Unit 20 Economics of the environment

• Production and distribution of goods and services unavoidably alter the biosphere.
• Climate change resulting from economic activity is a major threat to future human wellbeing, and it illustrates many of the challenges of designing and implementing appropriate environmental policies.
• Well-designed environmental policies implement the least-cost ways of reducing environmental damages and balance the cost of reducing environmental damage against the benefits.
• Some policies use taxes or subsidies to alter prices so that people internalize the external environmental effects of their production and consumption decisions; other policies directly prohibit or limit the use of environmentally damaging materials and practices.
• Some environmental systems exhibit processes of degradation, in which substantial and hard to reverse environmental damage occurs abruptly. Prudent policies avoid triggering such processes.
• Evaluating environmental policies raises challenging questions about how to value our natural surroundings and the wellbeing of future generations.

In 1980, one of the most famous bets in science history took place. Paul Ehrlich, a biologist, predicted that rapidly increasing population would make mineral resources scarcer. Julian Simon, an economist, thought that humanity would never run out of minerals because higher prices would stimulate the search for new reserves, and ways of economizing on the use of resources. Ehrlich bet Simon that the price of a basket of five commodities—copper, chromium, nickel, tin, and tungsten—would increase in real terms over the decade, reflecting increased scarcity.

inflation-adjusted price

Price that takes into account the change in the overall price level.

On 29 September 1980, they bought $200 of each of the five commodities (a total wager of $1,000). If prices of these resources went up faster than inflation over the next 10 years, Simon would pay Ehrlich the difference between the inflation-adjusted pricesinflation-adjusted price Price that takes into account the change in the overall price level.close and $1,000. If real prices fell, Ehrlich would pay Simon the difference. During that time, the global population increased by 846 million (19%). Also during that time, income per person increased by $753 (15%, adjusted for inflation in 2005 dollars). Yet, in those 10 years, the inflation-adjusted prices of the commodities fell from $1,000 to $423.93. Ehrlich lost the bet and sent Simon a cheque for $576.07.

The Ehrlich-Simon bet was motivated by the question of whether the world was ‘running out’ of natural resources, but an interval of 10 years is unlikely to tell us much about the long-run scarcity of raw materials. The basic framework of supply and demand (see Units 8 and 11) tells us why. Commodities such as copper or chromium generally have inelastic (steep) short-run demand and supply curves because there are few substitutes for these resources. This means that relatively small demand or supply shocks generate large and sudden changes in the market-clearing price, similar to the market for crude oil that you encountered in Unit 11.

Global commodity prices (1960–2015).

Figure 20.1 Global commodity prices (1960–2015).

The World Bank. 2015. ‘Commodity Price Data.’

But what should happen to the price and availability of copper or chromium in the long run?

As the price of copper rises, producers have an incentive to invest in new technologies that will make its extraction cheaper. Consumers will substitute away from copper to other raw materials. Both of these forces push prices down.

As prices of copper begin to fall, firms cut down on new extraction investments and consumers demand more copper. This pushes the prices back up. The presence of market prices for raw materials therefore ensures that despite increases in population and affluence, we do not ‘run out of resources’. The ratio of known reserves to production does not fall far.

resources (natural)

The estimated total amount of a substance in the earth’s crust. See also: reserves (natural resource).

Over the last 200 years, prices for many mineral resources have not changed much, although extraction has increased dramatically. Although prices fluctuate from year to year, the overall trend is flat. This indicates that the supply of many raw materials in the earth’s crust—natural resourcesresources (natural) The estimated total amount of a substance in the earth’s crust. See also: reserves (natural resource).close—is quite vast.

The transformation of living standards since the Industrial Revolution has been possible because of the combination of human ingenuity and available resources in the form of air, water, soil, metals, hydrocarbons like coal and oil, fish stocks, and so on. These were all once abundant and free, apart from the costs of extraction. Some, like hydrocarbons and mineral resources, are still abundant. Others, like unpolluted air, biodiversity (including coral reefs and many land and marine species), forests (due to deforestation and desertification), and clean water, are becoming scarce.

But the absence of prices is not the only reason why managing renewable natural resources is so hard. In some cases, the fragility of our environment under pressure from the growth of economic activity can lead not only to progressive degradation, but also to accelerating, self-reinforcing collapse. An example is the Grand Banks cod fishery, in the north of the Atlantic Ocean. In the eighteenth and nineteenth centuries, legendary schooners such as the Bluenose (Figure 20.2) raced back to port to sell their catch to be the first on the market, and to offer fresh fish. By the late twentieth century, the Grand Banks had sustained the livelihoods of the US and Canadian fishing communities for 300 years.

The Grand Banks fishing schooner, The Bluenose.

Figure 20.2 The Grand Banks fishing schooner, The Bluenose.

Then suddenly, the fishing industry in the Grand Banks died and, along with it, many of the old fishing towns. Figure 20.3 gives the quantity of cod caught over 163 years, showing a gradual upward trend and a pronounced spike coinciding with the introduction of industrial fishing less than 50 years before the eventual disappearance of cod from the Grand Banks. You learned some reasons why an open-access resource is likely to be overexploited in Units 4 Unit 12, and it appears that in this case the cod was greatly overfished. North Atlantic fisheries are now recovering after governments imposed restrictions, but we still do not know if the cod will come back in their previous numbers.

The amount of cod caught in the Grand Banks (North Atlantic) fisheries (1851–2014).

Figure 20.3 The amount of cod caught in the Grand Banks (North Atlantic) fisheries (1851–2014).

Millennium Ecosystem Assessment. 2005. Ecosystems and Human Well-Being: Synthesis. Washington, DC: Island Press.

positive feedback (process)

A process whereby some initial change sets in motion a process that magnifies the initial change. See also: negative feedback (process).

Rapid changes like the Grand Banks cod disappearance are referred to as ecosystem collapse, and result from environmental vicious circles. In the Amazon, for example, change may become self-reinforcing due to the positive feedback processespositive feedback (process) A process whereby some initial change sets in motion a process that magnifies the initial change. See also: negative feedback (process).close illustrated in Figure 20.4. Past a certain level of deforestation, the process becomes self-sustaining even without further expansion of farming.

Positive feedback processes and deforestation in the Amazon.

Figure 20.4 Positive feedback processes and deforestation in the Amazon.

Similarly, the process of global warming can be self-reinforcing due, for example, to its impact on Arctic ice cover, as we will see later in Section 20.8.

The depletion of commodities and global warming are two aspects of environmental degradation. But we will see that there is also an important difference between the two: commodities are priced and traded, and so over-use of some resources may self-correct as prices of scarce commodites rise. Negative external environmental effects are usually only corrected through coordinated policy or political action, which is harder to achieve. This action has often been too little or too late, as we will see.

In the rest of this unit, we will show that environmental problems are as diverse as nature itself, and that understanding the economics of the environment will require you to employ not only the tools you have learned already, but also to study the interaction of physical and biological processes with human economic activity.

Look back at Figure 11.7 showing world oil prices and global oil consumption to answer Question 20.1.

The study of environmental economics began in Unit 1 of this course, where we saw that economic activity (the production and distribution of goods and services) takes place within the biological and physical system. As we saw in Figure 1.5 and Figure 1.12, the economy is embedded within society, but also within the ecosystem. Resources flow from nature into the human economy. Waste, such as carbon dioxide (CO₂) emissions, or toxic sewage produced by firms and households, flows back into nature—mainly into the atmosphere and the ocean. Scientific evidence suggests that the planet has a limited capacity to absorb the pollutants that the human economy generates. In this unit, we investigate the nature of the global ecosystem, which provides the resources that feed economic processes and the sinks where we dispose of our wastes.

In Unit 4, we introduced environmental problems at a local level, among people who were similar in most respects. Anil and Bala were neighbouring landowners with a pest management problem. They could choose between an environmentally damaging pesticide and benign pest management systems. The outcome was inefficient and environmentally destructive because they could not make a binding agreement (a complete and enforceable contract) in advance about how they would act. In Unit 4, we also discovered that contributing to sustaining the quality of the environment is, to some extent, a public good, and that there are strong self-interested motives to free ride on the activities of others. So, while everyone would benefit if we all contributed to protecting the environment, we often do not do our part.

When small numbers of individuals interact, however, we saw that informal agreements and social norms (a concern for the others’ wellbeing, for example) might be sufficient to address environmental problems. Examples found in real life include irrigation systems and the management of common land.

In Unit 12, we expanded the scope of environmental problems to include two groups of people pursuing different livelihoods. We considered a hypothetical pesticide called Weevokil (based, again, on real-world cases) and its effects on fishing and the jobs of workers who produce bananas. In this case, there was a missing market—the plantation owners did not need to buy the right to pollute the fisheries, because they could do it for free. This is another case of an incomplete contract.

In cases like this, taxes can increase the polluter’s marginal private cost of production so that it equals the marginal social cost, resulting in the socially optimal level of production (and pollution). We canvassed a variety of solutions to the environmental problem (the external effects of the pesticide on the downstream fisheries), including bargaining between the organizations of fishermen and the plantation owners, and legislation (in the real-world case that inspired our Weevokil model, the government eventually banned the chemical).

Figure 20.5 reproduces a segment of Figure 12.8 that summarizes the nature of market failures in interactions between economic actors and the environment, and lists some possible remedies.

In this unit, we also consider the problem of climate change. Like the market failures above, climate change arises due to missing markets. However, unlike local environmental issues, climate change is global in scope. It involves people with vastly differing interests, ranging from those whose entire nation may be submerged by rising sea levels to those who profit from the production and use of the carbon-based energy that contributes to global climate change. We will see that many of the concepts developed already, such as feasible sets and indifference curves, apply in these cases as well.

The problem of climate change combines missing markets, uncertainty about its effect on the economy, the possibility of positive feedbacks and environmental tipping points, the need for international cooperation, and intergenerational issues. It is the greatest challenge of our time, and we need to use our entire toolkit (and more) to see how we can address it.

abatement policy

A policy designed to reduce environmental damages. See also: abatement.

Like other environmental problems, climate change can be addressed by environmental damage abatement policiesabatement policy A policy designed to reduce environmental damages. See also: abatement.close such as:

• discovering and adopting technologies that are less polluting
• choosing to consume fewer or less environmentally damaging goods
• banning or limiting the use of environmentally harmful substances or activities

However, the economic costs of immediately eliminating all CO₂ emissions would surely exceed the environmental benefits. But what level of environmental abatement should be adopted instead?

This is in part a question about the facts: What is the trade-off between the benefits of producing and consuming more, and the enjoyment of a less-degraded environment? It is also an ethical question: how should we value environmental quality? How should we trade off consumption now, with environmental quality enjoyed both by current and future generations?

If we ask citizens about their views of proposed environmental policies, we expect their responses will differ, partly because a deteriorating environment affects different people in different ways. Your point of view may depend on whether you work outdoors (you will benefit more from a less polluted local environment) or in fossil fuel production (you may lose your job if the higher abatement costs levied on your firm causes it to shut down). It may depend on whether you have no choice but to live near a source of air pollution, or are wealthy enough to have a second home in the countryside.

Your opinion about how much we should spend today to protect future environments would no doubt differ from the values of those who make up the distant future generations that would be affected by our choices, if we could ask them. People’s views are strongly influenced by their self-interest but, as you would expect from the behavioural experiments in Unit 4, not totally so. We worry about the effect on others, even complete strangers.

For simplicity, we begin by setting aside these differences and consider a population composed of identical individuals. We ignore future generations, or optimistically assume that we will all live forever. We will begin by also assuming that everyone enjoys (or suffers from) the same level of environmental quality. Later in this unit we will look at what changes when we do not make these assumptions.

We will also start off with what we call the ‘ideal policymaker’ who seeks to serve the citizens’ interests.

How can economics help the policymaker determine the level of environmental quality that we would like to enjoy, knowing that people may have to consume less so they can enjoy a better environment? The first thing to think about is the actions that we can take and their consequences: the feasible set of outcomes.

To do this, we need to consider the ways that the resources of the society could be diverted from their current uses to reduce the environmentally degrading effects of economic activity. The nation may adopt policies to limit environmental damage. We refer to such policies as abatement policies, since they abate (reduce) pollution and environmental damage. The amount of reduction in emissions caused by these policies is referred to as the quantity of abatement. Abatement policies include taxes on emissions of pollutants, and incentives to use fuel-efficient cars.

In the rest of this section, we use a specific example to illustrate the general approach to environmental cost-benefit analysis. The specific case is the choice of global policies that reduce greenhouse gas emissions. Keep in mind that we are assuming that the policymakers throughout the world are able to implement these policies.

Abatement costs and the feasible set

global greenhouse gas abatement cost curve

This shows the total cost of abating greenhouse gas emissions using abatement policies ranked from the most cost-effective to the least. See also: abatement policy.

To get some idea of how economists assess abatement policy options, we look at the estimated cost of reduction of global greenhouse gas emissions in Figure 20.9, which shows the relationship between potential abatement and the cost of abatement per tonne. It is the marginal cost curve for the good, which we refer to as the global greenhouse gas abatement cost curveglobal greenhouse gas abatement cost curve This shows the total cost of abating greenhouse gas emissions using abatement policies ranked from the most cost-effective to the least. See also: abatement policy.close. These estimates were made by the consultancy firm McKinsey.

The measure of potential abatement, gigatonnes (10⁹ tonnes) of carbon dioxide equivalent (GtCO₂e), is a unit used by the UN climate change scientific panel, the IPCC, to measure the effect of a technology or process on global warming. It expresses how much warming a given type of greenhouse gas would cause by using the equivalent amount of CO₂ emissions that would have the same effect. 

Each bar represents a change that could reduce carbon emissions. The height shows the cost of using the technology to reduce carbon emissions, in terms of euros per tonne of reduced CO₂ emissions. The width shows the reduction of CO₂ emissions, compared to the level without policy intervention. Therefore, for each method, a short bar means that there is a lot of abatement per euro spent. A wider bar means that this method has a higher potential to abate emissions.

Note that in this figure we have only included policies which have a cost. There are many other policies that are win-win, because they both reduce carbon emissions and save money, such as fitting insulation in older houses. The full range of policies can be seen in Figure 20.26; the costly ones are in Figure 20.9. We discuss the implications of win-win policies in Section 20.10. You may wish to read that section now before working through the rest of the unit.

The cost of potential global greenhouse abatement in 2030 (compared with business as usual), using different policies.

Figure 20.9 The cost of potential global greenhouse abatement in 2030 (compared with business as usual), using different policies.

McKinsey & Company. 2013. Pathways to a Low-Carbon Economy: Version 2 of the Global Greenhouse Gas Abatement Cost Curve. McKinsey & Company.

In Figure 20.9, we order the policies from those with the least cost per tonne of CO₂ abated on the left to the highest cost per tonne abated on the right. By this measure, abating carbon emissions through changes in agriculture is the most efficient method, if we disregard the win-win policies. Nuclear, wind, and solar photovoltaics are all moderately efficient. At the time these estimates were produced, retrofitting gas-fired power plants for carbon capture and storage is the highest-cost policy per tonne of CO₂ abated. Together, the bars form a marginal cost curve, showing the cost of an additional tonne of abatement at any given level of abatement, assuming that we adopt the most efficient technologies first.

The science in this field is young, and technologies are continuously devel­oping. As knowledge advances, the estimated abatement cost curve will change—indeed, it is likely to have changed already from the data shown here, which was published in 2013. For instance, rapid reductions in costs of solar power are likely to increase the efficiency of solar abatement, and therefore reduce the height of the bars associated with solar energy (see Figure 20.19a).

But even focusing on only the most efficient bars, implementing any of these abatement policies would divert resources from the production of other goods and services: the opportunity cost of an improved environment would be reduced consumption.

We can use data from the marginal cost curve for abatement (as in Figure 20.9) to estimate how much abatement we get for any level of expenditure, assuming we implement the most efficient methods first. These calculations are given in Figure 20.10. We would start by implement­ing the cheap and effective measures, such as land management and conversion policies. Having exhausted these policies, the curve becomes flatter at higher levels of expenditure, where we would be devoting more resources to less efficient methods such as carbon capture and storage (CCS) modifications to power stations. For more detail on the calculations of marginal abatement costs, see the Einstein at the end of this section.

The least-cost abatement curve: How total abatement (at least cost) depends on total abatement expenditures.

Figure 20.10 The least-cost abatement curve: How total abatement (at least cost) depends on total abatement expenditures.

McKinsey & Company. 2013. Pathways to a Low-Carbon Economy: Version 2 of the Global Greenhouse Gas Abatement Cost Curve. McKinsey & Company.

The curve in the figure, called the least-cost abatement curve, gives all the combinations of expenditures and resulting abatement when the lowest-cost changes are introduced first and the higher-cost ones are introduced later.

Using figures like 20.10, we can establish all of the possible combinations of consumption and abatement that are feasible. The available abatement technology is shown by the shaded set of points in Figure 20.11. In this figure, the horizontal axis measures the expenditure on abatement. The vertical axis measures environmental quality by the amount of abatement achieved. The zero point on the vertical axis is a situation in which no abatement occurs.

dominated

We describe an outcome in this way if more of something that is positively valued can be attained without less of anything else that is positively valued. In short: an outcome is dominated if there is a win-win alternative.

The shaded area is the feasible set of abatement expenditures and environmental outcomes. Points like A in the interior of the set are inefficient abatement policies. At A, we can see that there are alternative measures that would achieve the same level of abatement (25 gigatonnes) at lower cost (€400 billion rather than €600 billion). Similarly, for an expenditure of €600 billion, the choice of the most cost-effective abatement techniques would deliver 30 tonnes of CO₂ abatement and therefore higher environmental quality than at point A. Economists say that a point like A is dominateddominated We describe an outcome in this way if more of something that is positively valued can be attained without less of anything else that is positively valued. In short: an outcome is dominated if there is a win-win alternative.close by points A′ and A″ and all the points in between. This means that at any of these other points there could be lower abatement costs and the same level of abatement (A′), or greater abatement at the same cost (A″).

The least-cost abatement curve: The trade-off between total cost of abatement and amount of abatement.

Figure 20.11 The least-cost abatement curve: The trade-off between total cost of abatement and amount of abatement.

How would an inefficient point like A in Figure 20.11 occur? In Figure 20.10, the policies were ordered so that the first expenditures on abatement are devoted to the most effective abatement policy. After exhausting the potential of each policy we moved to the next most effective policy.

To highlight the difference between an efficient and an inefficient abatement policy, Figure 20.12 shows the abatement options based on the data in Figure 20.9, but with more costly policies adopted first. If a society has committed to spend €8.37 billion on abatement, and spends it all on coal carbon capture, nuclear, and other less effective options, then the least-cost abatement curve would be as shown in Figure 20.12.

An abatement cost curve in which more costly technologies are adopted first.

Figure 20.12 An abatement cost curve in which more costly technologies are adopted first.

We can see that if €8.37 billion were spent on abatement, the level of abatement would be 4.94 gigatonnes of CO₂, rather than the abatement of 11.2 gigatonnes that would have occurred if the society implemented least-cost policies, as shown in Figure 20.10.

Figures 20.10 and 20.12 send a clear message about priorities. If we have a limited amount to spend on abatement, and abatement technology does not change, focus on reducing pastureland conversion. According to Figure 20.10, we should also adopt nuclear power (assuming that waste storage and other security issues can be addressed), solar, and wind power before building new coal plants with carbon capture and storage (CCS), or retrofitting old coal plants for CCS.

To study environment-consumption trade-offs, we invert the least-cost abatement curve, just as we did with the grain production function in Unit 3. Suppose that, after a given level of government expenditure on other policies and also a given level of investment, the maximum amount that people could consume in the economy if no abatement is implemented is €500 billion of goods and services. Then the feasible choices are the shaded portion of Figure 20.13.

In Figure 20.13, the vertical axis still measures the quality of the environment, but the horizontal axis now measures the goods available for consumption after abatement costs (from left to right). So, abatement expenditures are now measured from right to left.

If no abatement policies are adopted

If abatement costs are zero, the nation can have €500 billion of consumption.

Figure 20.13a If abatement costs are zero, the nation can have €500 billion of consumption.

€50 billion of abatement costs

The nation is at point X after spending this amount.

Figure 20.13b The nation is at point X after spending this amount.

Figure 20.13 Feasible consumption and environmental quality.

The abatement choice problem now looks familiar. The policymaker wishes to select a point among the alternatives on the feasible frontier. Recall from the earlier units that the slope of the feasible frontier, also known as the marginal rate of transformation (MRT), is how much of the quantity on the vertical axis you would get by giving up one unit of the quantity on the horizontal axis. In the consumption-environment feasible frontier, this is the marginal rate of transformation of foregone consumption into environmental quality:

The steeper the feasible frontier (the greater the slope), the smaller the opportunity cost, in terms of foregone consumption, of further environmental improvements.

Environment-consumption indifference curves

Which point on the feasible set will the policymaker choose? The answer can be found by studying the policymaker’s environment-consumption indifference curves in Figure 20.14, which show how much consumption citizens are willing to trade in exchange for better environmental quality.

We can write the slope of the indifference curve, the marginal rate of substitution (MRS) as:

The policymaker’s MRS will be high (a steep indifference curve) if consumption is valued highly by the citizens (a large marginal utility of consumption), and if citizens do not place a high value on additional abatement to improve environmental quality (marginal utility of abatement is low). Conversely, if the citizens value additional environmental quality highly relative to consumption, the MRS will be less steep.

In Figure 20.14, the indifference curves are straight lines because we have assumed for simplicity that the marginal utility of consumption and the marginal utility of environmental quality are both constant. That means they do not depend on the quantity of consumption or on the amount of abatement.

Allocating €50 billion to abatement

Point X is the level of environmental protection that the policymaker would wish to implement, with environmental quality at E*.

Figure 20.14a Point X is the level of environmental protection that the policymaker would wish to implement, with environmental quality at E*.

Allocating less than €50 billion to abatement

At B, the MRS is less than the MRT (the slope of the feasible set at B), so the policymaker would be better off by switching more resources from consumption into improving environmental quality. Spending more on abatement shifts the policymaker onto higher indifference curves until point X is reached.

Figure 20.14b At B, the MRS is less than the MRT (the slope of the feasible set at B), so the policymaker would be better off by switching more resources from consumption into improving environmental quality. Spending more on abatement shifts the policymaker onto higher indifference curves until point X is reached.

Figure 20.14 The ideal policymaker’s choice of the abatement level.

To think about how citizens’ preferences affect the optimal policy chosen, we suppose that the policymaker takes account of the preferences of all of the citizens, counting them equally. This means that if citizens decide to value environmental quality more, then the indifference curves of the policymaker will be flatter to reflect this.

Cost-benefit analysis: The ideal policymaker chooses an abatement level

Our policymaker uses two principles to make a decision about the level of abatement:

• She considers only abatement policies on the frontier of the feasible set: This eliminates higher-cost abatement policies that are inside the shaded area.
• She chooses the combination of environmental quality and consumption that puts her on the highest possible indifference curve.

To satisfy both conditions, she finds the point on the feasible frontier that equates the MRT (the slope of the feasible frontier) with the MRS (the slope of her highest possible indifference curve).

We can see from Figure 20.14 that point X is the level of environmental protection that the policymaker will wish to implement. The benefit indicated by the environmental quality index of 62 is achieved at a cost of reducing consumption by €50 billion and allocating it to abatement.

What would produce a different choice of abatement level?

• Different values: If the citizens cared less about the environment, then the indifference curves would be steeper than those in Figure 20.14, and the policymaker would choose a point like B, with higher consumption and lower abatement.
• Different costs of abatement: If abatement became cheaper than shown in Figure 20.14, then the feasible set would be steeper at each level of abatement. This would expand the production frontier upwards, implying that the policymaker would choose a higher level of abatement and lower consumption.

Exercise 20.3 Choosing abatement strategies

Look at the high-cost abatement strategies that we use to illustrate an inefficient abatement policy in Figure 20.12. Can you think of reasons why these policies might be introduced instead of the more cost-effective ones?

Exercise 20.4 Optimistic and pessimistic policies

In Figure 20.14, we described how a policymaker representing a uniform group of identical citizens chooses the optimal amount of abatement.

1. Draw the indifference curves of the policymaker if she were to represent two different groups of citizens (again, we assume that all citizens in each group are identical, and the marginal utility of consumption and environmental quality are both constant). In the first group, citizens care more about environmental quality than consumption, and in the other group, citizens care more about consumption of goods and services. Explain why the optimal level of abatement costs will differ across groups.
2. Now consider the example in the text of the abatement of global greenhouse gases. What are the main simplifications in the model that might lead the policy maker who uses this model to ignore important aspects of the problem of global greenhouse gas abatement?

In reality, there is uncertainty about the effectiveness of abatement expenditure and hence how costly abatement of environmental damage will be.

3. On a new diagram, draw the feasible consumption frontier based on an optimistic assessment of the costs of abatement.
4. Now draw the feasible consumption frontier based on a pessimistic assessment of the costs of abatement on the same diagram.
5. By adding the policymaker’s indifference curves to your diagram in each case (assuming all citizens are identical), show how actual environmental quality chosen by the policymaker will differ, even if preferences are the same, depending on whether costs of abatement are assessed optimistically or pessimistically.

Einstein Marginal abatement costs and the total productivity of abatement expenditures

How do we construct the line segments that define the boundary of the feasible set in Figure 20.10 from the data in Figure 20.9?

Let the height of the first bar (the most cost-effective abatement expenditure) in Figure 20.8 be y and the width of that bar be x. Then, in Figure 20.10:

• the initial slope of the curve is 1/y
• the horizontal axis value of the first point is xy
• this point’s vertical axis value is x

The other line segments making up the curve in Figure 20.9 are constructed in the same way.

Conflicts of interest arise because environmental quality is never the same for everyone. Some people benefit or suffer more than others, depending on their location and income, as we saw in the banana pesticide case studied in Unit 12.

Here are two examples of how costs and benefits are not equally shared. In 2008 and 2009, two oil spills in the Niger River delta destroyed fisheries. The spills resulted from the oil extraction activities of the Anglo-Dutch company, Royal Dutch Shell. Lawyers for the Ogoni people, who suffered these external effects, brought a lawsuit against the Nigerian subsidiary of Shell in the British courts. In 2015, Shell settled out of court and paid £3,525 per person, of which £2,200 was paid to each individual, and the rest to support community public goods. This award amounted to more than most Ogoni people would earn in a year. Lawyers representing the community helped to set up bank accounts for the 15,600 beneficiaries.

The transfers may have compensated the Ogoni in part for the loss of a healthy environment, restoration of which the UN Environment Programme has estimated will cost $1 billion and take 30 years. For Royal Dutch Shell, the settlement at least partially internalizes the negative external effects of their activities, and might lead the company’s owners (and others extracting oil in the delta) to consider a change in their behaviour.

In 1974 a giant lead, silver, and zinc smelter owned by the Bunker Hill Company was the only major employer in the town of Kellogg, in the American state of Idaho, employing 2,300 people. Many children in the town developed flu-like symptoms. Doctors discovered that they were the result of high lead levels in their blood—high enough to impair cognitive and social development of children.

Three of the children of Bill Yoss, a welder at the smelter, had been found to have dangerously high levels of lead poisoning. ‘I don’t know where we’ll end up,’ he told a People reporter, ‘We may pull out of the state.’

The company refused to release its own tests of the smelter’s lead emission levels. Unless the state’s emissions regulations were relaxed, it said, the smelter would shut down, which it did, in 1981. Former employees looked for work elsewhere. The value of the homes and businesses in the town fell to a third of its earlier level. The local schools, which were supported by property taxes, did not have the funding to cope with those who remained.

We model this problem by considering a hypothetical town, Brownsville, with a single business that employs the entire labour force but whose toxic emissions are a threat to the health of the citizens. The firm can vary the level of emissions that it imposes on the town, but the costs of implement­ing emissions capture and storage means lost profits. The single owner of the firm (who bears the costs of reducing the level of emissions) lives far enough away that the level of emissions he selects does not affect the quality of his environment. Therefore citizens and the business will have a conflict of interest over the level of emissions in the town, and also over the wages paid. You can think of the citizens as valuing ‘environmental quality’, which decreases when emissions increase and can be measured by an air quality index.

The citizens of the town have some bargaining power because each is free to leave Brownsville and seek employment elsewhere. So the business must offer them a package of environmental quality and wages that is at least as desirable as their reservation option, which is what they might expect to receive if they left Brownsville. We call this limit on what the business must offer the citizens the ‘leave town condition’.

The business owner has bargaining power, too, because the wage and environment package that he offers must result in profits high enough that the firm does not simply shut down or relocate (we call this the firm’s ‘shutdown condition’). The citizens cannot demand more than this wage, or they would be unemployed (remember there are no other firms in Brownsville). Thus the firm’s reservation option places limits on the bargain that the citizens can strike with the firm.

We represent the relationship between the business and the citizens in Figure 20.15. The wage paid to the employees of the firm is on the horizontal axis. The level of environmental quality experienced by the citizens is on the vertical axis. We make the following assumptions:

• Citizens are identical and so experience the same environmental quality.
• The owner is unaffected by the level of pollution: For him, the environmental external effects resulting from his decision about emissions are borne by others. Pollution for him is a private ‘good’, and he does not consume any of it.

Work through the analysis in Figure 20.15 to see how the choices of the citizens and businesses are modelled.

The representative citizen’s reservation indifference curve is the ‘leave town condition’

This gives all the combinations of wages and environmental quality that would be just barely sufficient to induce a representative citizen to stay.

Figure 20.15a This gives all the combinations of wages and environmental quality that would be just barely sufficient to induce a representative citizen to stay.

The firm’s ‘shutdown condition’

This shows the combinations of wages and environmental quality offered by the firm that would just barely keep the firm in Brownsville.

Figure 20.15b This shows the combinations of wages and environmental quality offered by the firm that would just barely keep the firm in Brownsville.

Infeasible options

The portions of the figure above the firm’s shutdown condition and below the citizen’s leave town condition are infeasible.

Figure 20.15c The portions of the figure above the firm’s shutdown condition and below the citizens’ leave-town condition are infeasible.

The citizens have power, point B

Suppose the citizens could impose a legally enforceable level of environmental quality in the town and set their own wages. Consistent with the firm remaining in town, the citizens set wages at w* and quality of the environment at E^max.

Figure 20.15d Suppose the citizens could impose a legally enforceable level of environmental quality in the town and set their own wages. Consistent with the firm remaining in town, the citizens set wages at w* and quality of the environment at E^max.

A take-it-or-leave-it ultimatum, point A

On the other hand, if the firm could announce a take-it-or-leave-it ultimatum, it would minimize costs whilst ensuring the citizens do not choose to leave town at E^min.

Figure 20.15e On the other hand, if the firm could announce a take-it-or-leave-it ultimatum, it would minimize costs whilst ensuring the citizens do not choose to leave town at E^min.

The difference between E^max and E^min

This is a measure of the extent of mutual gains the citizens and the business may enjoy. Any outcome in the shaded area is preferred by both parties to their outside option, but only the points between A and B, such as C, are Pareto efficient.

Figure 20.15f This is a measure of the extent of mutual gains the citizens and the business may enjoy. Any outcome in the shaded area is preferred by both parties to their outside option, but only the points between A and B, such as C, are Pareto efficient.

Figure 20.15 Conflicts of interest over wages and abatement.

You may recall that this figure is very similar to Figure 5.8, in which Angela the farmer and Bruno the landowner were bargaining over the amount of grain Angela would transfer to Bruno. As in that problem, the study of a bargaining problem is easier if the slope of the indifference curves remains unchanged at a given wage as utility increases.

Here, the conflict is about the amount of emissions that the townspeople will suffer. The firm’s profits depend on the emissions, and profits are greater if it can dispose of more toxic materials freely.

The position of the citizens’ reservation indifference curve depends on what they would expect to get in some other location. If they could find a high-paying job in a non-toxic community, the curve would be higher and to the right of the one that is shown. Its slope, the marginal rate of substitution, is the citizens’ marginal utility of higher wages, divided by the marginal utility of environmental quality.

We assume that the citizens’ marginal valuation of improvements in the environment is constant, but (in contrast to the model in Section 20.3) they have diminishing marginal utility of receiving higher wages. At high wages (and very poor environmental quality) on the far right of the reservation indifference curve, the MRS is small (the curve is almost flat) because citizens would not care much about wages (as they are already getting paid a high wage) but they are very concerned about the poor environment. At low wages the curve is steep, because they place a high value on wage increases.

The firm’s shutdown condition shows the combinations of wages and environmental quality offered by the firm that would barely keep the firm in Brownsville. All of the points on this line have the same cost of producing a unit of output and, as a result, the same profit rate. The firm’s profits are increasing as you move towards the origin. It is like the isocost curve in Unit 2, and the isocost lines for effort in Unit 6.

The cost of raising the wage by $1 is $1. Assume the cost incurred by the owner if he reduces emissions is p per unit of abatement, so the owner’s MRS = 1/p. A steep line indicates that p is small—avoiding emissions and thereby allowing a healthier environment is cheap.

The firm faces a trade-off. If it is at point B in the figure, it pays wages and produces emissions at a level that makes it barely profitable enough to stay in business. Therefore, if it offers a higher-quality environment to the citizens, it can only do this by offering a lower wage. The opportunity cost of one unit of a better environment is p in reduced wages.

Any combination of wages and environmental quality in the shaded portion of the figure is a feasible outcome of this conflict. Any combination on the vertical line between A and B is a Pareto-efficient outcome. We cannot say which feasible outcome will occur, though, unless we know more about the bargaining power of the citizens and the firm.

The firm has all the bargaining power

If the firm could simply announce a take-it-or-leave-it ultimatum, then it would choose point A in Figure 20.15. The firm’s costs will then be well below the shutdown level of costs because they will be freely emitting toxic materials, which reduce the citizen’s environmental quality from E^max, the least emissions (and highest quality environment) consistent with the firm staying in business, to E^min. This difference (E^max − E^min) shows up as cost reductions, and hence as additional profits, in the firm’s accounts. It also shows up as exposure to health hazards in the medical records of the people who live in the town.

The firm’s chosen point, A, is on the citizens’ reservation indifference curve where the vertical distance between the firm’s shutdown condition and the citizens’ leave town condition is the greatest. This will occur when:

Citizens have all the bargaining power

If the bargaining power had been reversed, then the citizens would choose to impose E^max and wages w*. This ensures that the citizens are on their highest possible indifference curve, while also satisfying the firm’s shutdown condition. Again, at this point the MRS of the business is equal to the MRS of the citizens.

Dividing the mutual gains

The difference between E^max and E^min measures the extent of mutual gains the townspeople and the business may enjoy. Any outcome between A and B on the figure is preferable to the next best alternative for the business (shut down) and the citizens (leave town). You can think of the mutual gains as a pie that the citizens and the business owner will divide. How the pie is divided up between the two parties depends, as we have seen in Units 4 and 5, on their relative bargaining power.

A point such as C in Figure 20.15 might be possible if the citizens, acting jointly through their town council, imposed a legal minimal level of environmental quality and wages for the business to continue to operate. Acting together, the citizens would have more bargaining power than if they used the threat to leave town as individuals: they could require that the business at least meet the citizens’ ‘shut-it-down condition’ shown in Figure 20.15.

Bargaining power in this case would be affected not only by the two parties’ reservation options but also by:

• Enforcement capacity: The town government may not have enforcement capacities to impose an emissions limit on the firm.
• Verifiable information: The citizens may not have sufficient information about the levels and dangers of emissions to win a case in court. If so, the firm would not comply with an agreed-upon emissions level such as at C in Figure 20.15.
• Citizen consensus: If the town’s citizens were not in agreement about the dangers of the emissions, the elected officials of the town who legislate an emissions limit might not be re-elected.
• Lobbying: The firm may be able to convince the citizens that their health concerns were misplaced, or had little to do with the firm’s emissions.
• Legal recourse: The firm may be legally entitled to emit any level of emissions that it finds profitable (perhaps subject to having purchased permits allowing it to do this).

So far we have focused on the question of how much abatement there should be. Now we consider a second question: How should the desired level of abatement be accomplished?

price-based environmental policy

A policy that uses a tax or subsidy to affect prices, with the goal of internalizing the external effects on the environment of an individual’s choices.

quantity-based environmental policy

Policies that implement environmental objectives by using bans, caps, and regulations.

In Unit 12, we saw possible remedies for the market failure that arose from the negative external effects of pesticide use. The range of remedies included private bargaining between the pesticide users and the fishing community whose livelihoods were threatened, taxes to make the pesticides (or the bananas produced using them) more expensive, ownership of all affected assets by a single business or other decision-making entity, and quotas or outright bans on the use of the pesticide. Some of these policies would have made it more expensive to harm the environment so as to provide incentives for greener economic decision making (price-based policiesprice-based environmental policy A policy that uses a tax or subsidy to affect prices, with the goal of internalizing the external effects on the environment of an individual’s choices.close). Others would have made it illegal (quantity-based policiesquantity-based environmental policy Policies that implement environmental objectives by using bans, caps, and regulations.close).

cap and trade

A policy through which a limited number of permits to pollute are issued, and can be bought and sold on a market. It combines a quantity-based limit on emissions, and a price-based approach that places a cost on environmentally damaging decisions.

A policy called cap and tradecap and trade A policy through which a limited number of permits to pollute are issued, and can be bought and sold on a market. It combines a quantity-based limit on emissions, and a price-based approach that places a cost on environmentally damaging decisions.close is a policy that combines a legal limit on the amount of emissions with an incentive-based approach to assigning the abatement required to meet this legal limit among firms and other actors.

Here is the idea:

• The government or governments set the total level of abatement required: This is called the ‘cap’ and it constitutes the ‘quantity’ side of the policy.
• The government creates permits: The number of permits issued limits total emissions to the size of the cap.
• The government allocates permits: They can be given to the firms operating in industries emitting the pollutant, or they can be auctioned to polluting firms by the government.
• The permits are traded: For some firms, polluting is very profitable and abatement costly. They will buy permits from other firms. Firms that produce little pollution or have low costs of abatement may have excess permits, which they can sell. Trade occurs until the gains from trade are eliminated.
• The firms submit permits to government to cover their emissions: For each tonne of emissions produced, firms are required to provide one permit to the government. Ideally, government monitoring ensures that firms cannot cheat, and any firms caught violating the law are penalized with large fines.

Cap and trade policies are a way of implementing some desired level of emissions (or, equivalently, the total level of abatement required, E*) as the ideal policymaker did in Figure 20.13.

The desired level, however decided, is shown by the length of the horizontal axis in Figure 20.16. The question addressed by cap and trade is: given that firms vary in their production technologies, how will the total amount of required abatement be divided among them? The objective of a scheme for trading permits is that the abatement should be done by the firms for which this is least costly because this saves scarce resources that can be used elsewhere.

To see how this works, go through the analysis in Figure 20.16, which shows the case where the number of permits is initially divided equally between two firms with different costs of abatement.

The marginal private cost of abatement (MPCA) of firm A

This is shown in red and measured in the usual way from the left-hand axis. It rises as its cost of abatement increases. Firm A uses a relatively low-emissions technology to produce its product.

Figure 20.16a This is shown in red and measured in the usual way from the left-hand axis. It rises as its cost of abatement increases. Firm A uses a relatively low-emissions technology to produce its product.

The marginal cost of abatement (MPCA) of firm B

This is shown in blue and measured from the right-hand axis, so it rises from the right origin as B engages in more abatement. Firm B uses a more emissions-intensive technology to produce its product, and therefore its marginal cost of abatement is higher than for Firm A.

Figure 20.16b This is shown in blue and measured from the right-hand axis, so it rises from the right origin as B engages in more abatement. Firm B uses a more emissions-intensive technology to produce its product, and therefore its marginal cost of abatement is higher than for Firm A.

Permits split 50–50

Let’s see what happens if the permits to pollute are initially split 50–50 between the two firms.

Figure 20.16c Let’s see what happens if the permits to pollute are initially split 50–50 between the two firms.

Permits split 50–50: The possibility of gains from trading permits.

Firm B has a higher MPCA. If it can buy a permit to pollute more from Firm A for a price less than its marginal cost, it will purchase the permit, rather than abate. This creates the possibility of gains from the trade in permits.

Figure 20.16d Firm B has a higher MPCA. If it can buy a permit to pollute more from Firm A for a price less than its marginal cost, it will purchase the permit, rather than abate. This creates the possibility of gains from the trade in permits.

Firm B will buy permits from A: How many?

How many permits will they exchange? As long as MCPA of firm B exceeds the MPCA of Firm A, both benefit by A selling permits to B. If the market is competitive, we expect trading until the MPCA is equalized across all firms.

Figure 20.16e How many permits will they exchange? As long as MCPA of firm B exceeds the MPCA of Firm A, both benefit by A selling permits to B. If the market is competitive, we expect trading until the MPCA is equalized across all firms.

The gains from trade

The shaded triangle shows the gains from trade created by the market for permits. P* is the permit price and is equal to the marginal cost of abatement in the economy. The green area above the red dashed line is the share of the gains from trade that Firm B receives, while the area below is Firm A’s share of the gains from trade.

Figure 20.16f The shaded triangle shows the gains from trade created by the market for permits. P* is the permit price and is equal to the marginal cost of abatement in the economy. The green area above the red dashed line is the share of the gains from trade that Firm B receives, while the area below is Firm A’s share of the gains from trade.

Figure 20.16 Cap and trade: Buying and selling permits to pollute.

There are many ways in which the permits might be traded once they are issued. One is the auction-type market studied in Unit 11, in which we saw (from an experiment) that the traders quickly converged to trading at a price like P*, which is the market-clearing price. The trading of permits achieves the desired level of abatement at the lowest resource cost to the economy. P* is the permit price and is equal to the marginal cost of abatement in the economy.

Cap and trade: Examples of emissions trading

One of the earliest cases of successful emissions trading was the sulphur dioxide (SO₂) cap and trade scheme in the US, implemented in the 1990s and intended to reduce acid rain. By 2007, annual SO₂ emissions had declined by 43% from 1990 levels, despite electricity generation from coal-fired power plants increasing more than 26% during the same period.

The European Union Emissions Trading Scheme (EU ETS), launched in 2005, is the largest CO₂ cap and trade scheme in the world, and now covers 11,000 polluting installations across the EU. National governments auction 57% of permits in the EU ETS, and the overall emission cap (that is, the amount E* in Figure 20.16) is tightened every year. Some of the auction proceeds are used to fund low-carbon energy innovation. Similar carbon trading schemes exist in other countries and regions.

The EU ETS has been less successful than the US SO₂ scheme. Some analysts think this is due largely to the fact that the permitted level of emissions was too high (too large a cap). After the financial crisis in Europe, lower aggregate demand caused the demand for electric power to shrink and with it, firms’ profit-maximizing emissions levels. With demand exceeding supply, the price of permits fell dramatically, providing little incentive for firms to undertake abatement expenditures. These effects are shown in Figure 20.17.

Permit prices in the European Union Emissions Trading Scheme (EU ETS).

Figure 20.17 Permit prices in the European Union Emissions Trading Scheme (EU ETS).

Data provided by SendeCO₂ based on prices from Bloomberg Business.

This highlights a drawback of cap and trade. The price signal is not necessarily a reliable guide for future abatement investment decisions. In Germany, for example, the fall in permit prices led to several high-emitting coal power plants reopening, because dirty technology was profitable again.

But emissions trading schemes do not need to leave the market entirely free. The UK, for example, uses a carbon price floor, which sets a minimum price for British participants in the Emissions Trading Scheme. They do this to avoid the ‘virtually free pollution’ outcome that occurs when the permit price crashes.

The estimated total external cost of a tonne of carbon dioxide emissions differs depending on how we value future generations, as we shall see in Section 20.9. A low-end estimate in 2017 dollars is about $40 per tonne of CO₂ emissions, and it is rising fast because the greater the amount of CO₂ in the atmosphere, the higher the marginal effect on climate of adding more. The recent price of a permit on the European Union Emissions Trading Scheme (shown in Figure 20.17) is less than a fifth of this cost, so the permit plan is inducing decision-makers to internalize only a small fraction of the negative external effects.

Ideally, a tax on fossil fuels could entirely offset these external effects, with the added advantage that businesses and others would then face less uncertainty about the cost of burning carbon. A tax on carbon would raise the cost of emitting carbon in exactly the same way as having to pay for an emissions permit would do. In fact, the effect on costs would be identical if the market-determined cost of the permit were to be the same as the tax rate per tonne of emissions set by the government. The effect of the increase in costs would be higher prices of emissions-intensive goods and hence, ceteris paribus, demand for such goods would fall. Both the cap and trade and a carbon tax are said to be a way to ‘put a price on’ the external effects of carbon emissions.

How high should the price of carbon emissions be?

Given that producers and users of fossil fuels are usually heavily subsidized (at very different rates from country to country) the tax or the cost of a permit would have to exceed $40. On average around the world, fossil fuel subsidies are about $15 per tonne, so an optimal tax would be $55 per tonne (to internalize the external costs and to offset the subsidy). A simpler policy would be to eliminate the subsidies and set the carbon tax at our best estimate of the external cost of burning carbon.

The pros and cons of these two policies:

• a cap and trade permit based system with a sufficiently low cap
• a carbon tax at a sufficiently high rate to offset the external costs (and subsidies, if these remain)

These have been actively debated among environmental economists, with no clear consensus other than that either is preferable to the policies being pursued in most countries. Cap and trade, however, has been more popular, perhaps because it has the advantage of flexiblity. The ability to set the carbon price, but then to control the way in which permits are allocated and traded, gives the policymaker two ‘levers’. In contrast, a single tax may be politically unpopular for a policymaker to implement.

Exercise 20.5 Assessing cap and trade policies

1. Explain why the green area in Figure 20.16 represents the total gains from trade. Hint: think about the first permit that Firm B buys from Firm A. How much is the most that Firm B would have been willing to pay? How much was the least that Firm A would have been willing to accept in order to part with the permit?
2. How would you explain the way a cap and trade policy works to someone who has not studied economics? How would you respond to their concerns that the policy is likely to be ineffective or unfair? Many newspapers and blogs publish ‘op-eds’, that is, opinion editorials from the public. A common length limit is 600 words. Find some op-eds on climate pol­icy, and having looked at how they are written, draft your answer to this question in the form of an op-ed.

Exercise 20.6 A successful tradable emissions permit program

The cap and trade sulphur dioxide permit program in the US successfully reduced emissions. The program costs were approximately one-fiftieth of the estimated benefits.

Read Robert Stavins and colleagues’ views on the US sulphur dioxide cap and trade program at VOXeu.org.

1. In the view of the authors, why are cap and trade systems such powerful tools to achieve reductions in emissions?

Also read ‘The SO₂ Allowance Trading System’ by Richard Schmalensee and Robert Stavins of the MIT Center for Energy and Environmental Policy Research.

2. Summarize the evolution of permit prices using Figure 2 in the article.
3. How well can the price movements in permit prices be explained by the analysis in Figure 20.16?

Look again at Hayek’s explanation of prices as messages (Unit 11), and the analyses of asset price bubbles (Unit 11) and housing bubbles (Unit 17).

4. Could we use similar reasoning to explain price movements in Figure 2 of the paper by Schmalensee and Stavins?

Exercise 20.7 Would a carbon tax reduce emissions more than regulation?

In 2017, economists Martin Feldstein and Greg Mankiw (respectively economic advisors to US Presidents Ronald Reagan and George W. Bush), together with Ted Halstead, a climate campaigner, suggested in the op-ed ‘A Conservative Case for Climate Action’ that an ideal climate policy in the US should consist of three parts:

• A single carbon tax should replace all regulations that are aimed at reducing carbon emissions.
• Revenues collected from the tax should be refunded to American taxpayers in quarterly paychecks (‘carbon dividend’).
• American firms that export to countries without carbon taxes should not pay a carbon tax, while importers should face an import tax on the carbon contents of their products (a ‘carbon border adjustment’).

1. Explain the economic reasoning behind each part of the proposal.
2. Why do the economists think replacing regulations with a single carbon tax would be more efficient?
3. Some environmental groups oppose the carbon dividend. They argue that the money could be better spent. Do you agree? What should carbon revenues be spent on? Do you think citizens are more likely to support a carbon tax if there is a carbon dividend?
4. Why do the economists think a border carbon adjustment is necessary? What would be the effect of a domestic carbon tax without a border carbon adjustment? What incentives does it create for American companies and for foreign companies? Is it fair on firms from developing countries (who often generate a lot of electricity from high emissions coal) who export their products to the US?
5. Do you support the proposal by Feldstein, Mankiw, and Halstead. Explain why or why not. What changes would you make?

Equilibrium is a fundamental concept of economics. It is essential to the way we predict the prices of goods using the model of supply and demand, or the level of unemployment using the model of the labour market. But for practical purposes we need to know more than simply the equilibrium of a model. In Units 16 and 18, for example, you learned that it may take a very long time for the labour market to move from one equilibrium to another, so what happens along the way is important.

And as the examples of the Grand Banks fisheries collapse or the threats to the Amazon rainforest described at the beginning of the unit showed, there may be more than one equilibrium. A healthy sustainable environment could be an equilibrium—think of Grand Banks cod fishing in the 100 years prior to 1950. And another could be the same geographical location devoid of cod, an example of environmental collapse. We sometimes refer to the process of getting to the second equilibrium as a vicious cycle, and environmental sustainability as a virtuous cycle.

disequilibrium process

An economic variable may change either because the things that determine the equilibrium value of that variable have changed (an equilibrium process), or because the system is not in equilibrium so that there exist forces for change that are internal to the model in question (a disequilibrium process). The latter process applies when the economy moves towards a stable equilibrium (which itself is not moving) or away from a tipping point (an unstable equilibrium).

The passage from one of these equilibria to another—called a disequilibrium processdisequilibrium process An economic variable may change either because the things that determine the equilibrium value of that variable have changed (an equilibrium process), or because the system is not in equilibrium so that there exist forces for change that are internal to the model in question (a disequilibrium process). The latter process applies when the economy moves towards a stable equilibrium (which itself is not moving) or away from a tipping point (an unstable equilibrium).close—can be rapid, because it is propelled by positive feedback processes, which you studied in Unit 17 in the case of housing markets. Just as in the case of a house price bubble, the reduction in fish stocks in the Grand Banks became self-reinforcing.

Here we study these disequilibrium processes. We explain why, when they are present and when we lack important pieces of information about what kinds of human actions will set off a collapse, we need a different approach to policymaking, one that stresses the need to avoid a cataclysmic environmental collapse.

The dynamics of the biosphere

Long before human economic and other activity began to have a substantial effect, the natural environment was constantly changing as a result of the chemical and physical processes that make up the biosphere.

Over tens of thousands of years, an ice age would give way to a period of warming in which glaciers and sea ice covers retreated towards the poles, to be followed by a new period of cold temperatures with the advance of the ice sheets into what are now temperate climates. On shorter time scales, clouds of dust sent up by massive volcanic eruptions blocked out the sun, as oc­curred during the ‘little ice age’ 500 years ago (you can see the drop in average temperature around the middle of the fifteenth century in Figure 1.6b).

Climate today is heavily influenced by human economic activity, but it is a process with its own dynamics of change. A challenge to environmental policymaking is that some natural processes themselves set in motion positive feedback processes so that small initial changes can lead to much larger effects, resulting in faster and greater deterioration than anticipated.

tipping point

An unstable equilibrium at the boundary between two regions characterized by distinct movements in some variable. If the variable takes a value on one side, the variable moves in one direction; on the other, it moves in the other direction. See also: asset price bubble.

prudential policy

A policy that places a very high value on reducing the likelihood of a disastrous outcome, even if this is costly in terms of other objectives foregone. Such an approach is often advocated where there is great uncertainty about the conditions under which a disastrous outcome would occur.

Like the Grand Banks fisheries and the Amazon rainforest, many freshwater systems, such as lakes and rivers, are subject to similar vicious circles of deterioration and collapse.

Where positive feedbacks are important there may be some level of environmental deterioration called a tipping pointtipping point An unstable equilibrium at the boundary between two regions characterized by distinct movements in some variable. If the variable takes a value on one side, the variable moves in one direction; on the other, it moves in the other direction. See also: asset price bubble.close, which if passed, sets in motion a process leading to abrupt and hard-to-reverse destruction of an environmental resource. When this is the case, environmental policy must go beyond balancing the costs and benefits of the abatement of environmental damage. Instead, policymakers must devise measures to ensure that a tipping point—especially if it is uncertain—for a critical resource is not passed. In this context, a prudential policyprudential policy A policy that places a very high value on reducing the likelihood of a disastrous outcome, even if this is costly in terms of other objectives foregone. Such an approach is often advocated where there is great uncertainty about the conditions under which a disastrous outcome would occur.close would seek to avoid the risk that the given situation may itself be radically and irreversibly degraded.

Environmental equilibria

To understand the idea of planetary boundaries and environmental collapse, we will use the example of Arctic sea ice. This is an example of an environmental system that may have already passed a tipping point due to global climate change. Figure 20.22 shows that for the past 50 years, the extent of the sea ice at the end of summer has been declining at an increasing rate. The insert in the figure illustrates the change in the last few decades.

Arctic sea ice coverage (1935–2014).

Figure 20.22 Arctic sea ice coverage (1935–2014).

Miguel Ángel Cea Pirón and Juan Antonio Cano Pasalodos. 2016. ‘Nueva serie de extensión del hielo marino ártico en septiembre entre 1935 y 2014’. Revista de Climatología, Vol. 16 (2016): pp. 1–19.

First, consider the vicious cycle. Open sea surface area is darker than ice so more open sea surface area leads the earth’s surface to reflect less radiation. It therefore absorbs more radiation and warms up. The resulting higher winter and spring surface temperatures in turn cause less ice in the summer. The virtuous cycle is just the opposite: when there is extensive summer ice, the radiation is reflected rather than absorbed and the temperatures stay low, maintaining the ice which reflects the radiation, keeping temperatures low, and so on.

‘Extensive summer sea ice’ and ‘no summer sea ice’ are the stable equilibria of the Arctic sea ice ecology. Each of these states is reinforced by the positive feedback loop shown in Figure 20.23. You may want to compare this positive feedback process to the one causing housing price bubbles and busts discussed in Unit 17.

The environmental dynamics curve and the environmental tipping point.

Figure 20.23 The environmental dynamics curve and the environmental tipping point.

Environmental tipping point

• On one side of an environmental tipping point, processes of environmental degradation are self-limiting.
• On the other side, positive feedbacks lead to self-reinforcing, runaway environmental degradation.

What happens ‘in between’ these two stable equilibria? We analyse this using the model introduced in Unit 17 for the housing market. You will note the similarity between Figure 20.23 and Figure 17.18 of boom and bust in a housing market. But now, instead of the house price this year and next on the axes, the horizontal axis is the extent of sea ice today (called E_t to refer to the environment this year). The vertical axis is sea ice next year. This figure shows how the extent of sea ice today maps to the extent of sea ice tomorrow.

The 45-degree line depicts an unchanging environment, since along that line any value of sea ice this period on the horizontal axis is the same next period (on the vertical axis). The S-shaped line is the ‘environmental dynamics curve’ or EDC for short. Just as in Unit 17, points at which the EDC crosses the 45-degree line are equilibria. This is because the amount of sea ice this year is the same as next year (remember an equilibrium is something stationary, that is, unchanging from year to year). Two of the equilibria are stable: each equilibrium is stabilized by self-reinforcing feedback processes shown in the upper panel. You can refer back to Figures 11.18 and 11.19 for the adjustment processes around a stable and an unstable equilibrium. Point A is the unstable equilibrium or tipping point. Any slight change in sea ice at the unstable equilibrium leads in the direction of either B or C.

At any point in between the two stable equilibria at B and C, from year to year the sea ice cover will either be increasing towards the virtuous equilibrium at B or disappearing towards the no-sea-ice equilibrium at C. For example, beginning with a sea ice extent of E₀, the EDC shows the (higher) level the following year and the arrow indicates the adjustment to the equilibrium at point B.

This occurs as follows: from an initial level of E₀ with a cold climate and Arctic summer ice, the sea ice next year would be more than this year as shown, since the EDC is above the 45-degree line. When there is a lot of ice, the feedback in the direction of maintaining the ice cover is strong, and we tend to stay there even when variations in temperatures (due to seasons or decadal variation in ocean currents) cause temporary warming and temporary reductions in sea ice. The extent of the ice means that the system ‘rebounds’ towards the high equilibrium.

Planetary boundaries

As we have seen, the two stable equilibria are separated by an unstable equilibrium at A. So a reduction in sea ice below the tipping point will be amplified, rather than dampened. At that point, the feedback becomes stronger in the direction of reducing the ice cover and bringing the system to the no-Arctic-summer-ice state. The capacity of the system to recover would have been pushed beyond its limits.

What is the role of climate change in all that? We shall see that to analyse this we need to explain why the S-shaped environmental dynamics curve can shift down. If it shifts, the system will not stabilize around the high-summer-ice equilibrium at B.

A warming climate does two things, one of which is gradual, the other cataclysmic. First, starting from the high equilibrium, a warming climate brings the system closer to a tipping point, illustrated by a downward shift in the S-shaped curve. Second, it may change the system such that at some point, the equilibrium with extensive summer sea ice disappears.

To understand these effects, take a look at Figure 20.24. A warmer climate means that for any amount of sea ice this year, the amount that will be there next year is less. This is not a movement along the EDC but instead a downward shift of the whole curve. As a result, less ice forms in the winter and the whole system is more vulnerable to the increase in temperature and open surface area in the summer.

Initial high stable equilibrium

The environment starts at equilibrium point B.

Figure 20.24a The environment starts at equilibrium point B.

Global warming lowers the EDC curve

A warmer climate means that for any amount of sea ice this year, the amount that will be there next year is less. The whole curve shifts downward.

Figure 20.24b A warmer climate means that for any amount of sea ice this year, the amount that will be there next year is less. The whole curve shifts downward.

System collapse to ice-free summers

Beyond a certain amount of winter warming, the EDC shifts down so much that there is no longer a high stable equilibrium. The last tipping point, Z, disappears and the system is permanently locked in the no-sea-ice stable state at K.

Figure 20.24c Beyond a certain amount of winter warming, the EDC shifts down so much that there is no longer a high stable equilibrium. The last tipping point, Z, disappears and the system is permanently locked in the no-sea-ice stable state at K.

Figure 20.24 Climate change and irreversible loss of summer Arctic sea ice.

In Figure 20.24, the shift down in the EDC has moved the ‘high’ equilibrium downwards, so there will be less sea ice from year to year. Notice too that the warmer climate has also shifted the tipping point upwards to Z from its initial position at A, which widens the ‘danger zone’ of environmental collapse.

Is this what has been happening over the last century? From Figure 20.22, it appears that until the late 1960s, the Arctic sea ice was approaching a high equilibrium (like B). Thereafter, the extent of sea ice declined at first gradually, illustrated in Figure 20.24 by the movement from B downwards towards Z. But then Figure 20.22 shows that from the mid-1980s, the reduction in sea ice was much more rapid, as would occur if the last tipping point had been passed and the system was in freefall towards no summer sea ice at all (point K).

Combining the model and the available evidence, the change from the Arctic with extensive summer ice to the Arctic with no-summer-ice equi­libria appears to be underway. Scientists are unsure how reversible this loss of the Arctic summer ice is even if we reverse global warming. We may have crossed a point of no return. The lack of Arctic sea ice—if that is what is in store—will add to the already powerful forces creating a warmer climate.

The sea ice might be restored eventually by a new ice age of sharply colder climate. Given the pattern of climate change over the past 800,000 years, this might be expected 50,000 years from now.

Prudential policies to address tipping points

The aim of policies to slow global warming would be to keep the EDC within the set of feasible environmental equilibria shown by the green dashed line between B and Z. In the presence of tipping points, prudential policies should reduce the risk that a tipping point will be crossed.

The need to be prudent arises not just because there is a tipping point but also because of the uncertainty about how close we are to the last tipping point. Prudent policy means seeking to avoid cataclysmic risks even if their likelihood is extremely small. The closer we are to a tipping point, the higher the chance of unknowingly crossing it and finding it impossible to reverse the degradation and avoid a catastrophic outcome.

biodiversity loss (rate of)

Proportion of species that become extinct every year.

Planetary boundaries are defined for critical environmental variables (such as temperature and biodiversity lossbiodiversity loss (rate of) Proportion of species that become extinct every year.close), and give levels of these variables that scientists think will keep us sufficiently far away from problematic tipping points to be within a ‘safe operating space’. Respecting planetary boundaries is a prudential policy.

The value of prudence has implications for which kinds of policies are most appropriate. To see this, suppose there is no uncertainty about either:

• The state of the environment: How close to a tipping point the ecosystem was, for example.
• The effect of tax incentives: What will the effect be on carbon emissions?

Given this level of certainty, a tax on carbon emissions or a cap and trade policy could obtain the same outcome. Cap and trade would impose the desired level of abatement and the carbon tax would set the right price for carbon emissions, also leading to the desired level of abatement. In both cases, the policymaker must decide on the desired level of abatement before selecting the most appropriate policy.

However, we are often highly uncertain about both the state of the envir­onment and the effectiveness of tax or subsidy policies. In these cases, cap and trade is more prudent because it can guarantee a particular level of emissions (the cap), which can be set sufficiently far away from the possible thresholds.

Exercise 20.11 Representing regime shifts

The Regime Shifts DataBase documents different types of regime shifts (another word for tipping point) that we have evidence for in human-dominated ecological systems. Choose one from the database and describe the situation in your own words, including the types of equilibria and their characteristics, and how the system transitions from one equilibrium to another. Draw a diagram similar to Figure 20.23 to represent it, and explain the feedback loops that are involved.

Exercise 20.12 Self-reinforcing processes

Self-reinforcing processes, such as the ones described above, do not happen only in nature. In Unit 17, for example, we discussed how increases in house prices can reinforce a boom and become self-sustaining, leading to a housing price bubble.

Explain the ways in which the cumulative self-reinforcing processes described by environmental scientists are similar to (or different from) processes that occur in a housing or stock price bubble.

While scientists agree that climate change is occurring and that our economic activity is contributing to it, there are large gaps in scientific understanding of the processes involved and the costs of containing them.

Moreover, as we have seen in Sections 20.3 and 20.4, conflicts of interest over the extent and methods of abatement make it difficult for national governments to adopt broadly supported strategies for mitigating environmental degradation. These conflicts include disagreements about what climate science has shown. In 2015 in the US, 64% of Democratic Party supporters were of the opinion that global warming is both occurring and a result of human activity, but the similar fraction among Republicans was 23%.

Also, owners and employees of companies producing or using fossil fuels anticipate income losses as the result of policies to reduce emissions, and spend heavily to influence public opinion on environmental questions. You can read about the impact of this spending in a New York Times article on lead poisoning and examine a list of chemical industry lobbying expenditure for 2015 on OpenSecrets.org.

Lack of adequate information and conflicts of interest are impediments to good public policy in many other areas, but climate change poses two unusual challenges: the problem cannot be solved by national governments acting alone, and those affected by our choices today include generations in the distant future.

International cooperation

tragedy of the commons

A social dilemma in which self-interested individuals acting independently deplete a common resource, lowering the payoffs of all. See also: social dilemma.

Using the tools of game theory in Unit 4, we saw that avoiding the tragedy of the commonstragedy of the commons A social dilemma in which self-interested individuals acting independently deplete a common resource, lowering the payoffs of all. See also: social dilemma.close that affects the supply of public goods depends on the rules of the game (the institutions). Where there are repeated interactions of the players and there are opportunities to punish those who do not contribute to the public good, the socially optimal outcome can be sustained. The presence of sustainable water-use systems or fish stocks in several continents shows that the tragedy of the commons is avoidable.

dominant strategy equilibrium

An outcome of a game in which every player plays his or her dominant strategy.

In the case of climate change, game theory helps us understand the obstacles to its solution. Recall the way we modelled the climate change game as a prisoners’ dilemma in which two countries (the US and China) can either restrict carbon emissions or continue with business as usual (see Figure 4.17). Complete self-interest makes the business as usual scenario the dominant strategy equilibriumdominant strategy equilibrium An outcome of a game in which every player plays his or her dominant strategy.close.

To understand how an international agreement might be negotiated to avoid the business as usual outcome, we introduced inequality aversion and reciprocity. If citizens of the US and China give some weight to the wellbeing of citizens in the other country or experience less wellbeing when inequality rises, and if they are willing to implement costly measures as long as this is also done in the other country, then an outcome where both countries restrict emissions is possible.

Our hypothetical model of climate change negotiations between China and the US gave rise to two Nash equilibria if citizens had both inequality aversion and reciprocity. It is also not completely unrealistic: after intense negotiations following failed talks and a non-binding agreement in Copenhagen in 2009, all countries committed to eventual emission cuts at the United Nations Conference on Climate Change in Paris in December 2015, with the goal of stabilizing global temperatures at 2°C above pre-industrial levels. Virtually all countries also submitted their individual plans for cutting emissions, but these plans are not yet consistent with this temperature stabilization goal.

Unrepresented generations

Our economic activity today will affect climate changes in the distant future, so we are essentially creating consequences that others will bear. This is just an extreme form of external effects that we have studied through­out the course. It is extreme not only in its potential consequences, but also in that those who will suffer the consequences are future generations.

In many countries, public policies have been adopted to address other kinds of environmental external effects, such as local pollution, under pressure from voters bearing the costs of these effects. If you look ahead at Figure 20.25b, you will notice that many of the stars (well above the line) on the Environmental Performance Index are, and have long been, electoral democracies. This is not the case for most of the low performers.

But the future generations that will bear the consequences of our decisions are unrepresented in the policymaking process today. The only way the wellbeing of these unrepresented generations will be taken into account at the environmental bargaining tables around the world is the fact that most people care about, and would like to behave ethically toward, others, as we have seen in Unit 4.

These social preferences underlie the debates among economists about how much we should value the future benefits and costs of the climate change decisions that we make today.

In considering alternative environmental policies, how much we value the wellbeing of future generations is commonly measured by an interest rate, which is literally the rate at which we discount future generations’ costs or benefits. There are, however, debates about how this discountingdiscount rate A measure of the person’s impatience: how much the person values an additional unit of consumption now relative to an additional unit of consumption later. It is the slope of the person’s indifference curve for consumption now and consumption later, minus one. Also known as: subjective discount rate.close process should be done.

When economists disagree The discounting dilemma: How should we account for future costs and benefits?

discounting future generations’ costs and benefits

A measure of how we currently value the costs and benefits experienced by people who will live in the future. Note that this is not a measure of individual impatience about one’s own future benefits and costs.

discount rate

A measure of the person’s impatience: how much the person values an additional unit of consumption now relative to an additional unit of consumption later. It is the slope of the person’s indifference curve for consumption now and consumption later, minus one. Also known as: subjective discount rate.

When considering policies, economists seek to compare the benefits and costs of alternative approaches. Doing this presents especially great challenges when the policy problem is climate change. The reason is that the costs will be borne by the present generation but the benefits of a successful abatement policy will be enjoyed by people in the future, many of whom are not yet alive.

Put yourself in the shoes of the impartial policymaker we studied earlier and ask yourself: are there any reasons why, in summing up the benefits and costs of an abatement policy, I should value the benefits expected to be received by future generations any less than the benefits and costs that will be borne by people today? Two reasons come to mind:

• Technological progress: The people in the future may have either greater or lesser needs than we do today. For example, as a result of continuing improvements in technology, they may be richer (either in goods or free time) than we are today, so it might seem fair that we should not value the benefits they will receive from our policies as highly as we value the costs that we will bear as a result.
• Extinction of the human species: There is a small possibility that future generations will not exist because humanity becomes extinct.

pure impatience

This is a characteristic of a person who values an additional unit of consumption now over an additional unit later, when the amount of consumption is the same now and later. It arises when a person is impatient to consume more now because she places less value on consumption in the future for reasons of myopia, weakness of will, or for other reasons.

These are good reasons why we might discount the benefits received by future generations. Notice that neither of these reasons for discounting is related to pure impatiencepure impatience This is a characteristic of a person who values an additional unit of consumption now over an additional unit later, when the amount of consumption is the same now and later. It arises when a person is impatient to consume more now because she places less value on consumption in the future for reasons of myopia, weakness of will, or for other reasons.close.

This was the approach adopted in the 2006 Stern Review on the Economics of Climate Change (read the executive summary on the WWF website). Nicholas Stern, an economist, selected a discount rate to take account of the likelihood that people in the future would be richer. Based on an estimate of future productivity increases, Stern discounted the benefits to future generations by 1.3% per annum. To this he added a 0.1% per annum discount rate to account for the risk that in any future year there might no longer be surviving generations. Based on this assessment, Stern advocated policies that would have implemented substantial abatement investments today in order to protect the environment of the future.

Several economists, including William Nordhaus, criticized the Stern Review for its low discount rate. Nordhaus wrote that Stern’s choice of discount rate ‘magnifies impacts in the distant future’. He concluded that, with a higher discount rate, ‘the Review’s dramatic results disappear’.⁶

William D. Nordhaus. 2007. ‘A Review of the Stern Review on the Economics of Climate Change.’ Journal of Economic Literature 45 (3): pp. 686–702. 

Nordhaus advocated the use of a discount rate of 4.3%, which gave vastly different implications. Discounting at this rate means that a $100 benefit occurring 100 years from now is worth $1.48 today, while under Stern’s 1.4% rate it would be worth $24.90. This means a policymaker using Nordhaus’ discount rate would approve of a project that would save future generations $100 in environmental damages only if it cost less than $1.48 today. A policymaker using Stern’s 1.4% would approve the project only if it cost less than $24.90.

Not surprisingly, then, Nordhaus’ recommendations for climate change abatement were far less extensive and less costly than those that Stern proposed. When comparing the use of cap and trade with a carbon tax in Section 20.5, we referred to $40 per tonne as a low-end estimate of the external cost of carbon emissions. This is comparable to the carbon price of $35 per tonne in 2015 proposed by Nordhaus to deter the use of fossil fuels. Stern recommended a price of $360.

Why did the two economists differ by so much? They agreed on the need to discount for the likelihood that future generations would be better off. But Nordhaus had an additional reason to discount future benefits: impatience.

Reasoning as we did in Unit 10 for Julia’s and Marco’s consumption now or later, Nordhaus used estimates based on market interest rates as measures of how people today value future versus present consumption. Using this method, he came up with a discount rate of 3% to measure the way people discount future benefits and costs that they themselves may experience. Nordhaus included this in his discount rate, which is why Nordhaus’ discount rate (4.3%) is so much higher than Stern’s (1.4%).

Critics of Nordhaus pointed out that in evaluating the claims that future generations should have on our concern, a psychological fact like our own impatience is not a reason to discount the needs and aspirations of other people in future generations.

Stern’s approach counts all generations as equally worthy of our concern for their wellbeing. Nordhaus, in contrast, takes the current generation’s point of view and counts future generations as less worthy of our concern than the current generation, much in the way that, for reasons of impatience, we typically value current consumption more highly than our own future consumption.

Is the debate resolved? The discounting question ultimately requires adjudicating between the competing claims of different individuals at different points of time. This involves questions of ethics on which economists will continue to disagree.⁷

Frank Ackerman. 2007. ‘Debating climate economics: the Stern Review vs. its critics’. Report to Friends of the Earth, July 2007. 

Exercise 20.13 Simulating different discount rates

Download the simple discount rate simulation spreadsheet from our CORE website. The simulator allows you to calculate the present value of receiving $1 in one, 10, 50, and 100 years from now for four discount rates.

In the spreadsheet, the first three discount rates are fixed: zero, Stern’s suggestion, and the alternative suggested by Nordhaus.

1. Explain the effect of different discount rates on the present value of receiving $1 in the future.

The fourth rate is your choice: use the slider in the table to choose a discount rate you think is appropriate for the evaluation of the benefits and costs of climate change policy in the distant future.

2. Justify your choice. Is it closer to the Nordhaus or Stern proposal? Or is it higher than or lower than both?
3. Try to find out what discount rate your government (or another government of your choice) uses to evaluate public investment projects. Do you think it is appropriate?

Differences between countries

Environmental policies make a difference. We can see that countries vary greatly in the global environmental damage they inflict and in their success at managing environmental quality in their country. Figure 20.25a shows CO₂ emissions per capita for each country in 2010 alongside income per capita. Richer countries produce more CO₂ per capita than poorer ones. This is to be expected because greater income per capita is the result of a higher level of production of goods and services per capita, with associated impacts on the biosphere. This is shown by the upward-sloped line that indicates the relationship between the two variables.

Carbon dioxide emissions are higher in richer countries …

Figure 20.25a Carbon dioxide emissions are higher in richer countries …

The World Bank. 2015. ‘World Development Indicators.’ Note: Three small very high-income countries (Kuwait, Luxembourg, and Qatar) are not shown.

But notice, too, that among countries at approximately the same level of per capita income, some emit much more than others. Compare the high emissions levels in the US, Canada, and Australia with the lower emissions levels of France, Sweden, and Germany, countries at approximately the same level of per capita income. Another way to read the graph is horizontally: Norway has the same emissions level that would be predicted (by the line) for a country $20,000 poorer in per capita income. Russia pollutes as much as would be expected from a country $20,000 richer.

Measured by its direct emissions, Singapore is a high-performing outlier. It is a high-income city-state with an effective public transport network and a commercial rather than industrial economic base, resulting in limited levels of pollution. In addition to public transportation, the government has adopted other effective environmental policies. For example, if you want to use a car in Singapore, you are first required to purchase a permit for a car at an auction, and then pay the congestion charge (a tax) every time you drive into the city.

… but so is the quality of their local environment.

Figure 20.25b … but so is the quality of their local environment.

Development indicators; EPI. 2014. ‘Environmental Protection Index 2014.’ Yale Center for Environmental Law & Policy (YCELP) and the Center for International Earth Science Information Network.

Though richer countries emit more CO₂ per capita, they have also adopted more effective policies to manage their own environmental resources, such as forests, soil, biodiversity, and water. Figure 20.25b plots the Environmental Performance Index (EPI) against GDP per capita. The EPI is a broad index of country-level environmental health and ecosystem vitality, including the state of wastewater treatment, fisheries, and forests. It brings together 20 different country-level indicators including trends in carbon emissions, fish stocks, changes in forest cover, quality of wastewater treatment, access to sanitation, air pollution, and child mortality. In this case, a curved rather than straight line fits the data better, indicating that differences in per capita income are associated with major differences in the EPI for very poor countries, but not as major for the richer countries, on average.

As in Figure 20.25a, Russia underperforms, with the Environmental Performance Index expected of a country half as rich. Germany, Sweden, and Switzerland are high performers. Notice that Australia, which is an unusually big emitter of CO₂ (Figure 20.25a), is a top performer on the national environmental amenities measured by the EPI. A good part of the environmental damage done by economic activity in Australia is thus imposed as a cost on those outside the country.

The message of Figure 20.25b is similar to the previous one. Countries, even at similar levels of income per capita, differ greatly in their environmental performance. Compare Switzerland with the US or Spain with Russia, for example. Both India and China are substantially below the line. These country differences suggest the importance of the kinds of policies that are adopted and enforced.

Lessons from the existence of win-win policies

We have introduced many difficult trade-offs confronting environmental policies, for example, between our consumption now and our environmental quality now. But we have also uncovered some evidence of win-win opportunities.

In Figure 20.26, we look again at the estimates of the marginal abatement costs that we previously saw in Figure 20.9. The global abatement cost curve is displayed vertically in Figure 20.26. In Figure 20.9, we only included measures that are costly and would have to be promoted as an objective of government policy. In Figure 20.26, when the monetary benefit is greater than the cost, the bar extends to the left of the vertical axis. When cost is greater, it extends to the right.

All of the actions to the left of the vertical axis in Figure 20.26 would not only accomplish significant abatement, but would also be privately beneficial in the sense that they result in monetary benefits greater than the costs. These are win-win actions because they improve the environment, and their cost savings also allow greater consumption.

Replacing incandescent light bulbs with LED bulbs in our houses is one of these win-win opportunities. It is the most cost-saving policy of all but it is a narrow bar, meaning it does not have a big abatement potential. Fuel-efficient vehicles, insulation in houses and offices, and other technologies with bars to the left of the axis are also cost-saving. Note that if we were only to adopt cost-saving policies between now and 2030, we would still achieve more than a quarter of the total potential abatement shown in the figure.

Global greenhouse gas abatement curve: Abatement in 2030, compared with business as usual.

Figure 20.26 Global greenhouse gas abatement curve: Abatement in 2030, compared with business as usual.

McKinsey & Company. 2013. ‘Pathways to a Low-Carbon Economy: Version 2 of the Global Greenhouse Gas Abatement Cost Curve.’ McKinsey & Company.

We can represent the unrealized abatement potential of these changes in the feasible set figure. The dashed line in Figure 20.27 is the feasible frontier that we have been using thus far, which ignored the win-win opportunities shown on the left side of Figure 20.26. The solid feasible frontier takes account of the possible use of these win-win options.

Start at point C on the horizontal axis in Figure 20.27. The evidence from Figure 20.26 is that implementing the measures (starting at the top of Figure 20.26, with replacement of incandescent bulbs by LEDs) will generate abatement benefits and at the same time allow for higher consumption of other goods and services.

This produces the positively sloped part of the feasible frontier, with both environmental quality and consumption rising from C to D. Once all the win-win measures have been introduced, at D, it begins to be costly to achieve further abatement and the feasible frontier is negatively sloped, as we saw when we analysed the implications of Figure 20.9.

The unrealized abatement potential of changes, that would save money for the individuals or firms implementing them, suggests that implement­ation by market incentives may be slow and incomplete. The fact that environmental benefits could be generated by economic decisions that would provide monetary benefits (not costs) to the decision-maker means mutual gains are feasible but are not being realized. Thus, Figure 20.27 provides another piece of evidence that contemporary economies are often not even close to being Pareto efficient.

These factors point to a primary advantage of policies to make some environmentally harmful practices illegal rather than simply making them more expensive. In those cases where the government has the necessary information and enforcement capacities, implementation can be rapid and complete. An example is the dramatic reduction in the use of lead in petrol in many countries around the world, following a ban. But as we will see in Unit 22, governments often lack the information and administrative capabilities to design and implement effective policies of this kind.

Unrealized potential

We use the feasible set figure to represent the unrealized abatement potential.

Figure 20.27a We use the feasible set figure to represent the unrealized abatement potential.

Win-win actions

Moving from C to D takes the quality of the environment up to E. Consumption rises because costs (for example for lighting) fall.

Figure 20.27b Moving from C to D takes the quality of the environment up to E. Consumption rises because costs (for example for lighting) fall.

Implementing abatement along the feasible frontier

Moving from D to Z takes the quality of the environment above E, but at the cost of lower consumption.

Figure 20.27c Moving from D to Z takes the quality of the environment above E, but at the cost of lower consumption.

Figure 20.27 Is there always a trade-off between consumption and environmental quality?

Is ‘make the polluter pay’ fair?

polluter pays principle

A guide to environmental policy according to which those who impose negative environmental effects on others should be made to pay for the damages they impose, through taxation or other means.

Think about the polluter pays principlepolluter pays principle A guide to environmental policy according to which those who impose negative environmental effects on others should be made to pay for the damages they impose, through taxation or other means.close. This principle can be interpreted as an application of the basic economics of environmental policies. Environmental external effects often impose costs on others, and making the polluter pay for these external effects is a way to internalize (and therefore eliminate) them.

This could be accomplished by taxing the polluting activity so as to equate the marginal private cost with the marginal social cost. This may be an efficient way to abate the pollution. But as we saw in Unit 12, the same abate­ment could be accomplished by providing the firm with a subsidy for the use of an alternative technology that resulted in a lower level of pollution.

The firm’s view of these two policies may be that the tax is the stick and the subsidy the carrot. The tax, which reflects the polluter pays principle, lowers the profits of the firm. A subsidy raises the firm’s profits. Whether the carrot or the stick is the right policy depends on the feasibility and cost of implementing the subsidy compared to the tax, and whether raising or lowering the income of the target of the policy is desired on fairness grounds.

Seen in this light, the polluter pays principle is not always a good guide to the best policy. Think of a large city in a low-income country in which much of the cooking is still done over wood fires, generating high levels of airborne particulate matter and causing asthma and other respiratory illnesses:

• Fairness: It is mostly poor families who lack the income or access to electricity that would allow them to cook and heat their homes with fewer external environmental effects. In this case, many would object to making the polluters pay on the grounds of fairness, and instead favour subsidizing kerosene or providing a better electricity supply.
• Effectiveness: Subsidizing kerosene is likely to be cost-effective in reducing smog, compared to tracking down and extracting payments from hundreds of thousands of people who are polluting the city’s air with wood fires.

This example is helpful because it shows not only the value of considering fairness as well as efficiency, but also the importance of being clear about which objective we are pursuing when we design policies.

Exercise 20.14 High and low performers

Consider the labelled countries above the best-fit curve in Figure 20.25b and those below it.

1. What characteristics about the countries and the way they are governed do you think might explain their status as high and low performers respectively?
2. Find out about the environmental policies and political systems of one or more of these countries using the World Bank Development Indicators, the Freedom in The World 2016 data, and your own research. What information from these sources helps you to explain the differences between high and low performers, and how does it help?

For 100,000 years or more, humans—like other animals—lived in ways that modified the biosphere but did not substantially and irreversibly degrade its capacity to support life on the planet. Starting 200 years ago, humans learned how to use the energy available from nature (burning carbon) to transform how we produced goods and services, radically increasing the productivity of our labour.

The capitalist economy provided both the carrots and the sticks that made the technological revolution profitable to private firms and hence a permanent feature of our lives. The result was a sustained increase in the output of goods and services per person.

In many countries, the extension of the vote to people who worked as employees, and their organization into trade unions and political parties enhanced the bargaining power and the wages of workers (Figure 2.19). The increasing costs of hiring labour provided ongoing incentives for owners of firms to seek innovations that would use less labour, replacing human labour with machinery and the non-human energy of coal and other fuels that powered them.

In many countries, this process of increased productivity and bargaining power of labour resulted in growing living standards for workers. But the replacement of human labour by non-human energy to power the machines also led to an impoverishment of nature.

A degraded and threatened environment cannot be reversed, however, by the same mechanism that created this affluence. When it came to developing an economically equitable society, workers were their own advocates, and their success in pursuing their private interests of seeking a higher living standard led to wage increases and a pattern of technological change in which less labour was used in production.

You could imagine that a similar process would raise the price of using our natural environment, leading to nature-saving technical change, just as higher wages led to labour-saving innovations. But the biosphere does not have the vote. Political organizations of soon-to-be-extinct animals will not be formed. Future generations of our own species and non-human elements of the contemporary and future biosphere are not capable of advocating for saving nature in the same way that workers indirectly advocated for saving labour, that is, by raising its price.

Public policies to impose prices on the use of nature sufficient to deter the degrading external effects of the production of goods and services today will be propelled not by the silent voices of the biosphere and generations unborn, but by people today, concerned not only about their private interests, but about the preservation of a flourishing biosphere in the future.

Economists along with other scholars can clarify the costs and benefits of alternative environmental policies and practices and help to inform public debate on these policies.

Concepts introduced in Unit 20

Before you move on, review these definitions:

• Abatement
• Abatement policies
• Natural resources and reserves
• Global greenhouse gas abatement cost curve
• Marginal productivity of abatement expenditures
• Price- and quantity-based environmental policies
• Cap and trade
• Contingent valuation
• Hedonic pricing
• Discounting future generations’ costs and benefits
• The polluter pays principle
• Tipping point, disequilibrium process
• Prudential policy

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