecosystem health is related to at least three ecosystem characteristics:
There are no non-normative value-free ways to
operationalize this concept.
Measurement
of ecosystem integrity is also controversial.
One definition presented in the text has nine components, each of which
is multi-dimensional. Although there
have been attempts to develop an index of ecosystem integrity, the concept has
been largely unimplemented. An
additional area of concern is the appropriateness of using ecosystem integrity
for many urbanized, industrialized, or highly agricultural areas. These systems are largely engineered rather
than natural and a comparison to the historic ecosystem which no longer exists
is not appropriate.
At
least four methods have been suggested or employed to develop operational
indicators of environmental quality.
These include use of “representative” environmental variables, the
development of satellite accounts for National Income and Product Accounts,
green GDP/NDP and indices of sets of environmental variables. These are examined in turn.
Representative
environmental variables, such as sulfur dioxide pollution, have been used as
proxies of environmental quality in many studies. In the case of sulfur dioxide, arguments have
been made that this measure is completely unrelated to both land use changes
and water quality changes (with the exception of acidification of water
bodies). The difficulty with using a
“proxy” variable for environmental quality is finding the appropriate
indicator.
An
alternative to developing a separate measure of environmental quality is to
incorporate environmental changes into an existing measure such as GDP. Net Domestic Product is calculated by
subtracting consumption of man-made capital from Gross Domestic Product. As a result, when a machine is worn-out in
the production of current income, the loss in income producing ability is
subtracted from the measure of current income.
This “adjustment” in GDP does not occur with the degradation of
environmental resources in production. As a result, a choice to maximize production
(as represented by GDP) would fail to consider the negative impact on the
environment. This is of particular
concern in developing countries where the goal of economic development has
resulted in rapid deforestation, pollution, soil erosion and
desertification. Since the value of
these lost resources is not reflected in the GDP, the true “cost” of these
losses is not incorporated into government policy regarding economic
development.
Any
attempt to incorporate some value of the environment into macroeconomic
measures (for example a green GDP) will be confounded by the difficulty in
arriving at a monetary value associated with the environmental resources. In addition, because the focus of GDP is
production, there is a tendency to value the environment as part of a
production process rather than for any other use.
The
United Nations Statistical Division has recommended the development of a system
of environmental satellite accounts to monitor environmental change. Satellite accounts would be simple measures
of environmental variables that are maintained in addition to National Income
and Product Accounts. These
environmental variables are measured in physical units. Satellite accounts, by design, represent a disaggregation of measures of environmental change. The large number of measures that make the
examination of trade-offs and overall trends more difficult. However, these satellite accounts could serve
as a basis of an aggregate measure.
The
Environmental Monitoring and Assessment Program (EMAP) of the US Environmental
Protection Agency represents an effort to develop
indicators of environmental quality.
EMAP attempts to develop overall indicators for individual ecosystems by
summing a set of indicators (which differ by ecosystem). Problems with this approach include concerns
about relative weightings of each indicator and the level of the index being
influenced by the choice of unit of measurement for each individual variable.
Ethical dimensions are particularly important to include in decision-making but difficult to quantify. One question to consider is whether the firm or agency has an ethical obligation for environmental stewardship independent of the impact of the policy on social welfare? The economic approach to value and to valuation of the environment is but one perspective into how to incorporate environmental values into social decision making. It is a particularly anthropocentric approach. A biocentric approach is one where the land and all plant and animals species are intrinsically valuable, and value is not defined in terms of the satisfaction of human needs. While there are differences in culture and traditions across Native America tribes some perspectives on the value of environmental resources were shared by many. This included the belief that the human role was not to dominate or control nature. Deep ecology is also a biocentric approach that holds that all components of the ecosystem, as well as the ecosystems themselves, have an intrinsic value and an inherent right to exist in unaltered form.
The fairness and appropriateness of the process of arriving at a solution to an environmental problem is also considered important. Often people are willing to accept an inferior outcome if they feel that they have been part of the process. In general, environmental problems that are local in nature generate a greater need for public participation in the decision process. A good public participation process begins by identifying the stakeholders in the decision. There are four major techniques for incorporating public participation into the decision making process. These include:
There are problems with stakeholder selection
with the last three techniques. For this
reason, the first method may be better.
One
important aspect of developing policy is to recognize that knowledge regarding
ecological systems and production processes changes over time. For example,
research that contributes to the basic understanding of the properties of
material will result in future products and applications that contribute to
social welfare both through increasing economic output and by improving
environmental performance. Development
of environmental policy should include the potential for advances in knowledge
which will significantly change the choices available. The question is how to take the multiple
decision-making criteria discussed above and jointly employ them in developing
a policy.
Cost-benefit analysis is one of the most used and abused tools available to policy makers. The practitioner must make many decisions such as what costs and benefits must be included in the analysis, how the costs and benefits should be measured, and what discount rate should be used to compute the present value of future costs and benefits. One important component of cost-benefit analysis is the time horizon of the project. Since costs and benefits occur in future years, they must all be converted into present value in order to make the cost-benefit comparison. The discount rate becomes very important because of its ability to influence the weighting of future costs and benefits. There are two basic positions about the appropriate choice for the discount rate: one states that the discount rate should be set to the risk-free real market rate of interest and the other states that the discount rate should be less than the risk-free real market rate of interest.
Every interest rate has three components. These are an inflation component, a risk component and a real interest rate. Higher inflation will increase interest rates to compensate lenders for their loss. The risk premium portion of an interest rate reflects the probability of not getting paid back (the riskiness of the loan). The risk-free real market interest rate is an interest rate that has been adjusted for inflation and has no risk component.
The argument that the appropriate discount rate should be lower than the risk-free real market interest rate is based on the notion of intergenerational equity. Society should place a greater value on future generations than an individual would. The real market rate of interest reflects individual preferences and may not have this view of the future. Given the aid of spreadsheet software, the present value calculations can be performed easily for a range of discount values, and the sensitivity of the present values measures to alternative choices can easily be seen.
A cost-benefit analysis involves an identification of all opportunity costs associated with the proposed project. Construction costs generally reflect the opportunity cost of the resources used in the construction process. Costs of operation and maintenance also tend to reflect opportunity costs of materials and labor. The type of industry will dictate consideration of pollution externalities. For example a cost benefit analysis of a proposed coal burning power plant would involve a consideration of externalities. If construction involves the removal, destruction or flooding of a resource, then it may be necessary to calculate the opportunity cost of the land. If the land was farmland, the opportunity cost can be calculated by looking at the value of similar land in the area. If land is natural environment or land associated with important cultural significance, the type of valuation techniques discussed earlier could be used. It is important to consider the opportunity cost of lost recreational services as well.
Measuring the benefits associated with a proposed project involves identifying the difference between the cost of this project and the next cheapest alternative. Of course, the cost of the next best alternative should be measured to include all the social costs, including air pollution or other externalities. The benefits of any recreational services that are created have to take into consideration existing recreational opportunities. This is also true for job creation. The jobs associated with a particular project are seldom a social benefit, because the jobs are generally transferred from another area of the economy and are not new jobs.
Jobs only generate social benefits under one of two conditions. The first is when the project creates jobs that would not otherwise exist in the economy. The second is when the project creates jobs in areas of high structural unemployment, where barriers to mobility prevent potential workers from relocating to other areas where unemployment is lower.
In any cost-benefit study, the analyst makes many choices with regard to which valuation methodologies are employed, the fashion in which they are employed, and a host of parameters that might affect the analysis. These parameters might include the discount rate, the value of human life, and the rate of growth of certain economic and social variables such as population, GDP, or the demand for a good such as wood or electricity. The most useful way to conduct a cost-benefit study is to allow the treatment of assumptions to change and to see how the different treatments affect the results. Similarly, one can allow the values of parameters such as the discount rate and the value of life to change and see how sensitive the results are to changes in these values.
Occasionally it will not be possible to arrive at a value for certain benefits or costs associated with a project. Is this incomplete cost benefit analysis useful? When it is possible to identify a range for benefits and costs it may be possible to make a decision with this incomplete information. It also may be possible to extract cost and/or benefit information from the measurements in hand to determine the optimal choice.
If there is more than one decision-making criterion, then the decision-makers must assign weights to the different criteria in order to make a decision. This can be done implicitly and qualitatively, or explicitly and quantitatively.
Chapter 3 provided a discussion of marginal damage function and demonstrated that the optimal level of pollution occurs at the level where marginal damages are equal to marginal costs. A marginal damage function specifies a relationship between an incremental unit of emissions and the damages that the emissions generate. The relationship between emissions and damages is actually a complex series of cause-and-effect relationships. It is quite unlikely that it will be possible to completely identify the set of marginal abatement cost functions and marginal damage functions and solve for an optimal level of pollution. However, knowledge of a particular marginal damage function can help to identify policy goals.
KEY
CONCEPTS AND DEFINITIONS
Hicks-Kaldor
Criterion - also referred to
as potential pareto
improvement, this is said to occur when resources are reallocated in a fashion
which makes some people better off and no one worse off.
Lorenz
Curve – a graphical measure of
equity of income distribution, it examines the percentage of the income received
by a given percentage of the population.
The diagonal line indicates perfectly equitable distribution of
income. The further from the diagonal,
the less equitable the distribution.
Gini Coefficient - an alternative measure or the equity of income distribution, it is
calculated from the Lorenz Curve.
Perfectly equitable distribution of income is indicated with a Gini coefficient of zero.
The closer the value of the coefficient is to one hundred, the greater
the inequity in income distribution.
Intergenerational
equity – considers equity across
generations. This is particularly
important consideration because today’s generation may generate environmental
costs for future generations, who do not have a say in the development of environmental
policy.
Environmental
Justice – this is an issue of
concern because studies have suggested that certain segments of the population
face disproportionate exposure to environmental risk.
Ecosystem
health – the ability of an
ecological system to provide a flow of ecological services. The set of services being measured would
differ by ecological system.
Ecosystem
integrity – measures the closeness
of the ecological system to a hypothetical reference system that is completely
unperturbed by human activity.
Green
GDP – modification of current
measure of GDP to incorporate depreciation of natural capital similar to
depreciation of human-made capital.
EMAP – The
Environmental Monitoring and Assessment Program of the US Environmental
Protection Agency. EMAP attempts to develop overall indicators
for individual ecosystems.
Anthropocentric - centered around humans.
Biocentric - centered around
nature, the biosystem.
Cost-Benefit Analysis - involves a comparison of potential costs an potential benefits associated with a project, as well as
the selection of the appropriate discount rate for present value calculations.
Risk premium - addition to interest rate charged by
lender. This increase reflects the
potential for default on the loan, a high potential for default translates into
a high risk premium.
Risk-free Market Rate of Interest - interest rate which does not contain a
risk premium and reflects the rate of return on private investment. A good proxy is interest on long-term U.S.
Treasury bonds.
Social Discount Rate - discount rate which reflects an aggregation of individual rates of time preference.Marginal damage function - represents the addition to pollution damage that result from an additional unit of pollution emission. Examines the damage that pollution created by degrading the physical and natural environment. This includes effects on flora, fauna, humans, and aesthetics.
Marginal abatement cost function - represents the addition to cost associated with reducing pollution by one additional unit. These costs include costs of labor, capital and energy needed to lessen the emission. May also include the opportunity costs.
Optimal level of pollution emissions - the level which minimizes the total social costs of pollution. This minimization occurs at the point where marginal abatement costs are equal to marginal damages.
Chapter 5 Short-answer questions
1. List and define some factors which should be considered in the decision criteria for environmental policy?
· Efficiency
· Equity
· Sustainability
· Environmental justice
· Environmental stewardship
· Etc
2. What are two different approaches to examining economic efficiency?
· Net economic benefit = total willingness to pay less cost of providing activity
· Gross Domestic Product
3. Why do policy makers use GDP as a measure of social welfare and what are the drawbacks to this choice?
· GDP is an existing measure of economic performance.
· GDP = national income.
· GDP does not reflect the losses due to environmental destruction, only the costs of recovery.
· GDP does not consider equity of income distribution.
4. What are different perspectives regarding equity impacts of environmental policy?
· Intra-country – which considers differential impacts within the same country.
· Across country – which examines differential impacts across national borders.
· Intergenerational – which considers differential impacts across time (generations).
5. What are the three ecosystem characteristics of the proponents of the “wholistic health approach” to ecosystem management and risk assessment?
· An ecosystem’s ability to maintain desirable vital signs.
· An ecosystem’s ability to handle stress.
· An ecosystem’s ability to recover after perturbations.
6. What are the benefits and drawbacks associated with developing a green GDP?
· GDP is an existing measure that is recognized and used across economies.
· Depreciating environmental resources could be accomplished using a method similar to depreciation of human-made capital.
· It would be difficult to arrive at a monetary value associated with environmental resources.
· GDP’s focus on production would result in a valuation of the environment based on the production process.
9. What are the four major techniques for incorporating public participation into the environmental decision-making process?
· Incorporate information about stakeholders’ preferences in the decision-making process.
· Allow stakeholders to negotiate a solution amongst themselves.
· Allow stakeholders to arrive at a solution through role playing.
· Empower a representative group of stakeholders to hear the evidence and make a decision, jury style.
10. A cost-benefit analysis involves a comparison of potential costs and potential benefits associated with a project. How do cost-benefit studies incorporate future costs and returns? What are the potential problems associated with attempting to measure future costs and benefits associated with a project?
· Cost-benefit analyses attempt to recognize and quantify both current and future costs and benefits. This is limited by the information available about future costs and benefits. These values are then discounted, where the discounting increases as the further into the future these costs and benefits are incurred.
11. How important is the choice of a discount rate? What would happen if the discount rate reflected the average growth rate of the economy?
· The choice of discount rate is very important because it will determine the importance or weighting of future costs and benefits. If the discount rate is set at the average growth rate of the economy, then the value will reflect the ability of the future to withstand the costs.
12. What is the value of conducting a cost-benefit analysis without full information?
· The exploration of costs and benefits (marginal damage functions and marginal abatement costs functions) provides good insight into the full dimensions of an environmental decision. This can prove useful when identifying policy goals.