Environmental EconomicsEnvironmental Economics

Class 6Class 6

ConceptsConcepts

Static efficiencyStatic efficiencyDynamic efficiencyDynamic efficiencyStatic efficiency allows us to evaluate Static efficiency allows us to evaluate those circumstances where time is not a those circumstances where time is not a crucial aspect of the allocation problem. crucial aspect of the allocation problem. Allocating water or solar energy...Allocating water or solar energy...Dynamic efficiency is a suitable concept Dynamic efficiency is a suitable concept for circumstances where time is crucial. for circumstances where time is crucial. Allocation of depletable resources.Allocation of depletable resources.

Treatment of future generations.Treatment of future generations.Temporal allocationTemporal allocationIntertemporal allocationIntertemporal allocationTwo period modelTwo period modelObjective: Balance present and future uses of Objective: Balance present and future uses of the resource by maximizing the benefits derived the resource by maximizing the benefits derived from the use of these resourcesfrom the use of these resourcesDynamic efficiency: Allocation of depletable Dynamic efficiency: Allocation of depletable resourcesresourcesDemand is constant in two periods.Demand is constant in two periods.

Figure 5.1Figure 5.1

Figure 5.2Figure 5.2

Sustainable Development: Defining Sustainable Development: Defining the Conceptthe Concept

The nature of normative decision makingThe nature of normative decision making: : How How much should we leave for future generations? much should we leave for future generations? What is the appropriate rate of discount? How What is the appropriate rate of discount? How do we make decisions for a group of people do we make decisions for a group of people that are not around to negotiate for that are not around to negotiate for themselves? themselves?

““sustainability criterionsustainability criterion” ” holds that future holds that future generations should be left no worse off than generations should be left no worse off than current generations and should perhaps be left current generations and should perhaps be left better off. better off.

Are Efficient Allocations Fair?Are Efficient Allocations Fair?

With a discount rate greater than zero, an With a discount rate greater than zero, an economically efficient allocation will economically efficient allocation will allocate more of a resource to the first allocate more of a resource to the first period than the second. Net benefits will period than the second. Net benefits will be greater in the first period than the be greater in the first period than the second.second.The sustainability criterion can still be met The sustainability criterion can still be met if the first period sets aside sufficient net if the first period sets aside sufficient net benefits for the second period.benefits for the second period.

Applying the Sustainability CriterionApplying the Sustainability Criterion

The sustainability criterion is difficult to implement as it The sustainability criterion is difficult to implement as it requires knowing something about the preferences of the requires knowing something about the preferences of the future generation. future generation. A more operational criterion is called “Hartwick’s Rule.” A more operational criterion is called “Hartwick’s Rule.” The usefulness of Hartwick’s rule depends on how The usefulness of Hartwick’s rule depends on how substitutable physical capital and natural capital are.substitutable physical capital and natural capital are.Hartwick’s RuleHartwick’s Rule suggests that if all scarcity rent is suggests that if all scarcity rent is invested in capital, then a constant level of consumption invested in capital, then a constant level of consumption could be maintained in perpetuity. could be maintained in perpetuity. If all scarcity rent is invested in capital, the value of the If all scarcity rent is invested in capital, the value of the total capital stock will not decline.total capital stock will not decline.If the principal or the value of total capital is declining, If the principal or the value of total capital is declining, the allocation is not sustainable.the allocation is not sustainable.

Total capital is defined as Total capital is defined as physical capitalphysical capital plus plus natural capitalnatural capital. These are assumed to be . These are assumed to be substitutable under Hartwick’s Rule.substitutable under Hartwick’s Rule.Physical capitalPhysical capital consists of buildings, consists of buildings, equipment and infrastructure.equipment and infrastructure.Natural capitalNatural capital refers to environmental and refers to environmental and natural resources.natural resources.Complete substitutability between physical and Complete substitutability between physical and natural capital is an extremely strong natural capital is an extremely strong assumption.assumption.

The maintenance of The maintenance of totaltotal capital is termed capital is termed “weak substitutability.”“weak substitutability.”

Weak substitutability suggests that resource use Weak substitutability suggests that resource use by previous generations should not exceed a by previous generations should not exceed a level that prevents future generations from level that prevents future generations from achieving at least the same level of well-being. achieving at least the same level of well-being.

An alternative definition of sustainable allocation An alternative definition of sustainable allocation is called is called “strong sustainability.”“strong sustainability.”

Strong sustainability implies that the value of Strong sustainability implies that the value of the stock of the stock of natural natural capital is maintained. capital is maintained.

Strong sustainability assumes that there is little Strong sustainability assumes that there is little or no substitution between physical and natural or no substitution between physical and natural capital and emphasizes preserving natural capital and emphasizes preserving natural capital as opposed to total capital. Again, the capital as opposed to total capital. Again, the focus is on preserving value and on preserving focus is on preserving value and on preserving an aggregate of natural capital.an aggregate of natural capital.

Implications for environmental Implications for environmental policypolicy

Not all efficient allocations are sustainable.Not all efficient allocations are sustainable.Not all sustainable allocations are efficient. Not all sustainable allocations are efficient. Market allocations may be either efficient or Market allocations may be either efficient or inefficient and either sustainable or inefficient and either sustainable or unsustainable. unsustainable. Given a number of sustainable allocation Given a number of sustainable allocation possibilities, choose the one that maximizes possibilities, choose the one that maximizes either static or dynamic efficiency (net benefits either static or dynamic efficiency (net benefits or the present value of net benefits), e.g. or the present value of net benefits), e.g. maximize wealth, subject to a sustainability maximize wealth, subject to a sustainability criterion. criterion.

Why do discount rates matter?Why do discount rates matter?

Higher discount rates…Higher discount rates…

……favor more rapid depletion of nonrenewables favor more rapid depletion of nonrenewables and lower stock levels of renewablesand lower stock levels of renewables

……can make investments to improve environmental can make investments to improve environmental quality relatively less attractive compared to quality relatively less attractive compared to those in the private sectorthose in the private sector

Conrad, J.M. Resource Economics. 1999.Conrad, J.M. Resource Economics. 1999.

Discount rate justificationDiscount rate justification7% is approximately the real return to 7% is approximately the real return to investment in large companies over the period investment in large companies over the period 1926–1990 and is the rate currently 1926–1990 and is the rate currently recommended by the US Office of Management recommended by the US Office of Management and Budget for standard cost–benefit analysis and Budget for standard cost–benefit analysis

FFor the relatively short-term (~<30 yrs), plausible or the relatively short-term (~<30 yrs), plausible might mean 2-7%. Depends on perspective might mean 2-7%. Depends on perspective (firm, individual), assets/endowments, risk (firm, individual), assets/endowments, risk preferences, etcpreferences, etc

R.G. Newell, W.A. Pizer / Energy Policy 32 (2004) 519–529R.G. Newell, W.A. Pizer / Energy Policy 32 (2004) 519–529

Green AccountingGreen Accounting

Systematic presentation of data on Systematic presentation of data on environmentally important stocks and flows (e.g. environmentally important stocks and flows (e.g. stocks of life-sustaining natural resources, flows stocks of life-sustaining natural resources, flows of pollutants), accompanying conventional of pollutants), accompanying conventional economic accounts (e.g. measures of gross economic accounts (e.g. measures of gross domestic product) with the ultimate objective of domestic product) with the ultimate objective of providing a comprehensive measure of the providing a comprehensive measure of the environmental consequences of economic environmental consequences of economic activity. activity.

(Euroean Environment Agency)(Euroean Environment Agency)