Monday, March 11, 2013

Markets and the Environment

by Duncan Gromko

There's a great audio file up of a recent presentation by Joshua Farley. If you have 80 minutes to burn, I really recommend listening.

Dr. Farley lays out the new approach of thinking of the environment in terms of benefits to humans - ecosystem services. In short, the market has mostly ignored value of ecosystem services, meaning that we have fewer environmental services than "optimal." Having identified and quantified this value, there is optimism that we can "internalize" ecosystem services by including them in markets.

Recognizing the benefits to such an approach, Dr. Farley then explains how, even using the ecosystem services framework, markets can never do a good job of managing natural resources.

I love the context he provides for his critique of neoclassical economics. When economists were coming up with these ideas, the world population was one-fourth the size and per capita consumption was one ninth what it is now. That means that our economic output is now 36 times greater! At the advent of the industrial revolution, natural resources were abundant and human-made products were limited. Using natural capital to create built capital made a lot of sense. Now the situation is reversed and we are constrained by limited natural resources, but economic thinking has not adjusted! Nature is assumed to be limitless.

Some economists and environmentalists are thrilled by the idea of ecosystem services because, having identified these benefits, we can use markets to protect them. A simple example is a situation where an upstream farmer is clearing trees from his land, negatively affecting a downstream individual, like a hydro power plant. The market solution is to value the benefit of the trees on the farmers land to the hydro owner and for the hydro owner to pay the farmer that amount. The farmer is better off because of the payments and the hydro owner is better off because her power plant is more productive. Win-win, or in economic speak, a Pareto outcome. In some situations this mechanism (known as payment for ecosystem services - PES) may be effective, but Dr. Farley says that, for the most part, markets will fail to protect ecosystem services for many reasons.

One reason is that markets discount benefits to future generations. A discount rate is used to value benefits today over benefits tomorrow. This makes sense for most situations: would you rather have $100 today or $100 ten years from now? Clearly money today is worth more - you could invest that money and have much more in ten years or spend the money now on something you need immediately. But for inter-generational benefits, the discount rate values benefits far in the future as close to zero. In a climate change cost-benefit analysis, what we're saying is that benefits to future generations from reducing green house gas emissions are worth much less than the benefits that come from pollution-causing activities today. Neoclassical economics makes this mistake because it assumes perfect substitutability, the second problem outlined by Dr. Farley.

Neoclassical economics assumes that all inputs and goods (capital, labor, and natural resources) are substitutable. For example, a car factory can replace workers (labor) with machines (capital) and produce the same amount. You can do this to an extent with natural resources, but at some point natural resources are not substitutable! Climate change may reduce agricultural output by one third, but since agriculture is such a small part of GDP, according to this model, no big deal! We can substitute agricultural products with more TVs or cars. But this is obviously absurd: at some point you can't substitute food! Applying the discount rate to benefits to future generations is assuming that decline in ecosystem services because of climate change can be substituted by other products and services from built capital.

A related issue is that we're getting marginal benefit/cost analysis wrong. What is the added benefit of an extra bushel of wheat versus the cost of producing that bushel? Most of the time this works: if there are fewer bushels, the value of an extra bushel goes up. If there are many bushels, the value of an extra bushel goes down. But at some point (when someone is starving), the value of an extra bushel nears infinity! Markets have no way of dealing with infinite value.

This is an especially important concept when talking about critical natural capital. Ecosystems are not simple resources that produce benefits proportionate to their size. Take the Amazon rainforest. Destroying 1% of the Amazon reduces the ecosystem services provided by the rainforest by X amount. But if you destroy 20%, it doesn't reduce services by 20X. Since the rainforest actually generates most of the rainfall that trees use, destroying 20% of the rainforest would lead to lower rainfall in other parts of the Amazon. Drought would lead to tree die off, more forest fires, and the possible collapse of the entire ecosystem. There are tipping points beyond which the Amazon cannot recover. If the tipping point for the Amazon is 20%, the cost of destroying 20% is much much more than 20X, it could be as much as the entire value of the rainforest. Economics has a tough time dealing with that.

A third problem is equity. Markets distribute resources based on purchasing power and price signals (the value of a good is the price paid for it), not where the resource would be best used. If you have a finite quantity of ecosystem services, people with the most money will "buy" most of the ecosystem services. A poor farmer in India cannot afford to pay as much for clean water as a banker in New York. Distributing resources by purchasing power leads to "bad" outcomes. Say, for example, there were 100 extra calories per person per day produced in global agricultural markets. Most of these calories are going to end up in wealthy countries where there is actually negative value to additional consumption (wouldn't most Americans be healthier if they ate a little less?) instead of where those calories would have a greater benefit: in the stomachs of those who don't have enough.

In terms of ecosystem services, this distribution is particularly damaging. The poor are much more dependent on ecosystem services than the rich. Take a mangrove in Indonesia that provides locals with protection from storms and food from the fish that live in the mangrove. If the mangrove is destroyed, a wealthy Indonesian can buy food from elsewhere; their home may be more threatened by storms, but they can afford to move. A poor Indonesian will be much more impacted as they cannot afford to move or purchase food elsewhere. I like how Dr. Farley summed this up: markets don't distribute resources to the most important uses, they distribute resources to the most important people!

Despite all these problems, Dr. Farley still likes the idea of ecosystem services. It's a great way of talking about the environment in terms of value to people. The environmental movement previously talked about things like pandas and tigers, which people in developed countries like, but do not affect them in a tangible way. Now we're talking about human well-being and things that matter. However, just because we are starting to better understand the value of nature, that doesn't mean that we use that value information to let the market determine resource distribution. If we do, we will: 1) undervalue future generations; 2) risk destroying critical natural capital; and 3) exacerbate wealth inequality.

What's the solution? Valuing ecosystem services is a start and hopefully it will better communicate the magnitude of these issues to policy makers. But as Dr. Farley says, we need to seek economic institutions that work with ecosystems rather than trying to internalize ecosystems into our existing system. Not particularly satisfying, but if we had an easy answer, we wouldn't be in this mess.


  1. Very interesting and challenging post. I haven't had a chance to listen to the podcast, but all three of the major criticisms here seem both valid and perhaps misdirected, depending on how he framed them. Here are my, very preliminary, thoughts:

    The three problems, inter-generational optimization, differences between natural and human made capital, and distribution, all seem, to me, not to be a problem with an economic approach in general as much as the specific economic approach that is most common.

    The first one, inter-generational exchange, can likely be solved by modeling optimal resource use at the societal or macrolevel, rather than a micro one, basically: an individual may die and not care about the future, but society (we hope) is indefinite. Likely this is not a popular approach because for some resources the answers are probably unpalatable. For fixed resource X how much can we consume each year if we hope to use it forever? The answer is zero. Which, to some extent, is why I think the second issue is more important:

    The second issue is basically when we have a typical production function, Y = a(L)^(alpha) + b(K)^(1-alpha), or something, subsuming natural capital under all capital, K, doesn't work because of issues with sustainability and limited resources. That said, I would suggest the issue is not so much a natural vs unnatural distinction (a false distinction in my opinion, but we can save that philosophical point for another time) as it is a distinction between limited and unlimited resources (the latter not meaning infinite, necessarily, but our capacity to produce more. basically I mean fixed vs renewable, but I want to avoid the specific environmental connotations of the latter). Thus, something like wood used to build factories, is potentially unlimited because, if we cared enough, we could plant a new tree for everyone we cut down. Something like steel might not be because there is a fixed amount of iron on earth and we cannot just 'plant' more iron. The result is you might group kinds of capital together that cross over the natural/unnatural 'distinction.' Some examples of things I think might be limited: steel, oil, radio wave frequencies. Some example of things that might be unlimited: wood, electrical power, anything that could be built out of a variety of different materials. So the question is how do we rewrite our production function to have both kinds of capital? (and throwing on of the old models with land doesn't work, because land doesn't disappear when you use it, while, say, oil mostly does) I don't know. It's an interesting question. Once you figure that out though, the optimization problem from the previous issue is likely a straightforward issue.

    The last issue, I think, is the kind of thing form a practical stand point we feel comfortable with knowing what to do: if people cant afford the basic things they need to live, we should make sure they have access to the de minimis income necessary to purchase these things. How to think about this from a more economic theory perspective is tougher. The closest thing I can think of is suggesting that something like a minimum income is a kind of public good, with social value, which we can then model in as an externality to economic activity in general. Such a broad based externality would likely only require a minute form of taxation to cover it. Unfortunately, I can't really think of any more elegant way to bring it into a broader economic theory and would be interested to hear other people's thoughts on the subject.

    Anyways, great post. “In all affairs it's a healthy thing now and then to hang a question mark on the things you have long taken for granted.” - Bertrand Russell

  2. Thanks for your comment, Blue. Let me say that if anything was framed incorrectly, it was my misinterpretation of Dr. Farley that was at fault.

    I don't think I did a good enough job of giving context for Dr. Farley's argument. What he's arguing against is the internalization of the value of ecosystem services into markets. He's saying that we can't get the values right (because of challenges of marginal analysis and assuming substitutability) and that even if we did, the discount rate and income inequality would still lead to suboptimal distribution.

    In terms of your production function, the people at Global Footprint Network have tried to do something sort of similar: Basically they are trying to measure the resources that in your words are "limited," estimate the rate that they are being consumed, and compare that consumption rate to the rate that they renew themselves.

    Which brings up a point that I would push back on your limited vs. unlimited distinction. While I can understand why you might want to stay away from the "renewable" term, it has important meaning. Renewable resources (like timber) are not unlimited. They do renew themselves, but not immediately or limitlessly; it is possible to use these resources faster than their rate of renewal. My favorite analogy for this scenario is that people would be using the "principal" of our natural capital balance rather than just the "interest." Sustainability (another loaded term) would be living on just the interest. The people at Global Footprint Network are trying to measure how much "interest" we're earning. Their estimate is that, for a global average, we are consuming renewable resources at about 1.5X their interest rate.

    But even that analysis runs into problems (critical natural capital, issues of substitutability) like I described in my post.

    Thanks for your comment. It certainly is an affair to hang yourself on.