ECON 310 Chapter 6 Notes
The Macroeconomics of the Environment
Thinking to get at once all the gold the goose could
give, he killed it and opened it only to find—nothing.
Aesop, The Goose with the
Golden Egg, c.550 B.C.
CHAPTER SUMMARY
Although much of the current focus of environmental economics is on more microeconomic issues, the conceptual discussion of the interrelationship between the environment and the macroeconomy began early in the development of the field of environmental economics. Boulding (1966) made an analogy of the earth to a spaceship and stressed that our activities were constrained by our endowment of resources and the ability of environmental systems to assimilate wastes. Although Boulding did not develop formal models of the relationship between the economy and the environment, his article was central in specifying the idea that the overall economy was constrained by the environment and that the economy impacts the environment and may change the nature of that constraint.
Environmental quality impacts social welfare in a variety of ways. People benefit from improved environmental quality if it beneficially affects their health, if it improves social justice, if it improves the economy, or simply because they view their quality of life as higher if environmental quality is higher. Improved environmental quality will increase the health of the population, which will increase the marginal productivity of labor, which in turn will increase the health of the economy.
Figure 6.1 illustrates the environment and the economy as inherently systems with a finite set of linkages. While this is very useful for highlighting some of the most important linkages between the two, it is important to realize that the two systems are not distinct systems. The properties of the economic system are fundamentally constrained by the properties of the larger earth system.
There are three basic mechanisms by which the environment and environmental policy affect economic productivity. Environmental policy forces firms to make decisions that are in the social interest, but not in their private interest. This will necessarily reduce the efficiency with which firms operate. While the use of resources to reduce emissions can have a negative impact on the economy, an increase in environmental quality would be expected to have positive impacts as well. The first will be an improvement in the quality of the resources, and more efficient production. The second is due to the improved productivity of other resources due to the improved environmental quality. Cleaner air, less exposure to toxic waste, cleaner water, more forests, more fish, greater levels of ecological services (such as biological diversity), and greater protection from ultra-violet radiation make the economy more productive.
Improving environmental quality has both positive and negative economic impacts. Determining the net effect of these two opposing impacts requires the development of a comprehensive measure of environmental quality, which would include air quality, water quality, and the health of the ecosystems such of forests,
wetlands, aquatic ecosystems, toxic contamination, biodiversity, and a multitude of other factors. It would also be necessary to have these historical observations of these measurements. The difficulty in measuring these complex relationships has caused people to focus on the negative and not the positive impact of improved environmental quality.
A study by Jorgensen and Wilcozen estimate that the impact of environmental regulation on the economy is to reduce GDP by 2.592 percent. Hazilla and Kopp find a cumulative impact through 1990 of a reduction of nearly 6 percent. The US EPA attempted to rectify the problem of biased estimates by incorporating the health benefits of the air quality regulations, including reduced medical costs, increased productivity as well as impacts on agriculture and household soiling. The result of this study was that GDP is approximately 2 percent higher than it would be in absence of air quality regulations. A study by Porter argues that reduction in production costs associated with strict environmental policy not only directly stimulates the domestic economy, but also increases the competitiveness of the domestic economy relative to foreign economies, bolstering exports and reducing imports.
Many economists do not believe that there are cost reducing options available that would benefit firms that firms do not voluntarily pursue. They argue that there must be institutional barriers that prevent the firms from pursuing these cost-reducing opportunities. These barriers include the inefficiency, and shortsightedness of the firm and the difficulty of appropriating the benefits from research and development into cleaner technologies. The argument that firms may be stupid (or ignorant) and simply fail to take advantage of beneficial opportunities is not very satisfying. It is difficult to imagine that this would occur on a systematic basis, particularly since our free market system encourages survival of the most efficient firms.
Another reason firms may bypass cost-reducing opportunities is that the difficulty of appropriating the benefits from research and development prevent firms from engaging in socially optimal level of research and development into technologies that are less polluting. An additional reason has to do with the asymmetric nature of the potential rewards and penalties of adopting new technologies. Firms have no incentive to adopt new technology that is easy to copy. If the new technology lowers costs, then all firms will immediately copy the technology. The lead firm doesn’t get to realize the benefits. Likewise, if costs rise, no firm will adopt and the lead firm doesn’t realize benefits.
There are various arguments about the impact of economic growth on the environment. Herman Daly argues that policy-makers need to consider establishing limits to the growth of the economy because growth leads to an increase in the number of polluters and negative impacts on the economy. A counter argument is that economic growth associated with the adoption of clean technologies can lessen the negative impact on the environment of economic growth.
One perspective argues that as the economy grows and per capita income becomes greater, environmental quality will increase. This is because the demand for environmental quality will increase. However, even if the demand for a clean
environment rises with increases in income, the continued small incremental increases in pollution will contribute to the cumulative impact of pollution.
An additional problem is with the measures we use for income. As discussed in Chapter 5, GDP and the related measure Net GDP do not subtract the depreciation of the income producing ability of natural and environmental capital. One issue raised in the debate about the link between the economy and the environment is whether current income depletes future income producing capability. If current environmental degradation causes the desert to move into food producing areas, income will not be able to grow in the future, so the impact of income increasing environmental quality could never be realized. A sustainable growth path for GDP would assure that increased well-being for the current generation does not constrain the well-being of future generations.
Economists’ discussion of sustainability generally focuses on the accumulation of capital, artificial (human-made structures) and natural (renewable and non-renewable natural resources). An axiom known as the Hartwick Rule suggests that sustainability is possible provided the economic rents (the difference between revenue and the cost of extraction) are reinvested in artificial capital. This assumes that artificial and natural capital are perfect substitutes for one another. While this assumption works well with artificial, natural and human capital, it does not work with environmental capital. Environmental capital refers to renewable resource systems that provide a flow of ecological services. It is not possible to produce ecological services on the same scale as provided by ecosystems.
When the assumption of substitutability is dropped, the Hartwick rule will no longer hold. Sustainable development then requires the maintenance of a certain stock of environmental capital, plus growth in stocks of other capital.
Within the last several years, an energetic debate has developed surrounding the potential existence of macroeconomic benefits associated with environmental taxation. These environmental taxes could be used to correct a market distortion and at the same time, reduce the level of other taxes that may cause market distortions. There is not full agreement on this point.
There are several significant environmental issues that are intertwined with international economic issues. These include the global public good nature of many environmental resources, transfrontier pollution, the effect of environmental policy on international competitiveness, and the effect of international trade policy on environmental policy.
Rainforests, wetlands, and biodiversity are examples of environmental resources contained in a country that create public good benefits for citizens of other countries. The difference between global public goods and local or national public goods is that with global public goods there will be international separation between those who benefit from the environmental resources, and those who bear the costs of preserving the environmental resources. Thus, what is optimal from the global perspective is unlikely to be generated by the policies of a particular country, so global optimality can not be generated without negotiating an international agreement. International policies need to be developed that shift
some of the benefits of preserving these environmental resources toward the countries that preserve them.
Transfrontier pollution is pollution that is generated in one political jurisdiction that creates damages in another political jurisdiction. The problems generated by transfrontier pollution become more complex when these are different international jurisdictions. International negotiation must be conducted in order to generate the appropriate level of emissions.
The effect of environmental policy on international trade is a highly contested issue. There are four major ways that environmental policy can have an effect on international trade. First, if increased trade increases economic activity, holding everything else constant, the increased activity will be associated with greater emissions of pollution.
Second, increased economic activity and income associated with trade may give the country the ability to switch to cleaner technologies. Third, an increase in trade may change patterns of economic activity and change the mix of economic activity in a particular country. The new mix could either be cleaner or more polluting. And finally, elimination of trade barriers may sweep away important environmental regulations.
The critical provision in GATT with respect to the environment is that a country cannot establish import barriers for a good based on the way the good is produced. This was designed to prevent countries from developing artificial reasons for keeping foreign good out. The problem for environmental quality is that the effect of production methods on environmental quality cannot be used as a means for discriminating against impacts. For example, when the United States required domestic canners of tuna to produce “dolphin safe” tuna, it attempted to ban impacts of Mexican canned tuna that was not. However, GATT regarded this as discrimination based on the method of production and ruled that the United States was in violation of GATT. A more recent ruling with respect to sea turtles being caught in shrimp nets resulted in a different outcome. US law requires that shrimpers operating in US waters use a special device (TED) to protect sea turtles. The US also placed an embargo on the importation of shrimp that were harvested without a device to protect marine turtles. The embargo was challenged and the WTO ruled that the shrimp embargo was legitimate. GATT is currently being renegotiated, and it could swing in either direct as far as the environment is concerned.
While it is possible that trade can lead to economic development and the provision of resources to implement environmental protection, the potential for negative impacts remains strong, requiring international cooperation to ensure that trade objectives do not dominate environmental objectives.
Social
Welfare – measures the
benefit to society as a whole of a change in policy.
Environmental
Kuznets Curve - hypothesizes a u-shaped relationship between
environmental quality and income. Low
income countries have little detrimental
impact on the environment because their level of
economic impact is low. As economic
growth occurs, the negative environmental impact increases and then eventually
decreases as higher income supports actions to improve the environment.
Sustainability
– current choices concerning
resource use, economic growth and trade do not restrict choices available for
future generations.
Hartwick Rule – sustainability is possible with a finite resource base provided that
the economic rents (the difference between revenue and cost of extraction) are
reinvested in artificial capital.
Artificial
Capital – consists of
human-made structures and goods that are used to produce other goods and
services. This includes factories, the
machines in factories, other buildings, highways, etc.
Natural
Capital – consists of
renewable and non-renewable natural resources such as oil, wood, coal, minerals
and fish.
Environmental
Capital – refers to
renewable resource systems that provide a flow of ecological services. An example would be the vast wetlands of the
huge floodplain of the upper Mississippi River which provide flood control
services.
Transfrontier Pollution - pollution that is generated in one political jurisdiction that
creates damages in another jurisdiction.
NAFTA - North American Free Trade Agreement, a trade agreement between the
United States of America, Mexico and Canada.
GATT - General Agreement on Trade and Tariffs, a treaty signed by most
nations that establishes procedures that define
"fair trade practices" and establishes procedures by which a country
can legally retaliate against a country that engages in unfair trade practices
against it. One of the
three Breton Woods Organizations of the UN, along with the World Bank and the
International Monetary Fund.
WTO - World Trade Organization, successor
institution to GATT.
Chapter 6 Short-answer questions
1. The conceptual discussion of the interrelationship between the environment and the macro economy began early in the development of the field of environmental economics. What position did Kenneth Boulding take is this discussion?
· Although Boulding did not develop formal models of the relationship between the economy and the environment, his article was central in specifying the idea that the overall economy was constrained by the environment and that the economy impacts the environment and may change the nature of the constraint.
2. Illustrate and discuss the link between the health of the economy, the health of the environment, the health of the population and social justice.
· People benefit from environmental quality if it beneficially affects their health, if it improves social justice, or if it improves their well-being. If environmental quality improves the health of the population and this leads to increased productivity, then there will be an increase in the health of the economy.
3. Compare and contrast the three basic mechanisms by which the environment and environmental policy affect economic productivity.
· Environmental policy forces firms to make decisions that are in the social interest but not in their private interest. This will necessarily reduce efficiency.
· Environmental policy which leads to cleaner resources (clean water or air) could lead to improved efficiencies in production.
· Environmental policy which leads to a cleaner environment and, as a result, a healthier population could lead to increased productivity.
4. What is the Porter hypothesis and what are the arguments against it?
· Porter argues that stricter environmental policy would force firms to use cleaner technologies, reduce waste, and adopt newer, more efficient technology. Many economists believe that environmental quality improvement options that also lead to lower costs are not available. If they were, firms would be using them.
5. What is the link between environmental quality and income?
· There are different viewpoints about the link between environmental quality and income. One argument is that as production increases and income increases, the demand for environmental quality (a luxury good) will increase. A counter argument is that the growth in production destroys environmental quality. A third option is represented by the environmental Kuznets curve which hypothesizes a u-shaped relationship between environmental quality and income. Low income countries have little detrimental impact on the environment because their level of economic impact is low. As economic growth occurs, the negative environmental impact increases and then eventually decreases as higher income supports actions to improve the environment.
6. Define sustainability and explain the importance of this concept relative to environmental policy.
· Sustainability is the notion that growth is possible but there are limits. Growth that destroys environmental quality will eventually lead to economic destruction as well. It is possible to identify a growth level that will not destroy the environment or the economy.
7. What is the Hartwick Rule and what is its link to sustainability?
· The Hartwick Rule states that sustainability is possible with a finite resource base provided that the economic rents (the difference between revenue and cost of extraction) are reinvested in artificial capital.
8. What is the difference between artificial capital, natural capital and environmental capital?
· Artificial capital is human-made structures and goods that are used to produce other goods and services. This includes factories, the machines in factories, other buildings, highways, etc. Natural capital consists of renewable and non-renewable natural resources such as oil, wood, coal, minerals and fish. Environmental capital refers to renewable resource systems that provide a flow of ecological services. An example would be the vast wetlands of the huge floodplain of the upper Mississippi River which provide flood control services.
9. Your text argues that pollution taxes are an optimal choice for revenue generation because they correct a market distortion while income taxes create market distortions. Discuss.
· If policy is well designed, pollution taxes can serve as a source of revenue in addition to correcting market externalities. If these taxes work, this would not be a long-term source of revenue.
10. What is transfrontier pollution?
· Transfrontier pollution is pollution that is generated in one political jurisdiction that creates damages in another political jurisdiction. The problems created by this become very complex when these are different international jurisdictions.
11. What are four major ways that environmental policy can affect international trade?
· If an increase in trade increases economic activity, holding everything else constant, the increased activity will be associated with greater emissions of pollution. Increased economic activity and income associated with trade may give the country the ability to switch to cleaner technologies. An increase in trade may change patterns of economic activity and change the mix of economic activity in a particular country. Elimination of trade barriers may sweep impact the ability of a country to implement environmental regulations.
12. According to your author, the GATT has the potential to adversely impact the environment. Explain his argument.
· A specific provision with GATT does not allow a country to establish import barriers based on how a product is produced. This makes it difficult for a country to bar imported goods from the domestic market based on environmental quality considerations. It is difficult to accurately predict what restrictions will be allowed to exist. The sea turtle/shrimp controversy resulted in a ruling in supporting bans based on the failure to use turtle exclusion devices. An earlier ruling was against the use of trade restrictions based on protecting dolphins.