Web Unit 1.1: An Introduction to the Course

1. Introduction

2. Objectives

3. The framework of natural resource and environmental economics

4. What is scarcity?

5. How is economic value measured?

6. Natural resource economics

7. Environmental economics

8. Diagrammatic comparison of natural resource and environmental economics

9. Economic and Environmental Policy

Introduction

A) Understanding economic models of natural resource utilization.

Natural resources provide many goods and services for our society. Forests provide lumber for building houses and natural ecosystems for hiking and picnics; soil provides a medium for growing agricultural products; fisheries provide food and recreation. The first part of this course concentrates on reviewing how economic systems allocate these resources to potential users. After covering how markets are supposed to work, the course then focuses on market failure. Markets often fail to incorporate aesthetic or recreational values when allocating natural resources. In many cases, these market failures cause environmental conflicts. By understanding how markets work, and how they fail, we can begin to see the advantages and disadvantages of using market systems to improve environmental conditions.

B) Understanding market failures.

We will focus on four main types of market failure in this course:

1. Failure due to the presence of common property resources

2. Failure due to the presence of externalities

3. Failure due to the presence of public goods

4. Failure due to unaccounted for risk and information asymmetries

It is important to understand where markets fail and how they fail before asking what should be done to eliminate the results of market failure.

C) Understanding the potential and limitations of economic policy to correct market failure.

With an understanding of how markets operate and how they fail, the course turns to a discussion of how policy can incorporate economics. Here we will learn about the following ways in which economics is used in environmental policy:

Valuation of environmental or non market resources: Contingent valuation, travel cost, and hedonic approaches.

Benefit-Cost analysis: What is it and how is it done?

Mechanisms for correcting market failures: Command and control regulation, taxes, and tradable discharge permits.

D) Understanding how concepts apply to environmental problems.

Case studies -- or examples from the real world -- will be used throughout the web units. They will provide you with an opportunity to learn about actual environmental problems and how economics might be used to help solve these problems. Through these examples you will learn what questions are important to ask, what analysis must be performed before policies are enacted, and what policies are best for a given situation.

Objectives

At the end of this course, students should be able to:

Identify critical economic factors in environmental issues

Detail the social benefits and costs of environmental policy

Understand economic methods for valuing social benefits and costs

Apply environmental valuation studies to policy

Critically analyze an environmental benefit-cost analysis

Understand several contemporary environmental issues

The framework of natural resource and environmental economics

The science of economics is concerned with the allocation of resources, and especially those resources that are scarce or limited in their availability. If a resource is not scarce, then there is no need to ration, or allocate, it among economic agents. Economics provides a framework for allocating scarce resources efficiently, where efficiency is defined in a very specific way (to be discussed later). From this perspective, economics is well suited to addressing environmental issues because environmental quality, like many other goods and services, is now considered to be a scarce resource. And, because many environmental issues involve complex tradeoffs between degradation (such as air or water pollution) and other economic goals (such as economic growth and job creation), economics can be used to help determine the efficient allocation.
In short, the science of economics is built around the idea that it can evaluate the potential tradeoffs among different goods and services in terms of monetary units, including environmental goods and services. It is important to realize that nearly all our decisions in life involve the evaluation of tradeoffs, whether small and simple (as in example 1 below) or large and complex (as in example 2). The principles behind how economists evaluate problems are generally the same no matter how complex the problem might be -- its just the specifics of the quantitative analyses that might differ.

Examples of real world tradeoffs:

1. If you have only $1, do you want to purchase a candy bar or a pack of bubble gum?

2. Should the Federal Reserve Bank increase interest rates to reduce economic growth and control inflation, or should it allow interest rates to remain the same in order to maintain economic growth and add more jobs to the economy?

Something to think about: List out several environmental problems you have heard about, and describe what tradeoffs might be involved. Now, list the individuals or groups who might advocate one particular solution or another. If you were a policy maker who could decide the outcome of this problem, how would you decide? What decision criteria might you use?

Environmental economists also use monetary units to describe the trade-offs between market and nonmarket goods. Nonmarket goods are things we value, but that are not traded formally in markets and thus may not have a dollar value attached to them. Economists use several different techniques (discussed later) to derive monetary, or dollar, values for these types of goods.

Examples of tradeoffs involving market and nonmarket goods:

1. Should we continue to harvest trees on public forest lands? The answer to this question depends on the market value of trees as a commodity and the nonmarket value of ecosystems (of which the trees are a part) as an environmental resource. While the value of trees as a commodity is easy to obtain by looking at prices established in lumber markets, the value of ecosystems as an environmental resource involves values that are not determined by markets. These values may include recreational uses, nutrient cycling, and carbon sequestration. Economists use other means to associate prices with these nonmarket values, thus providing an opportunity to compare the value of alternative forest uses.

2. If clean air is a goal, how should we regulate industries that pollute the air? The government has at its disposal a host of market and nonmarket mechanisms for getting firms to reduce air pollution. It can simply set standards for each firm, it can set taxes on pollution discharges, or it can provide mechanisms to allow individual firms to establish pollution levels on their own as long as total air pollution does not exceed a specified goal. These different approaches will have different costs for firms and for society. Economists use monetary values to determine the costs associated with the alternatives in order to determine which are the cheapest.

Much of the work of natural resource and environmental economics involves comparing alternative courses of action. If economists focus on quantitative monetary comparisons, then policy makers face the task of choosing the appropriate course of action using both the quantitative analysis and other considerations. This quantitative approach by economists is known as POSITIVE economics because it attempts to explain how a system works and to provide information on potential benefits and costs of different actions using data. NORMATIVE economics, on the other hand, involves suggesting how the policies themselves should be made, usually by relying on theoretical or conceptual ideas. Rather than simply explaining the potential tradeoffs, NORMATIVE economics involves value judgments over what the best course of action should be.

Examples:

1. A positive economic statement is: "The new policy will result in a 10% unemployment rate."

2. A normative economic statement is: "The unemployment rate should be under 6%."

What is scarcity?

Scarce resources are those that are limited in quantity or supply.

Examples of the different types of scarce resources:

1. Renewable resources: Although forests and fisheries will replenish themselves, they can only do so over a period of time and thus are not unlimited in the short-run. It may be terribly costly to us in the long-run, but humans can and do exploit them to near extinction (and often to economic extinction, or the point where there is not enough of the resource to use in economic activity).

2. Nonrenewable resources: The quantities of oil and natural gas are generally considered to be physically limited on earth. They exist in reserves around the world, but they regenerate so slowly that they are considered nonrenewable. While we continue to find new reserves for many nonrenewable resources, the cost of extracting reserves increases as they are drawn down. This suggests an important point -- although some resources may appear to be unlimited, the costs of extracting or using them plays a role in how economists define scarcity. We will discuss this concept more thoroughly later in the course.

3. Environmental resources: Wetlands and other natural ecosystems provide a good example of scarce environmental resources. If humans did not exist on earth, wetlands would exist across the globe, but they would not exist everywhere. They are therefore limited. Human activity has converted natural wetlands to other uses, such as houses or farms, and thus wetlands have become more scarce. What do you think has happened over time to the value of remaining natural wetlands?

Can you think of something that exists in unlimited quantity? Within the context of our own lives, sunlight is surely unlimited. Although their may be cloudy days, or you may happen to be above the arctic circle in the middle of winter, the sun is still shining somewhere. But, considered within the context of economic activity, sunlight it is not unlimited. As the seasons change, we cannot grow food crops on fields in the winter in temperate regions. Thus, our use of sunlight for crop production is limited.

Another example is the use of sunlight for power production. Solar panels provide the opportunity to harness the unlimited power of the sun. However, our technologies for solar panels have not developed enough to make them competitive price wise with other sources of energy. The cost of solar power is higher than the cost of coal power right now. In the context of solar power, therefore, our ability to harness the sun’s power is limited by the cost of doing so.

Scarcity drives most of the economic tradeoffs we are concerned about in this course. As resources become more scarce, we value the remaining units more heavily. For example, if the quantity of remaining oil reserves becomes scarce, the price of oil (or the value of the remaining units of oil) is likely to become very high.

How is economic value measured?

The economic concept of value is that value is human driven (i.e., it is anthropocentric), meaning that goods and services are not considered to have value unless humans place value on them. From a strict economic perspective, there is no such thing as intrinsic or natural value. Of course, this focus on human-based value leads economists to measure market and nonmarket values using monetary instruments such as dollars.

Philosophers, environmentalists, and recently even some economists, have suggested that a complete focus on anthropocentric valuation may be an improper way to value environmental resources. Their argument is that environmental resources have value regardless of whether or not humans place values on them. This is often referred to as intrinsic value. This debate is likely to continue for some time, although the vast majority of economists continue to agree that natural resource values arise primarily from anthropocentric sources.

Using dollars as a common measure to value environmental resources provides an opportunity to make the comparisons between very different objects or courses of action. This approach provides a common reference point, allowing policy makers to compare alternatives in terms of the values they are familiar with.

Example:

Suppose policy makers are reviewing a proposal to build a bypass highway around Baton Rouge (as, in fact, they are). On the one hand, they can use a money measure of value to estimate the labor and material costs of the highway project. But, are these costs (and thus the project) justified? One way to determine this would be to estimate the monetary value of increased highway safety and the potential for reduced death and injury costs from accidents. These potential savings can then be compared to the project costs to estimate the net benefits of the bypass. If the net benefits are positive, the project is said to have a favorable benefit/cost ratio. We will cover this idea of benefit/cost analysis in more detail later in the course.

Natural resource economics

Natural resource economics is concerned with how markets allocate natural resources. We commonly consider natural resources to be marketable commodities, such as timber, fish, oil, and natural gas -- in other words, direct production or consumption resources created by the natural processes of the earth.
In general, markets operate so that natural resources are allocated to the users who value them the most, presumably because they can make the best (most profitable) use of them in some way. Natural resources are provided to these potential users by resource owners who can supply them to the market for a profit. As you might guess from this short description, the issues of who owns the resources and who can afford to purchase them for use are critical to natural resource economists.
In simple terms, the efficient allocation and utilization of natural resources considers only the actions of markets, and generally avoids discussion of market failures. Thus, it is important to understand how markets operate in the absence of market failure in order to understand our later discussions about how market failures affect the markets. In reality, efficient natural resource allocation critically depends on solving ubiquitous market failures.

Environmental economics

Environmental economics is somewhat different than natural resource economics in that its focus is almost entirely on the issue of market failure and how these failures affect the continued existence of environmental systems. In general, these environmental resources are measured and assessed in terms of their quality as well as their quantity (natural resource economics also has a quality dimension, but the focus is primarily on quantity). Quality often cannot be split up and allocated among different users (for example, how can you allocate different levels of clean air?), which makes it a fundamentally different issue to deal with. Thus, environmental economics also concentrates on categorizing and valuing environmental quality changes and using environmental policy to provide these resources to society.

Example of a natural and an environmental resource, and how they often overlap:

Forests fall into both the natural resource and the environmental resource category. As natural resources, they can be allocated to users by harvesting timber. As environmental resources, they are valued as part of an ecosystems if they are not harvested, perhaps for their production of oxygen or their ability to support a large number of animal and other plant species. Because many of us value intact ecosystems that other people own, markets cannot allocate ecosystem quality to individual people (like you and me). This characteristic leads us to define ecosystem quality as a public good (which we will examine in more detail later).

Something to think about: Society values both forest products and ecosystem quality. How would you decide how much timber to harvest on US forests?

Diagrammatic comparison of natural resource and environmental economics

Consider the world as it was 200 years ago, perhaps with a population of X. Figure 1 shows that technology, capital, and labor are used to produce goods from natural assets. Natural resource economics involves how these resources could be used efficiently to meet the needs of society, as shown by the arrow between the technology circle and the human consumption circle. As natural assets are converted via industrial processes to goods consumed in society, however, pollution if often generated. The natural world can assimilate many of these pollutants, and if population is low enough, as it was 200 years ago, pollution has little real effect on the well being of society as a whole.

Figure 1: World with population X.

Second, consider a world with population 10X (Figure 2). In this world, we are using natural assets to provide goods and services, and our technology is creating pollution. All of the circles are larger because we have more people. In particular, the human consumption circle is larger because it also includes more demand for natural assets. For example, society's interest in consuming the knowledge that pure forest ecosystems exist in nature, rather than as timber products, has grown along with income and population. Pollution is also larger because we are consuming more goods and services with greater incomes and more people. The circles now overlap. Overlap means that pollution is affecting our consumption of natural assets and that it may be affecting our consumption of other things as well. If pollution destroys natural forests, then we cannot consume them as environmental resources. Also, pollution may cause health problems, so that we have to spend more money and time going to the doctor rather than consuming wilderness areas or zoos.

Figure 2: World with population 10X

Figures 1 and 2 illustrate that conversion of natural assets to consumption has implications beyond satisfying human wants and needs. It may ultimately affect our use of natural assets. In fact, the technology circle may also enter the consumption circle, suggesting that our use of natural assets for human consumption affects our enjoyment of those assets naturally. Environmental economics is about quantifying the tradeoffs between human consumption and pollution, or human consumption and use of natural assets for other purposes, such as wildlife viewing.

Economic and Environmental Policy

The development and implementation of economic policy occurs on a daily basis. For example, the Federal Reserve decides how much to increase or decrease the prime interest rate, or the treasury decides how many bonds it needs to sell in order to finance federal deficit spending. These actions have far reaching consequences for markets, and they are often evaluated on a daily basis.

Environmental policy decision can also occur on a daily basis, if for no other reason than the fact that economic policy directly affects how potential environmental policy decision are evaluated. Thus, economics plays a direct role in environmental policy by defining the potential tradeoffs. Of course, environmental policy involves many other non-economic components, but economic analysis must be considered in any environmental policy issue. These ideas will be more completely discussed in the latter part of the course.