How economists think about environmental problems

posted in: Economics, Energy | 0

Externalities and missing markets

Microeconomics, which is the economics of individual agents, companies and markets, argues that if certain conditions for well functioning markets are in place then there is little need or justification for government intervention. These conditions sometimes apply – reasonably well informed consumers and a competitive industry (meaning little or no monopoly power). But one condition often fails – the absence of externalities.
An externality is an effect caused by one person’s actions on another that is not mediated by a market. It can be positive or negative but most environmental problems are negative externalities. The textbook examples are about pollution. A factory discharges waste into a river, damaging the fish and therefore reducing the income of the fishing industry. The externality is a cost imposed by the factory on the fishermen. It is not mediated by the market because there is no market for the pollution, or if you prefer for the quality of the water. The factory owner takes into account costs such as wages, rent and the cost of raw materials but not the cost of reduced fishing yields.
Emphasising the absence of market mediation is central to how economists think about solutions. If somebody owned the river then they would charge the factory for the right to discharge into the river and that charge would reflect the lower income from selling the rights to catch fish. The river owner would naturally and rationally trade off the benefits of pollution (the factory’s ability to produce) against the costs (the reduced fishing catch). No further intervention would be needed.
Companies routinely trade off costs and benefits in making investment decisions, but they only take into account the costs and benefits mediated by markets. If the markets are incomplete or cannot be defined, there is a case for the government to fill the gap with a corrective tax or quota that aims to restore the correct cost/benefit ratio that would have been reached if the market had existed. Sometimes a market can be created, perhaps by making clear what the property rights are, which can lead to privatisation. There may be significant distributional consequences of such policies of course. Common land in the pre–industrial period in England was “enclosed” – essentially stolen by landlords for agriculture. Private ownership meant that there would be less likelihood of over-grazing, which was a risk on commonly owned land. But it also meant a transfer of wealth from lower income to higher income people, or if you prefer, outright class theft.
But there can be practical or moral barriers to the creation of markets and private ownership. Social cost benefit analysis is a method used in public policy to include a wider range of consequences than would a private company using only market information. For example a new road might reduce journey times, which in theory could be captured by charging tolls – a form of market that is commonly used in many countries though not in the UK, where drivers seem almost pathologically hostile to any form or road charges.
The road might also save lives because it reduces accidents. This might perhaps be taken into account by the drivers (i.e. they incorporate it into their market decision as to when or how much to drive) but this is unlikely in practice. Yet the benefit of reduced accidents is real. Economists have over the years developed ways to evaluate lives saved. You could calculate the value of a person’s future earnings if they had lived – though this puts a higher value on a banker than a shop assistant. Or you could look at the evidence from life insurance costs as to the implicit value people put on their lives. Or you could see if there is a wage premium for more dangerous jobs that tells us something about the market value of personal risk. Medical policy makers use the concept of QALY – quality adjusted life years – to do cost-benefit analysis on the adoption of new drugs. All these options are imperfect and some see the idea of quantifying the value of a life saved or improved as immoral. But the alternative is not to value it at all and that values it at zero, which cannot be right.
Now consider the damage a new road does to there local woodland and wildlife. This is also real but how do we measure it? Social cost benefit analysis only works if we can quantify things. Unless there is a cost that is agreed to be so high, even if we can’t measure it, that the project should not proceed. Such total prohibition rules do exist such as the convention on not digging for oil in the Antarctic or the nuclear test ban treaty. It is easier and more effective in some cases to outlaw or ban some activities. But these are in a sense the easy cases. Much more difficult is the vast range of daily activities when there is clearly some actual or potential damage but banning the activity is impractical or would be very costly.
Note that the policy framework of cost benefit analysis is utilitarian – it judges decisions by their outcomes. That might seem sensible but there is another and very important point of view in ethics that says that some decisions are wrong, whatever their consequences. Actions, in the deontological view, should be judged relative to duty or principle. Of course one principle can be to maximise net benefit, which is the utilitarian view. But it’s important to acknowledge that our moral intuitions tend to include a strong sense that some things are just wrong, even if we can see there is a net benefit. (The trolley problem is a good example of this – see below). Michael Sandel has written brilliantly on the discomfort many people suffer from the extension of market-based thinking to more and more aspects of our social life (here is a TED talk by him).
But utilitarianism tends to dominate practical ethics, as exemplified by the Australian philosopher and popular author Peter Singer, who argues for treating animals better (including not eating them, but also for treating higher primates as if they had certain rights similar to those of humans) and for giving a significant part of our incomes to the poor (the actual percentage he recommends has fallen over the years). Singer founded the organisation The Life You Can Save, whose website includes a list of charities which he recommends for having particularly high effectiveness. That is, they have a high ratio of benefits to costs. (Top of the list, judged by the criterion of saving lives per dollar contributed, is the Against Malaria Foundation.)

The economics of climate change

Economists have been analysing the problem of global warming for decades. The growing scientific evidence of a human contribution to climate change makes this the largest externality-based economic policy problem. While Lord (Nick) Stern is deservedly well known as the author of the influential Stern Review, commissioned by the British Chancellor of the Exchequer (finance minister) Gordon Brown, published in 2006. But US professor William Nordhaus has been writing on this subject for many years. Among many other things, he is an expert on integrated climate change assessment models, alongside CJBS’s own Chris Hope. His latest book, aimed at a general audience, The Climate Casino, was reviewed at length in the New York Review of Books by Paul Krugman, who worked as a research assistant to Nordhaus in his youth. Martin Wolf also mentioned the book in his FT column today.

Stern and Nordhaus disagree about the right economic policy to combat climate change but they agree on the need to take action and they use a common economic framework. The core of their dispute is on the matter of the right discount rate to apply to the future costs and benefits of climate policy. The costs are actions taken to shift to lower carbon fuels and so forth. The benefit is the avoidance of climate change damage.

The discount rate is needed to take account of timing. The costs tend to fall in the near term, the benefits in the longer term. The question is, how to weigh these relative to each other? Economics provides a detailed framework for thinking about these matters, whether it’s a private investment decision or a social cost benefit analysis. But some part of the decision is unavoidable ethical. Any positive discount rate implies that the welfare of future generations is being valued less highly than that of people today. There is a longstanding point of view that this is ethically wrong – all people should be considered equally. But the contrary view argues that future generations will quite likely have much higher incomes than we do – assuming that climate change doesn’t destroy the economy.  So imposing costs on today’s people, including the poor, is surely less fair than imposing costs on tomorrow’s richer populations?

The benefit of the economics framework is that it clarifies such questions and, to some degree, separates the technical and logical from the value judgements. Economics is not value free, but it does provide a common and well thought through context for very difficult decisions to be debated. This is one reason why using the ideas of economics, including natural capital, offer a potentially fruitful way to improve understanding, increase the data collection on problems and to encourage a better policy outcome, one that is more likely to command wider agreement.

Conclusion: economic analysis is part of the solution

Economists find it relatively easy to analyse climate change as a policy challenge because it is a recognisable case of a well known economic problem, albeit on a much larger scale than usual. That doesn’t mean that economists have the answers. Their recommendations provide a good basis for policy that might accelerate progress towards an answer. A mechanism for “pricing” carbon either through tax or through tradable permits to emit CO2 (as in the faltering European Union Emissions Trading Scheme – ETS) should provide the right signals to consumers to buy fewer carbon-based products. There is also a good economic argument for governments to subsidise research and development into advanced technology, since the market does a poor job of funding early stage research which has a very uncertain payoff. Once technologies are proven they can be left for the most part to the market.


Appendix: the trolley problem

These two thought experiments are designed to get people to reflect on their sense of moral actions. An interesting review of two books on the subject can be found here.

1. You are at a trolley junction, where the track turns into two forks. On fork A, five people are tied to the track and on fork B, one person is tied. An out of control trolley is hurtling down the track. The track switch is currently set to send the trolley down fork A, with the inevitable death of five people. The question is, do you alter the switch, which requires a simple pull on a lever, to divert the trolley to track B, inevitably killing one person but saving five?

2. You are now on a bridge above a trolley track. This time there is a single track but with five people tied to it. An out of control trolley is approaching. On the bridge happens to be a very large, fat man standing on the edge of the bridge. You are confident that this man, if he were to land on the track, would stop or divert the trolley but at the cost of his death. The question is, do you push the fat man from the bridge, saving five people but killing him?

In utilitarian terms the situations are identical: you save five lives at the cost of losing one. Most people say they would push the lever in scenario 1. Far fewer people are comfortable with pushing the fat man off the bridge, even though the outcome is equivalent. There is no correct answer to these questions, which are intended to push students (including future soldiers) to examine their moral instincts. It seems that there is, for many people, a difference between the death of the single person on fork B, who is unfortunately already part of the peril, and the death of a complete bystander who has no prior involvement in the problem. Quite why this should matter is hard to pin down, but it seems to.

A purely utilitarian approach therefore doesn’t do justice to the full range of human moral decision making.

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