The Economic Approach to Environmental and Natural Resources, 3e

Theory and Tools of Environmental and Resource Economics 3e Part I

Introduction • This chapter shows how the economic value measures discussed in Chapter 4 can be used to test the “economic efficiency” of a potential decision or outcome. • One aspect of this process is the measurement of both the value of environmental resources and the value of changes in the level of environmental quality. • This is essential information when comparing the benefits of environmental policy against the costs of obtaining those benefits.

Decision-Making Criteria • The development of a set of criteria on which to base public policy decisions is difficult. • Everyone agrees on a few key criteria, for example, economic efficiency. • However there is general disagreement about what other criteria should be considered. • The following is a suggested list of relevant criteria.

Decision-Making Criteria • Economic efficiency • Equity • Sustainability • Environmental Justice • Ecological impact/environmental stewardship • Ethics • Public participation • Advancement of knowledge

Economic Efficiency • Economic efficiency has to do with maximizing the difference between the social benefit and social cost of an economic activity, policy, or project. • Economic efficiency is usually measured in one of two different ways: • Net economic benefit – preferred by economists and explored in Chp. 4; • Gross domestic product – preferred by international development and lending agencies.

Economic Efficiency – Net Economic Benefit • As the information presented in Chapter 4 indicated, the demand curve represents marginal willingness to pay and the supply curve represents marginal opportunity cost of production. • Net economic efficiency subtracts total opportunity cost from total willingness to pay and is represented by the area under the demand curve and above the supply curve for a particular good or service.

Economic Efficiency – Gross Domestic Product • Gross Domestic Product is a measure of the total value of all goods and services produced in an economy. • Because expenditures become income, GDP is also a measure of national income. • GDP is not a measure of social welfare because it does not measure other dimensions of the quality of life, such as health, environmental quality, social justice, freedom from crime, etc.

Economic Efficiency – Gross Domestic Product • GDP also fails as a measure of economic efficiency. • It does not consider the opportunity costs of producing the good or service. • This failure means that GDP would rise because of a rise in HIV/AIDS due to the increased expenditure on health care costs. • Net economic efficiency would not rise because this measure includes the opportunity cost of using those monies in next best option.

Economic Efficiency – Pareto Criterion • What constitutes an improvement in economic efficiency? • One option is the Hicks-Kaldor criterion, or the criterion of potential Pareto improvement. • Pareto improvement – resources are reallocated in such a fashion that some people are better off and no one is worse off. • Potential Pareto improvement – is reallocation whereby the gain of people who are helped is larger than the losses of those made worse off. If the gainers could compensate losers, the gainers would still be better off.

Equity • Potential Pareto improvement does not consider equity issues. • The equity criterion for evaluating policy considers how costs and benefits are distributed among members of society. • These distributional impacts could be within a country, across international borders, or across generations.

Intracountry Equity • Both environmental degradation and environmental policy create consequences for reducing or increasing the differential in the quality of life that may exist across subgroups of a country’s population. • In the past environmental quality was perceived as a luxury good, ill afforded by lower income individuals. • The negative impact of environmental degradation on agrarian life and urban environments has lead to a change in this view.

Equity Across Countries • Some environmental problems such as global warming require international cooperation. • In the area of preservation of shrinking environmental resources, lower-income countries bear the burden of preserving these for the higher-income countries. • Many policy makers in lower-income countries think they should be compensated for their preservation efforts. • There is also the potential link between poor environmental quality and lower standards of living.

Equity Across Generations and Sustainability • Intergenerational equity is important because many of the decisions regarding resource use today may generate important environmental costs for future generations. • The process of discounting future costs and benefits can exacerbate this problem. • An alternate criterion of sustainability is based on improving the condition of the current generation without compromising the ability of future generations to meet their needs and improve their quality of life.

Equity Indicators • Income is one component of equity. • Two different measures are the primary tools for considering the inequality of the distribution of income, the Lorenz curve and the Gini coefficient. • Figure 5.2 contains an example of a Lorenz curve. • The curve illustrates the percentage of income received by a given percentage of the population. • Equity is illustrated by the diagonal line bisecting the origin. Along this line the two percentages are equal. • Inequity in income distribution is illustrated by a curved line.

Equity Measures - Lorenz Curve

Equity Measures – Gini Coefficient • The farther the Lorenz curve is skewed away from the diagonal line, the more inequitable the income distribution. • This curve can be transformed into a single variable, the Gini coefficient. • The Gini coefficient is calculated by taking the area between the diagonal line and the Lorenz curve and dividing by the entire area under the diagonal line. This value is then multiplied by 100. • The Gini coefficient can range from 0 to 100, where greater numbers are associated with greater inequity.

Equity Measures – Gini Coefficient

Equity -Environmental Justice • Studies have suggested that certain segments of the population face disproportionate exposure to environmental risk. • In the US, minorities, especially those of low income living in rural areas, face greater exposure to carcinogenic and mutagenic hazardous chemicals. • In developing countries, with giant cities, levels of air pollution as well as exposure to toxic waste surpass that of developed countries. • Environmental justice is an issue in rural areas where high levels of pesticide use by large plantation owners impacts villages downwind.

Ecological Criteria • There is no consensus on how to develop measures for quality and functionability of an ecological system. • The first question is how to define a desirable state of an ecosystem. • Ecosystem health – measures a system’s ability to provide a flow of ecological services. • Ecosystem integrity – measures the closeness of the system to a hypothetical reference system that is completely undisturbed by human activity.

Ecosystem Health • Difficult to define what would constitute a healthy ecosystem in terms of the flow of ecological services. • Schrader-Frechette (1998) argues that ecosystem health can be measured with an extension of the traditional ecological risk paradigm. • She discusses the “wholistic” health approach.

Ecosystem Health • Shrader-Frechette notes that many proponents of the concept believe it to be related to at least 3 ecosystem characteristics: • An ecosystem’s ability to maintain desirable vital signs. • An ecosystem’s ability to handle stress. • An ecosystem’s ability to recover after perturbations. • She notes that there are no nonnormative value-free ways to operationalize this concept.

Ecosystem Integrity

Ecosystem Integrity • Cairn’s definition is difficult to operationalize because the definition has nine components, each of which is multidimensional. • For many urbanized, industrialized, or highly agriculturalized areas, the concept of ecological integrity might be inappropriate. • The concept of ecosystem health may be the better choice.

Operational Indicators of Environmental Quality • At least 4 methods have been suggested to develop operational indicators: • The use of “representative” environmental variables. • The use of a “green” GDP. • The development of satellite accounts for National Income and Product Accounts. • The development of indices of sets of environmental variables.

Representative Environmental Variables • Measures of individual types of pollution have been used where the trend in these variables somehow reflected the trend in environmental quality. • This concept is similar to using output in the steel industry as a proxy for GDP. • While using the spotted owl as an indicator species for the Pacific old-growth forests might be appropriate, it would be very difficult to identify an indicator species for as diverse a system as the Amazon.

Green GDP • Many economists have argued that disastrous consequences for the environment result when macroeconomic policy is based on growth of GDP. • While net domestic product (NDP) subtracts the depreciation of human-made capital from GDP, it does not consider the depreciation of natural capital. • If increasing NDP is the primary policy goal, then the loss of future income from depleted natural capital is important.

Green GDP • The resulting measure would still only take into account one link between the environment and social welfare. • It ignores the direct effect of the health of the environment on social welfare. • In addition, macroeconomic approaches tend to focus on environmental resources that are part of the economic production process and less on the resources that contribute to more basic life support services or amenities.

Satellite Accounts • The United Nations Statistical Division recommends the development of a system of environmental satellite accounts to monitor environmental change. • Environmental costs, benefits, and natural resource assets, as well as expenditures for environmental protection, are presented in flow accounts and balance sheets in a manner consistent with National Income and Product Accounts.

Satellite Accounts • Satellite accounts represent a disaggregation of measures of environmental change. • Satellite accounts could serve as inputs for developing indicators of environmental change but not as independent sets of indicators. • The development of independent indicators to examine the trade-offs and overall trends in environmental change would require a large number of measures.

Aggregate Indices • The US Environmental Protection Agency’s Environmental Monitoring and Assessment Program (EMAP) attempts to develop overall indicators for individual ecosystems. • In the case of estuaries, EMAP develops a series of over 20 indicators, but creates an aggregate index by summing the indicators based on water clarity, the benthic index, and the presence of trash. • There is equal weighting for each individual indicator. • Alternatives to equal weighting include normalizing each variable by dividing by its largest value and/or choosing weights based on expert opinion.

Ethics • Ethical dimensions are particularly important and particularly difficult to quantify. • Does the firm or agency have an ethical obligation for environmental stewardship independent of the impact on social welfare? • Should decision-making have an anthropocentric or biocentric approach? • “Deep ecology”, developed by Arne Ness, rejects management of the environment. All components of an ecosystem, as well as the ecosystems themselves, have an intrinsic value and an inherent right to exist. • Ethics can be treated as constraints to the decision-making process.

Public Participation • This is a very different type of decision-making criterion because it relates more to process than outcome. • Fairness and appropriateness of process of arriving at the outcome are also considered to be important. • A good public participation process begins with identifying stakeholders. • A process must be developed where people feel free to voice their concerns. • Skilled moderating is needed. • All results of the process must be communicated to the public at large.

Public Participation • Unlike the old-style public participation process of “decide-announce-defend”, most environmental agencies now begin the public participation process early in the decision-making process. • Four major techniques have been used to incorporate public participation: • Incorporate information about stakeholder 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.

Advancement of Knowledge • This criterion is extremely diverse and has multiple attributes. • Care must be taken to include advancement of knowledge in the decision-making process. • This is best done in a qualitative fashion, because experts can evaluate the importance of potential gains in knowledge associated with a project or decision.

The Use of Multiple Criteria in Decision Making • How do policy makers take multiple decision-making criteria and jointly employ the criteria so as to inform the actual decision? • If too much aggregation is done across criteria, then a lot of the information that is contained in the different criteria will be lost. • Cost-benefit analysis is one approach which has been frequently employed and is even legally required of governmental agencies in many countries.

Cost-Benefit Analysis • The most important concept is that cost-benefit analysis is NOT a decision-making tool; it is only an information organizing tool. • There is no single correct answer to a cost-benefit analysis exercise. • Different assumptions about future states of the world or key analytical parameters will have a big impact on the final outcome. • The analysis should produce a suite of numbers reflecting the sensitivity of the analysis to alternative analytical assumptions.

Cost-Benefit Analysis • Cost-benefit analysis should be a dynamic analysis, investigating costs and benefits far into the future, where future costs and benefits are discounted. • The simplest version of a discounting formula is PV = FV(1/(1+r))t, • where PV is present value, FV is future value, r represents the discount rate and t is the time period.

Cost-Benefit Analysis • The objective of cost-benefit analysis is to identify the alternative project, plan, or policy that has the greatest net present benefit, which will therefore maximize economic efficiency. • A critical aspect of the analysis is the choice of the appropriate discount rate. • The market rate of interest is not appropriate because it includes inflation rates and risk components. • Many analysts argue that the rate used should be the real, risk-free rate of interest.

Cost-Benefit Analysis • The choice of discount rate is critically important because it represents the relative importance of the future. • Even small differences in discount rate can become very important. • This is illustrated in Table 5.3, where the present value of a future stream of income decreases by 90 percent with a 1 percent change in the discount rate. • This difference in value is much less at greater distances in the future where the value in the distant future is unimportant.

Cost-Benefit Analysis

Cost-Benefit Analysis • Displacement theory suggests that the appropriate discount rate to use is one that reflects the opportunity cost of government intervention or the rate of return on private investment which was not made. • However, it is important to recognize that no individual investment can grow faster than GDP for long periods of time. • As such, the discount rate should be no greater than the long-term real rate of growth of GDP. • Sensitivity analysis should be performed to determine the sensitivity of present value measures to alternative choices of discount rates.

Cost-Benefit Analysis • The first step in implementing any cost-benefit analysis is to determine what should be evaluated. • The analyst must identify the credible alternatives to the proposed project and include them in the cost-benefit analysis. • In defining alternatives, the analyst must consider political feasibility, technical feasibility, and economic feasibility.

Cost-Benefit Analysis • The next step is to list the costs and benefits to make sure that all relevant issues are considered. • Care must be taken to factor in environmental costs, both on-site and off-site. • In some cases religious, cultural, and historical significance must be taken into account. • Indirect costs must also be considered.

Cost-Benefit Analysis • In general, benefits are easier to measure than costs. • It is important to recognize alternative solutions in the measurement of the benefit of one project. • It is also important to recognize both private and social benefits associated with a project. • It is important to recognize the difference between the creation of new benefits and the transfer of benefits from one area to another.

Cost-Benefit Analysis- Multiple Scenarios • It is important to build different scenarios when conducting a cost-benefit analysis. • These different scenarios need to consider differing assumptions or predictions about the future states of the world. • Among these are: • Rates of population growth • Rates of growth in GDP • Level of global climate change • Rate of technological innovation • Change in environmental policy.

Cost-Benefit Analysis-Decision Rules • Each scenario should also be evaluated using different discount values. • Various decision rules can be made to allow qualitative comparison and determination of which projects are best. • Examples of decision rules include: • Choose the project that is in the top ranking in the most states of the world. • Choose the project that is in the top two categories in the most states of the world.

Cost-Benefit Analysis – Missing Values • One of the major problems with cost-benefit analysis is how to deal with missing values. • It is not appropriate to use a value of zero. • If the missing value is associated with environmental costs, then it is possible to conduct an analysis without the costs and then consider how the answer might change with those costs factored in. • Alternative approaches to comparing projects with missing information include: • The dominance method choose the option that is best across multiple scenarios; • Estimate how big the missing value would have to be to change the outcome. • Provide general impressions of the unmeasured environmental benefits.

Multiple Decision-Making Criteria • One way to incorporate multiple criteria within decision making is to use a public participation process. • All the alternatives can be scored according to the criteria and the public can be used to choose. • If there is more than one decision-making criterion, then the decision-makers must assign different weights. • One method is to assign weights through informal discussion of the merits of each. • Formal weights can be assigned through a consensus among decision-makers. • A more quantitative approach is to use conjoint analysis.

The Economic Approach to Environmental and Natural Resources, 3e