Markets and the Environment (2nd Edition) PDF

 Markets and the Environment Second Edition Foundations of Contemporary Environmental Studies Ecology and Ecosystem Conservation Oswald J. Schmitz Global Environmental Governance James Gustave Speth and Peter M. Haas Coastal...

 Markets and the Environment Second Edition Foundations of Contemporary Environmental Studies Ecology and Ecosystem Conservation Oswald J. Schmitz Global Environmental Governance James Gustave Speth and Peter M. Haas Coastal Governance Richard Burroughs Water Resources Shimon C. Anisfeld Ecology and Religion John Grim and Mary Evelyn Tucker  Markets and the Environment Second Edition Nathaniel O. Keohane Sheila M. Olmstead Washington | Covelo | London Copyright © 2016 Nathaniel O. Keohane and Sheila M. Olmstead First Island Press edition, 2007 All rights reserved under International and Pan-American Copyright Conventions. No part of this book may be reproduced in any form or by any means without permission in writing from the publisher: Island Press, 2000 M Street, NW, Suite 650, Washington, DC 20036. ISLAND PRESS is a trademark of the Center for Resource Economics. Library of Congress Control Number: 2015939771 Printed on recycled, acid-free paper Manufactured in the United States of America 10 9 8 7 6 5 4 3 2 1 Keywords: environmental economics, environmental policy, cost-benefit analysis, externalities, capital assets, natural resources, green accounting, water pricing, carbon market, limits to growth For Frances and Eleanor, and for Gau. —N.O.K. For Kevin, Finn, and Laurel. —S.M.O.  Contents Preface xv Chapter 1: Introduction 1 Economics and the Environment 1 Global Climate Change 2 Organization and Content of This Book 6 What We Hope Readers Will Take Away from This Book 9 Chapter 2: Economic Efficiency and Environmental Protection 11 Economic Efficiency 12 Efficiency and Environmental Policy 20 Equating Benefits and Costs on the Margin 22 Dynamic Efficiency and Environmental Policy 31 Conclusion 34 Chapter 3: The Benefits and Costs of Environmental Protection 35 Measuring Costs 35 Evaluating the Benefits 44 Benefit–Cost Analysis 55 Conclusion 68 Chapter 4: The Efficiency of Markets 69 Competitive Market Equilibrium 70 The Efficiency of Competitive Markets 74 Conclusion 78 Chapter 5: Market Failures in the Environmental Realm 80 Externalities 81 Public Goods 85 The Tragedy of the Commons 91 Conclusion 97 xii contents Chapter 6: Managing Stocks: Natural Resources as Capital Assets 99 Economic Scarcity 100 Efficient Extraction in Two Periods 103 A Closer Look at the Efficient Extraction Path 105 What about Market Power? 110 The Critical Role of Property Rights 111 Conclusion 113 Chapter 7: Stocks That Grow: The Economics of Renewable Resource Management 114 Economics of Forest Resources 114 Fisheries 128 Conclusion 137 Chapter 8: Principles of Market-Based Environmental Policy 139 The Coase Theorem 140 The Array of Policy Instruments 143 How Market-Based Policies Can Overcome Market Failure 147 Raising Revenues 160 Setting Prices versus Setting Quantities 162 Conclusion 167 Chapter 9: The Case for Market-Based Instruments in the Real World 168 Reducing Costs 169 Promoting Technological Change 179 Market-Based Instruments for Managing Natural Resources 184 Other Considerations 189 Conclusion 198 Chapter 10: Market-Based Instruments in Practice 199 The U.S. Sulfur Dioxide Market 200 Individual Tradable Quotas for Fishing in New Zealand 207 Municipal Water Pricing 214 The European Union’s Emissions Trading System 217 Water Quality Trading 221 Waste Management: “Pay as You Throw” 223 Habitat and Land Management 224 Conclusion 230 Chapter 11: Sustainability and Economic Growth 231 Limits to Growth? 232 Sustainability, in Economic Terms 238 Keeping Track: Green Accounting 245  contents xiii Are Economic Growth and Sustainability Compatible? 252 Conclusion 253 Chapter 12: Conclusion 254 What Does Economics Imply for Environmental Policy? 254 The Roles of Firms, Consumers, and Governments 256 Some Final Thoughts 257 Discussion Questions 259 References 267 Further Reading 291 Index 297  Preface This book provides a concise introduction to the economic theory of environmental policy and natural resource management. If you have used this book before, you may be asking yourself what is new in the second edition. In the 8 years since the publication of the first edition, although little has changed in economic theory with respect to environmental quality and environmental policy, readers urged us to revise the book for several reasons. First, faculty members using the book to teach undergrad- uate environmental and resource economics encouraged us to strengthen the links between the material in the book and that covered in a typical introductory microeconomics course, mostly via changes in the language we used in discussing economic concepts.We’ve done this throughout the book. Also at the recommendation of users, the descriptions of cost and benefit estimation in Chapter 2 have been revised and expanded, and the discussion of environmental taxation in Chapter 8 has been restructured. Research in the field of environmental economics moves quickly, and we’ve incorporated a good deal of important new knowledge created since the first edition. Throughout the book, we have updated old ex- amples and added many new examples of market-based environmental policy in action, primarily in the boxes that accompany the text but also in the text itself. In this vein, major updates were made to the cover- age of deforestation in Chapter 7, the discussion of market-based instru- ments and nonuniformly mixed pollutants in Chapter 9, and all sections in Chapter 10. Finally, we were shocked at how quickly some of the popular culture references in the first edition (those to compact discs and Napster, for example) became dated, so we’ve done our best to sound current, al- though we admit that our children are now better sources for this kind xv xvi preface of information than we are. Despite these many changes, this edition pre- serves the basic structure of the original, with some small exceptions; for example, we have dropped the mathematical appendix on the economics of fishing from Chapter 7. As in the first edition, our goal is to illuminate the role economic the- ory—and more broadly economic thinking—can play in informing and improving environmental policy. To our minds, noneconomists tend to perceive economics rather narrowly, as being concerned only with money or with national indicators such as exchange rates and trade balances. In fact, economics has a much wider reach. It sheds light on individuals’ con- sumption choices in the face of scarce resources, the interaction between firms and consumers in a market, the extent to which individuals are likely to contribute toward the common good or ignore it in the pursuit of their own self-interest, and the ways government policies and other institutions shape incentives for action (or lack thereof ). As we explain in the first chapter of the book, economics is central to understanding why environmental problems arise and how and why to address them. As concerned citizens as well as economists, we think it is vital for anyone interested in environmental policy to be conversant in the language of economics. The approach we have taken here draws on our own experience teach- ing environmental and natural resource economics to master’s students and undergraduates. It also draws on our experiences in the real world of environmental policy, in the public and nonprofit sectors. The emphasis is on intuition rather than algebra; we seek to convey the underlying concepts through words and graphs, presenting mathematical results only when necessary. We have also included a wealth of real-world examples, from the conservation of the California condor, to mitigation of global climate change, to using markets to manage fisheries in New Zealand and elsewhere. The book was written with university students in mind, but its infor- mal style and the importance of the subject make it suitable for a wide range of professionals or other concerned readers seeking an introduction to environmental economics. We have tried to make the language acces- sible to someone without any prior knowledge of economics. At the same time, the treatment is comprehensive enough that even an economics major with little experience in environmental policy could learn a great deal from the book. The lack of mathematical notation does not reduce the rigor of the underlying analysis.  preface xvii In our teaching, we have noticed a gap between short articles on how economists think about the environment and textbooks filled with alge- bra and detailed information on the history of U.S. federal environmental legislation. In addition, most textbooks on the subject of markets and the environment treat either the economics of pollution control or the eco- nomics of natural resource management. At an introductory level there is little integration of these two “halves” of the discipline of environ- mental and resource economics. This book aims to fill these gaps. It can be used as a primer for a core course in environmental studies, at either the undergraduate or master’s level. In that context, this book would be the sole economics text, used alongside several other books representing different perspectives on environmental studies from the social, natural, and physical sciences. The book is also well suited to a semester-long course in environmental or natural resource economics, either as a main text (supplemented with more mathematical lecture notes and problem sets) or as a complement to another, more detailed (but perhaps less in- tuitive) textbook. Finally, the book could be used (as we ourselves have used the notes from which it grew) as an introduction to environmental economics in a course with a different focus. For example, a course on business strategy can use this book to explain the basic logic and prac- tice of market-based policies to regulate pollution. Similarly, a principles of microeconomics course could use this book to show how economic theory can be applied to real-world problems and illuminate the market failures aspect of the course. At the end of the volume, readers will find a list of references, includ- ing works cited in the text and other recommended readings of possible interest. We have also provided a set of study questions for each chapter, designed to be thought provoking and open-ended rather than simply reiterating the material. We thank Karen Fisher-Vanden for providing thoughtful comments on the first edition and Robert Stavins, Elizabeth Walker, and Louise Marshall for their extensive input on what to fix in the second.We are also grateful to the book’s many other users who have e-mailed us comments, suggestions, and corrections over the years. Please keep that information coming. Our editors at Island Press for both editions, Todd Baldwin and Emily Davis, patiently moved us through the process of writing and revis- ing the book. We thank our spouses, Todd Olmstead and Georgia Leven- son Keohane, for their support and encouragement. Finally, we both owe a great deal to Robert Stavins, whose passion for teaching environmental xviii preface economics and communicating its principles to policymakers—and un- rivaled ability to do so—continues to inspire us. Nathaniel O. Keohane Sheila M. Olmstead New York, New York Austin, Texas  1 Introduction This book is a primer on the economics of the environment and natural resources. The title, Markets and the Environment, suggests one of our cen- tral themes. An understanding of markets—why they work, when they fail, and what lessons they offer for the design of environmental policies and the management of natural resources—is central to an understanding of environmental issues. But even before we start thinking about how markets work, it is useful to begin with a more basic question: What is environmental economics? Economics and the Environment “Environmental economics” may seem like a contradiction in terms. Some people think that economics is just about money, that it is preoc- cupied with profits and economic growth and has nothing to do with the effects of human activity on the planet. Others view environmentalists as being naive about economic realities or “more concerned about animals than jobs.” Of course neither stereotype is true. Indeed, not only is “the environ- ment” not separate from “the economy,” but environmental problems can- not be fully understood without understanding basic economic concepts. Economics helps explain why firms and individuals make the decisions they do—why coal (despite generating significant local air pollution and carbon dioxide emissions) still generates almost 40 percent of electricity in the United States, or why some people drive large sport utility vehicles instead of Priuses. Economics also helps predict how those same firms and individuals will respond to a new set of incentives—for example, what investments electric utilities will make in a carbon-constrained world and Nathaniel O. Keohane and Sheila M. Olmstead, Markets and the Environment, 1 DOI 10.5822/ 978-1-61091-608-0_1, © 2016 Nathaniel O. Keohane and Sheila M. Olmstead. 2 markets and the environment how high gas prices would have to rise before people stopped buying enormous cars. At its core, economics is the study of the allocation of scarce resources. This central focus, as much as anything else, makes it eminently suited to analyzing environmental problems. Let’s take a concrete example. The Columbia and the Snake Rivers drain much of the U.S. Pacific North- west, providing water for drinking, irrigation, transportation, and electric- ity generation and supporting endangered salmon populations. All these activities—including salmon preservation—provide economic benefits to the extent that people value them. If there is not enough water to meet all those needs, then we must trade off one good thing for another (less irrigation for more fish habitat, for example). How should we as a society balance these competing claims against each other? To what lengths should we go to protect the salmon? What other valued uses should we give up? We might reduce withdraw- als of water for agricultural irrigation, remove one or more hydroelectric dams, or implement water conservation programs in urban areas. How do we assess these various options? Economics provides a framework for answering these questions. The basic approach is simple enough: Measure the costs and benefits of each possible policy, including a policy of doing nothing at all, and then choose the policy that generates the maximum net benefit to society as a whole (that is, benefits minus costs).This is easier to say than to do, but econom- ics also provides tools for measuring costs and benefits. Finally, economic theory suggests how to design policies that harness market forces to work for rather than against environmental protection. To illustrate how economic reasoning can help us understand and ad- dress environmental problems, let’s take a look at perhaps the most press- ing environmental issue today: global climate change. Global Climate Change There is overwhelming scientific consensus that human activity—pri- marily the burning of fossil fuels and deforestation caused by agriculture and urbanization—is responsible for a sharp and continuing rise in the concentration of carbon dioxide (CO2 ) and other heat-trapping gases in the earth’s atmosphere. The most direct consequence is a rise in average global surface temperatures, which is why the phenomenon is known widely as global warming. (Globally averaged surface temperatures have already increased by 0.85°C, or about 1.5 degrees Fahrenheit, since the late nineteenth century.)1 But the consequences are much broader than  introduction 3 warming, which is why the broader term climate change is more apt. Ex- pected impacts (many of which are already measurable) include sea level rise from the melting of polar ice caps; regional changes in precipitation; the disappearance of glaciers from high mountain ranges; the deteriora- tion of coastal reefs; increased frequency of extreme weather events such as droughts, floods, and major storms; species migration and extinction; and spatial shifts in the prevalence of disease. The worst-case scenarios include a reversal of the North Atlantic thermohaline circulation, better known as the Gulf Stream, which brings warm water northward from the tropics and makes England and the rest of northern Europe habitable. Although there has been much international discussion about the poten- tial costs and benefits of taking steps to slow or reverse this process, little progress has been achieved. What are the causes of climate change? A natural scientist might point to the complex dynamics of the earth’s atmosphere—how CO2 accumu- lating in the atmosphere traps heat (the famous greenhouse effect) or how CO2 gets absorbed by ocean and forest sinks. From an economic point of view, the roots lie in the incentives facing individuals, firms, and govern- ments. Each time we drive a car, turn on a light, or use a computer, we are indirectly increasing carbon emissions and thereby contributing to global climate change. In doing so, we impose a small cost on the earth’s population. However, these costs are invisible to the people responsible. You do not pay for the carbon you emit. Nor, indeed, does the company that provides your electricity (at least if you live in most of the United States) or the company that made your car. The result is that we all put CO2 into the atmosphere, because we have no reason not to. It costs us nothing, and we receive significant individual benefits from the energy services that generate carbon emissions. Economics stresses the importance of incentives in shaping people’s behavior.Without incentives to pay for the true costs of their actions, few people (or firms) will voluntarily do so.You might think at first that this is because the “free market” has prevailed. In fact, that gets it almost exactly backward.Very often, as we shall see in this book, the problem is not that markets are so pervasive but that they are not pervasive enough—that is, they are incomplete. There is simply no market for clean air or a stable global climate. If there were, then firms and individuals who contributed to climate stabilization (by reducing their own carbon emissions or off- setting them) would be rewarded for doing so, just as firms that produce automobiles earn revenue from selling cars. This is a key insight from economics: Many environmental problems would be alleviated if proper 4 markets and the environment markets existed. Because those markets usually don’t arise by themselves (for reasons we shall discuss later on in the book), governments have a crucial role in setting them up—or in creating price signals that mimic the incentives a market would provide. If this is such a problem, you may have asked yourself, why haven’t the world’s countries come together and designed a policy to solve it? After all, the consequences of significant climate change may be dire, especially for low-lying coastal areas and countries in which predicted changes in temperature and precipitation will marginalize much existing agricultural land. If you have been following the development of this issue in the global media, and you know of the difficulty experienced by the interna- tional community in coming to agreement over the appropriate measures to take in combating climate change, it will not be terribly surprising that economics predicts that this is a difficult problem to solve. Carbon emission abatement is what economists would call a global public good: Ev- eryone benefits from its provision, whether they have contributed or not. If a coalition of countries bands together to achieve a carbon emission abatement goal, all countries (including nonmembers of the coalition) will benefit from their efforts. So how can countries be induced to pay for it if they will receive the benefit either way? This is a thorny problem to which we will return in later chapters. As a starting point, we must understand just what the benefits of car- bon emission abatement are. They may be obvious to you. Put simply, slowing climate change can help us avert damages. For example, rising seas may inundate many coastal areas. If it is possible to slow or reverse this process, we might avoid damages including the depletion of coastal wetlands, the destruction of cultural artifacts, and the displacement of hu- man populations. Warming in Arctic regions may lead to the extinction of the polar bear and other species; the benefits from slowing or reversing climate change would include the prevention of this loss. Climate change may exacerbate local pollution (such as ground-level ozone) and boost the spread of disease (such as malaria in the tropics and West Nile virus in North America); we would want to measure the benefits from avoid- ing those damages as well. Policies to mitigate climate change may also bring “co-benefits,” as when a shift away from burning fossil fuels results in lower levels of local and regional air pollution from sulfur dioxide or particulate matter. All these benefits (even the intangible ones such as species preserva- tion) have economic value. In economic terms, their value corresponds to what people would be willing to pay to secure them. Measuring this  introduction 5 value is easy when the losses are reflected in market prices, such as dam- ages to commercial property or changes in agricultural production. But economists also have developed ways to measure the benefits of natural resources and environmental amenities that are not traded in markets, such as the improvements in human health and quality of life from cleaner air, the ecosystem services provided by wetlands, or the existence value of wilderness. The economic cost of combating global climate change, meanwhile, is the sum of what must be sacrificed to achieve these benefits. Economic costs include not just out-of-pocket costs but also (and more importantly) the forgone benefits from using resources to slow or reverse climate change rather than for other objectives. Costs are incurred by burning cleaner but more expensive fuels or investing in pollution abatement equipment; by changing individual behavior, say by turning down the heat or air conditioning; by sequestering carbon in forests, oceans, depleted oil res- ervoirs, and other sinks; and by adapting to changing climatic conditions, for example by switching crops or constructing seawalls. Costs arise from directing government funds for research and development into climate- related projects rather than other pursuits. And of course the implemen- tation, administration, monitoring, and enforcement of climate policy incurs some costs, as with almost any public policy. Sound public policy decisions require an awareness of these costs and benefits and some ability to compare them in a coherent and consistent fashion. Economics provides a framework for doing so. In practice, as you will see through the theory and examples in this book, implementing the framework requires taking account of a number of other wrinkles. For example, we must worry about how to weigh near-term costs against benefits that accrue much later. Rigorous consideration of economic benefits and costs can help answer the questions, “How much should we reduce greenhouse gas emissions in order to limit future climate change? How stringent should policies to address climate change be?” Economics can also shed light on a distinct but equally important question: “How should those policies be designed?” For example, under the Copenhagen Accord, signed in 2009, the United States committed to reduce greenhouse gas emissions by 17 per- cent below 2005 levels. Although a large number of economic analyses informed the debate about this target, it was ultimately the result of politi- cal decisions rather than any explicit calculation of economic efficiency. Even so, economics can help inform the design of policies to meet the target. Emissions can be reduced in myriad ways: by requiring polluters 6 markets and the environment to install and operate specific abatement technologies or to meet specific standards of performance at their facilities, by mandating tough energy efficiency standards for consumer appliances and tightening fuel economy requirements for vehicles, by levying a tax on greenhouse gas emissions, or by capping emissions and allowing emitters to trade allowances under that cap. (And that is hardly an exhaustive list!) As we will discuss at length in this book, especially in Chapters 8 through 10, both economic theory and experience provide compelling arguments for market-based policies, such as emission taxes and cap-and-trade policies, that harness market forces to achieve regulatory goals at less overall cost than traditional approaches. In sum, economics offers quite a different approach than other disci- plines to the problem of global climate change—and to a range of other environmental issues we will explore in this book.You will find that the economic approach sometimes arrives at answers that are compatible with other approaches and sometimes at answers that conflict with those approaches. Regardless of such agreement or disagreement, economics provides a set of tools and a way of thinking that anyone with a serious interest in understanding and addressing environmental problems should be familiar with. Organization and Content of This Book This book provides an introduction to the application of economic rea- soning to environmental issues and policies. In each chapter, we draw heavily on a range of real-world examples to illustrate our points. Chapter 2 begins by asking, “Why compare benefits and costs?” Here we introduce the central concept of economic efficiency, meaning the maximization of the net benefits of a policy to society. We illustrate the key points by discussing the abatement of sulfur dioxide at U.S. power plants, and many other examples. We introduce the key concepts of mar- ginal costs and benefits, showing how they relate to total costs and ben- efits and how they inform the analysis of efficiency. We also extend the concept of efficiency to the dynamic context, in which policies are de- fined by streams of benefits and costs occurring over time. In doing so, we introduce the concept of discounting, the process by which economists convert values in the future to values today, and explain its usefulness in a dynamic setting. Chapter 3 follows up on the same themes. We discuss at length how economists define and measure the costs and benefits of environmental protection. We then consider how benefit–cost analysis has been used to evaluate policies in the real world. Finally, we explore the philosophical  introduction 7 justification for benefit–cost analysis and consider some of the most fre- quent criticisms lodged against its use. In particular, benefit–cost analysis focuses on the net benefits from a policy rather than its distributional consequences. Partly for this reason, economists do not advocate using a simple cost–benefit test as the sole criterion for policy decisions. Al- though it is a valuable source of information, benefit–cost analysis is just one of a number of tools to use in assessing policies or setting goals. We then turn our attention more explicitly to markets: how they func- tion, what they do well and what they do poorly, and how they can be designed to achieve desirable outcomes. We begin Chapter 4 with a key insight from economics: Under certain conditions, competitive markets achieve efficient outcomes. That is, they maximize the net benefits to society from the production and allocation of goods and services. This is a powerful result, and it helps explain the wide appeal of markets. It also aids understanding of the root causes of environmental problems: To an economist, they stem from well-defined failures in how unregulated mar- kets incorporate environmental amenities. Moreover, it lays the ground- work for designing policies that rely on market principles to promote environmental protection. The notion of “market failure” is the focus of Chapter 5. We discuss three ways of framing the types of market failure most common in the environmental realm: externalities, public goods, and the tragedy of the commons. In each case we offer a range of motivating examples. We then unify the discussion by showing how each of the three descriptions of market failure captures the same underlying divergence between indi- vidual self-interest and the common good. In Chapter 6, we apply the concept of dynamic efficiency to the prob- lem of the optimal rate of extraction of a nonrenewable natural resource, such as petroleum. We define scarcity in economic terms, which leads naturally to the concept of rent, the extra economic value imparted by scarcity. We illustrate the underlying similarities between nonrenewable resources and other capital assets and emphasize the powerful market in- centives that encourage private owners of nonrenewable resources to ac- count for scarcity in their extraction decisions. Chapter 7 applies the same reasoning to two renewable resources, for- ests and fish.We develop bioeconomic models to demonstrate the efficient level of fishing effort and the efficient rotation period for a forest stand, both graphically and conceptually. In both cases, we include noncom- mercial benefits in an economic approach to efficient use of the resource. Chapter 8 discusses the design of policies to overcome market failures 8 markets and the environment in the provision of environmental amenities and the management of nat- ural resources. We start by considering a central debate in economics: Should the government intervene to solve market failures? After satisfy- ing ourselves that the answer is yes, at least in many cases of real-world concern, we go on to review the various tools a government regulator has at her disposal, ranging from conventional command-and-control policies such as technology standards to market-based instruments such as taxes on pollution or resource use and tradable allowances.We discuss the intuition behind how these latter approaches can restore the efficient workings of the market. We close by contrasting the two market-based instruments, asking when prices or quantities are the preferable tool for governments to wield. Chapter 9 continues our discussion of policy design but focuses more broadly on cases where efficiency may not be the objective. Even so, market-based instruments have two strong advantages: They can (in the- ory) achieve a desired level of environmental protection at the lowest total cost while spurring the development and diffusion of new technologies over the long run. We briefly consider a range of other factors relevant to the design of policy. Market-based instruments are not the solution to every problem, and we show when conventional command-and-control approaches are preferable even on strictly economic grounds. But the main conclusion is that market-based instruments are a crucial compo- nent of the regulatory toolkit. Chapter 10 reviews the real-world performance of market-based in- struments in regulating pollution and managing natural resources. We consider three cases in careful detail: the market for sulfur dioxide (SO2) emissions from power plants in the United States, the tradable individual fishing quota (IFQ) system for New Zealand’s fisheries, and municipal drought pricing of water resources in the United States. In each of these cases, we discuss the performance of the market-based approach, consider the implications for distributional equity, and assess the ease of monitor- ing and enforcement. We go on to review a longer catalog of examples, each in less detail than the initial case studies. Our aim is to equip readers to think broadly and creatively about the ways in which prices and mar- kets can be injected into the regulatory process, aligning the incentives of firms and consumers with those of society in achieving environmental and resource management goals. Chapter 11 addresses the links between economic growth and the natural environment—topics grouped under the heading of macroeconom- ics, in contrast to the microeconomic reasoning (based on the behavior of  introduction 9 individuals and firms) that characterizes most of the book. We begin by reviewing the debate over the limits imposed on economic growth by natural resource scarcity, focusing on the critical importance of two often overlooked factors: substitutability and technological change. The same key issues arise in our discussion of sustainability in economic terms. We highlight the insights of economic definitions of sustainability for current natural resource management and environmental protection.We end with a discussion of green accounting, emphasizing the need to incorporate natural resource depletion and changes in environmental quality into tra- ditional measures of economic growth. In the concluding chapter, we reflect on the relative roles of firms, con- sumers, and governments in the creation and mitigation of environmental and resource management problems. We then offer some final thoughts about the role of economic analysis as one of many important tools at the disposal of decision makers in environmental policy. What We Hope Readers Will Take Away from This Book If this is your first and last exposure to economics, and your interests lie in other areas of environmental studies, we offer three good reasons to use this text. First, many of the causes and consequences of environmental degradation and poor natural resource management are economic.That is, they arise from the failure of an unregulated market to give firms and in- dividuals adequate incentives to promote environmental quality. Second, so-called market-based approaches to environmental regulation and natu- ral resource management are increasingly common at local, national, and global levels. Prominent examples include the cap-and-trade policies used to limit sulfur dioxide pollution from U.S. power plants between 1995 and 2010, and CO2 emissions in Europe, California, and elsewhere, and tradable fishing quotas to manage commercial fisheries. Third, economic arguments play an important role in some environmental policy debates, such as management of public lands and the structure of international ap- proaches to counter global climate change. Without an understanding of basic economic principles, it is difficult to formulate an economic argu- ment—or to refute one. Thinking systematically about benefits, costs, and tradeoffs can improve your ability to tackle real-world environmental problems, even when it is not possible to estimate benefits and costs explicitly. The theory we in- troduce and the applications we discuss are meant to demonstrate this. Of course, our treatment of individual topics in this text is necessarily brief; 10 markets and the environment our intention is to give you just a basic grounding in the field. But we hope the information we do present will pique your interest and prompt you to explore environmental and resource economics in greater depth. Reading this book will not make you an economist. Nonetheless, we hope to convince you that despite its reputation as a “dismal science,” economics can make vital contributions to the analysis of environmental problems and the design of possible solutions.  2 Economic Efficiency and Environmental Protection Imagine that you are planning a spring break trip to the Bahamas, and you are choosing from among four vacation packages you have found on the web. The “Bahamas on a budget” trip, a 3-day affair staying in tent cabins, costs $200. Suppose you would be willing to pay up to $550 for that trip but no more. In other words, you wouldn’t care if you paid $550 for the trip or spent the money on something else. The next step up is a trip that costs $500. This trip includes 4 days’ lodging in beachfront cabanas, and the setting is so beautiful that you would be willing to pay up to $900 for it. An even pricier 5-day trip, with a few extras thrown in, would cost $850 and be worth $1,100 to you. Finally, a deluxe week-long package is available for $1,250, which on your student’s budget is just about the maximum you would be willing to pay for any vacation, although this package is so breathtaking, you might just be willing to pay that much for it. Faced with these possibilities, which trip should you choose? At first glance, you might think that the deluxe trip is the best one to take; after all, you value it the most and are willing to pay the cost (even if only just barely). But in that scenario, you end up with zero net benefits. Indeed, be- cause we have defined your “willingness to pay” as the amount for which you would be indifferent between paying for the trip and staying home, going on (and paying for) the week-long trip would make you no better off than if you didn’t take a vacation at all. Choosing the deluxe trip on the grounds that you would be willing to pay the most for it amounts to ignoring the costs of the vacation completely. Instead of choosing the trip with the highest gross value to you, Nathaniel O. Keohane and Sheila M. Olmstead, Markets and the Environment, 11 DOI 10.5822/ 978-1-61091-608-0_2, © 2016 Nathaniel O. Keohane and Sheila M. Olmstead. 12 markets and the environment regardless of cost, you would be better off choosing the trip that gives you the greatest net benefit—that is, the difference between the benefit of taking the trip (measured by your willingness to pay) and the cost (mea- sured by its price). On these grounds, the best option turns out to be the 4-day $500 trip, which you value at $900, for a net benefit of $400. This is greater than the net benefit from the more expensive $850 trip: the added cost (+$350) outweighs the increase in value (+$200), so that net benefits decline to $250. The $500 trip is also better (from a net-benefit perspective) than the “budget” trip. Although that trip is cheaper, it is also worth less to you, and the drop in value is greater than the cost savings. So how does this resemble an environmental problem? Well, imagine that, instead of taking a trip to the Bahamas, you are evaluating the pos- sibilities for reducing pollution in your community, and there are a num- ber of different options and price tags. As in the case of the vacation, a reasonable criterion for making decisions is maximizing net benefits. The net benefits of controlling air pollution, for example, are the difference between the total benefits of cleaner air and the total costs of reducing emissions. Maximizing the net benefits of a policy corresponds to the notion of economic efficiency. And as we’ll see in Chapter 3, willingness to pay is indeed at the heart of how economists conceive of and measure the value of environmental protection and natural resources. You may be surprised to learn that if we accept economic efficiency as a reasonable goal for society, then the optimal level of pollution will in general be greater than zero. The reason for this will become clear as we proceed, but it can be summed up as follows: Although there would cer- tainly be benefits from eliminating pollution completely, the costs would (in most cases) be much higher. We could get nearly the same benefit, at much lower cost, by tolerating some pollution. Economic Efficiency To an economist, answering the question “How much environmental protection should society choose?” is much like answering the question “Which vacation package is best?” in the simple example above (albeit on a much larger scale): It depends on comparing benefits and costs and finding where their difference is greatest. This comparison between benefits and costs leads to a central con- cept in economics: that of economic efficiency. To an economist, an efficient policy or outcome is one that achieves the greatest possible net benefits. You should note that efficiency has a precise meaning here, which differs somewhat from common usage. In other contexts, efficiency connotes a  economic efficiency and environmental protection 13 minimum of wasted effort or energy. For example, the energy efficiency of a home appliance is the amount of electricity the appliance uses per unit of output—for example, the amount of electricity used by an air con- ditioner to cool a room of a certain size.The less energy an appliance uses to produce a given outcome, the more energy-efficient it is. Similarly, the efficiency of a generator in an electric power plant measures how much useful energy a turbine generates, relative to the energy content of the fuel burned to drive the turbine. In both of these examples, efficiency is a function only of inputs and processes.The goal (cooling a room of a given size or generating a certain amount of electricity) is taken as given, and efficiency measures how little energy is used to achieve it. In other words, energy efficiency does not relate benefits and costs—the comparison at the heart of the concept of economic efficiency. To illustrate this contrast, suppose you are choosing between a top- of-the-line air conditioner that costs $500 and a model that uses more electricity but costs only $150.The more expensive air conditioner is cer- tainly more energy efficient. However, whether it is more efficient from an economic point of view—that is, whether the net benefits are greater— depends on how often you will use the air conditioner, how much more electricity the lower-end model uses, and the price of electricity. To understand what economic efficiency means for environmental policy, let’s start by considering a real-world environmental issue: sulfur dioxide (SO2) emissions from fossil-fueled electric power plants. Burn- ing oil or coal to generate electricity creates SO2 as a byproduct, because those fuels contain sulfur. In downwind areas, SO2 emissions contribute to urban smog, particulate matter, and acid rain. For these reasons, the con- trol of SO2 emissions from power plants has been a focus of air pollution legislation in the United States and many other countries. From an economic perspective, we can frame this issue in terms of the efficient level of SO2 emissions abatement. (It is often easier to think in terms of abatement, or pollution control, which is a “good,” rather than pollution, which is a “bad.”) Suppose we observe the amount a firm or industry would pollute in the absence of any regulatory controls. Abate- ment is measured relative to that benchmark. If a firm would emit a thousand tons of pollution in the absence of regulation but cuts that to six hundred tons of pollution (for example, by installing pollution control equipment), it has achieved four hundred tons of abatement. What level of sulfur dioxide abatement will maximize net benefits to society? To answer this question, of course, requires thinking systemati- cally about the costs and benefits of pollution control. 14 markets and the environment The Costs of Sulfur Dioxide Abatement Typically, a minor amount of abatement can be achieved at very little cost simply by improving how well a power plant burns coal, because a cleaner-burning plant will emit less pollution for any given amount of electricity generated. (One reason the resulting abatement is cheap is that a cleaner-burning plant will also use less fuel to produce the same amount of electricity, saving money for its managers.) At a somewhat higher cost, power plants can increase their abatement by burning coal with slightly less sulfur than they would otherwise use. The abatement cost increases further as the power plant burns coal containing less and less sulfur that is more and more expensive. For example, a power plant in Illinois can burn cheap high-sulfur coal from mines in the southern part of the state. To reduce SO2 pollution, such a plant might switch to coal from eastern Kentucky with half the sulfur content but a slightly higher transporta- tion cost. Still greater reductions could be achieved, at still greater cost, by switching to very low-sulfur coal from Wyoming. Finally, achieving reductions of 90 percent or more from baseline levels typically requires investment in large end-of-pipe pollution control equipment, such as flue gas desulfurization devices (better known as scrubbers) that remove SO2 from the flue gases. Such equipment is often very expensive, making high levels of abatement much more costly than low levels. Moreover, the cost is typically driven by the percentage reduction achieved, so that removing the first 90 percent of pollution costs about the same as going from 90 to 99 percent removal. The costs we just described trace out a particular pattern. Costs rise slowly at first, as abatement increases from zero. As abatement contin- ues to increase, however, costs rise more and more rapidly. This pattern is reinforced when we consider the To an economist, being efficient costs of abatement at the level of the industry rather than the individual means maximizing net benefits. power plant. Some power plants (those located close to low-sulfur coal deposits, for example) can abate large amounts of pollution at low cost, whereas others may find even small reductions very expensive. As we increase pollution control at the industry level, we must call on plants where abatement is more and more expensive. Figure 2.1 depicts a stylized abatement cost function that corresponds to this pattern of rising cost. By abatement cost function we mean the total cost of pollution control as a function of the amount of control achieved. In The Energy Efficiency Gap The difference between what economists mean by efficiency and what engi- neers and others often mean is illuminated if we think about the concept of energy efficiency. Many studies have estimated significant private net benefits to technical energy efficiency investments by households and firms, including things such as switching from incandescent lightbulbs to compact fluorescent lamps (CFLs), installing more effective insulation, and buying more efficient appliances. Outside economics, analysts often wonder why these investments don’t happen on a larger scale, identifying an energy efficiency “gap” between what would appear to be cost-minimizing and actual energy efficiency invest- ments. The solution, according to these analyses, is a broad effort by the pub- lic sector to reduce barriers to the adoption of energy efficient technologies, through education or information provision, subsidies, and other polices. In response, economists point to several problems with this perspective. We’ll discuss a few here.1 First, analyses that identify this gap usually rely on engineering estimates of the potential energy cost savings associated with efficiency investments, and real-world savings often differ from potential savings. As we will explore in greater detail in Chapter 3, economic costs are opportunity costs, which would include perceived risks from new technologies (for example, if your usual plumber is not willing or able to install a tankless hot water heater), changes in the quality of the produced service (as with the change from incandescents to CFLs), and other costs—not simply the dollars spent on your energy bill. These costs, though hard to quantify, are real eco- nomic costs not accounted for in technical efficiency studies. Second, energy use behavior changes when households and firms purchase more efficient technologies; a rebound effect of increased usage due to lower operating cost has been observed for many energy technologies. Thus, both energy savings and cost savings in the real world will differ from engineering estimates of potential savings. Third, the rate at which energy consumers are willing and able to trade the future benefits of reduced energy costs for current invest- ment costs is poorly understood; in particular, low-income households may face significant credit constraints and steeper consequences for this tradeoff than others. In addition, to the extent that energy and cost savings from ef- ficient technologies have been estimated from households and firms that have adopted these technologies, the results of these studies may not be generalized to nonadopters. The inherent bias could go either way: Those who adopt en- ergy efficient technologies may be “conservation-oriented,” or they may be energy “hogs” who purchase efficient technologies to support increased use (at lower cost). 16 markets and the environment The Energy Efficiency Gap continued The point is not that households and firms in the real world always make economically efficient decisions about energy technology investments. Con- sumers may lack the information necessary to understand how energy effi- ciency varies between different appliances or how that translates into potential savings; other characteristics of those appliances may seem more salient at the time of purchase. Incentives may not be properly aligned: For example, renters will lack sufficient incentive to install energy-efficient technologies, knowing that some of the benefits will accrue to landlords and future occu- pants. But it is difficult to tell from data on the technical efficiency of these investments—both how much energy they would save if operating according to engineering specifications and how much these savings would reduce the total cost of energy consumption—how large the economic energy efficiency gap might be. the figure we have used X to represent the amount of pollution control and C(X ) to denote the total cost (in dollars) as a function of X. A func- tion with this bowed-in shape is called a convex function. The Benefits of Sulfur Dioxide Abatement Recall that in Chapter 1 we described the benefits from reducing green- house gas emissions as corresponding to the avoided damages from global climate change. In the same way, the benefits of SO2 abatement are simply the avoided damages from pollution. How do these damages vary with pollution? As the air gets dirtier, pol- lution damages tend to increase more and more rapidly. At low concen- trations, SO2 corrodes buildings and monuments. Higher concentrations lead to acid rain, with the attendant damages to forest ecosystems from the acidification of lakes and soils. In urban areas, the adverse effects of SO2 increase from eye and throat irritation, to difficulty breathing, and ulti- mately to heart and respiratory ailments. These effects are felt first by the most vulnerable members of society: infants, older adults, and asthmatics. But as concentrations rise, the affected population grows. This pattern of damages corresponds to total benefits from pollution control that increase rapidly when abatement is low (and pollution is high) and increase more slowly when abatement is high (and pollu- tion is low). This is illustrated by the curve in figure 2.2, where we have used B(X ) to represent the abatement benefit function. A function with the bowed-out shape of B(X ) is called a concave function. Figure 2.1  Total costs of pollution abatement, as a function of the level of abatement. Figure 2.2  Total benefits of pollution abatement, as a function of the level of abate- ment. 18 markets and the environment Putting Costs and Benefits Together: Economic Efficiency We are now ready to answer the question we posed earlier: What is the efficient level of sulfur dioxide abatement? To answer this question, we must compare benefits to costs and find where the difference between them—net benefits—is greatest. Figure 2.3 places the cost and benefit curves in figures 2.1 and 2.2 on a single pair of axes. As in the previous figures, abatement increases as we move along the horizontal axis from left to right; pollution increases as we move from right to left.We have denoted maximum abatement—equivalent to zero pollution—by X MAX. Recall that net benefits are simply benefits minus costs. Thus on the figure, the net benefit from a given level of pollution control is measured by the vertical distance from the benefit curve down to the cost curve. At low levels of pollution control, net benefits are small. As abatement increases from a low level, the benefits increase more rapidly at first than do the costs, so that net benefits increase. As more and more abatement is done, however, the benefits rise less rapidly, while the costs of abatement increase. Eventually, the benefits increase more slowly than costs, and net benefits fall as more and more abatement is done. In between those two extremes, of course, the difference between benefits and costs must reach a maximum. On our graph, this happens at level X*. By definition, this is the efficient level of pollution control. You can see from the figure that X* is greater than zero but less than the maximum possible abatement. Accordingly, the efficient level of pollution must also be less than its maximum (unregulated) level but greater than zero. We come right away to the point that we mentioned at the outset of the chapter: In general, the economically efficient level of pollution is not zero. Zero pollution is not efficient (in general), because the gains from achieving it are not worth the extra cost required. Consider increasing abatement from the level X* to the level X MAX. In our real-world ex- ample, this might correspond to installing expensive scrubbers on every power plant. This much abatement would certainly bring benefits, such as reductions in acid rain and improvements in urban air quality. On the graph, the increase in benefits is shown by the fact that curve B(X ) in- creases as we move to the right, so that B(X MAX) > B(X*).  economic efficiency and environmental protection 19 Figure 2.3  The efficient level of pollution abatement, denoted X*, achieves the greatest possible net benefit. However, those extra benefits from maximizing abatement are out- weighed by the extra costs of achieving them. While benefits increase, costs rise even faster. As a result, the gap between benefits and costs shrinks dramatically as we increase abatement from X* to X MAX. In the real world, requiring scrubbers on all power plants would raise costs by an order of magnitude, and the boost in benefits would be much smaller. Therefore, zero pollution is generally not desirable—at least not if we measure the success of our policy by the magnitude of its net benefits. Of course, it is equally true (although perhaps less surprising) that zero abatement is also not efficient. Abating less than X* would reduce costs, but the cost savings would be less than the forgone benefits. On balance, net benefits would fall. If you find these results surprising or counterintuitive, it may help to recall the distinction between economic and technical notions of ef- ficiency. Pollution is sometimes described as “inefficient” when the pol- lution represents a form of wasted inputs. For example, a key component of water pollution from paper mills or textile factories is excess chemicals used in the production process—bleach in the case of paper mills, dye in 20 markets and the environment the case of textile factories. Although such pollution may be “inefficient” in a technical sense, it is a mistake (albeit a common one) to conclude that it is also necessarily inefficient in an economic sense. Economic efficiency depends on the costs as well as the benefits of controlling pollution. If it is extremely costly to clean up pollution completely, zero pollution is unlikely to be a reasonable goal if we aim to maximize net benefits. Efficiency and Environmental Policy In our example of SO2 pollution from power plants, the benefits from abatement rise rapidly at first and then tail off, while costs rise much more slowly at first before becoming steep. Put them together, and we find that net benefits are greatest somewhere in the middle. Because the shapes of the cost and benefit curves are critical in driving the results, it is worth discussing them in a bit more detail. The pattern of “increasing costs at an increasing rate” is common. The costs of producing most goods—for example, steel or shoes—typically increases with production at an increasing rate (at least in the short run and over some range of quantities). In the case of pollution control, you can think of “clean air” as the good that is being produced: Clean air is costly, and the costs rise more and more steeply as the air gets cleaner and cleaner. Removing the last few ounces of pollution from a waste stream is likely to be prohibitively expensive. On the benefit side, meanwhile, assuming a concave benefit function corresponds to the simple idea that although we would usually like more of a good thing, the amount we are willing to pay for something is likely to decline as we get more of it.You would probably pay more for one pair of designer shoes or one pair of tickets to a rock concert than you would pay for the second, third, or tenth pair of the same item. These characteristics of costs and benefits apply in a wide range of cases in the environmental realm—not just other forms of air pollution but also water pollution, biodiversity preservation, endangered species protection, the management of natural resources such as fisheries, and so on. For ex- ample, consider the protection of habitat for an endangered species such as the red-cockaded woodpecker, which lives in old-growth stands of longleaf pine forest in the southeastern United States. Habitat protection requires managing forests to maintain suitable old-growth conditions.The cost of such management varies widely between different parcels of land, depending on ownership, suitability for intensive timber production, soil conditions, and so on. If we arrange lands from least to greatest expense, we can construct an increasing cost-of-protection function similar to the  economic efficiency and environmental protection 21 one in figure 2.1. Similarly, on the benefits side, an increase in the wood- pecker population from one hundred birds to two hundred birds is likely to yield much greater benefits than from one thousand birds to eleven hundred birds, leading to a benefit-of-protection function much like the curve in figure 2.2. Accordingly, although we will continue to discuss our model in terms of pollution control or abatement, you should keep in mind that it is much more general than that. For convenience, we will continue to refer to X as pollution control or abatement, but you could substitute any other dimension of environmental quality, such as habitat protection, and the arguments that follow would still apply.The crucial assumptions underly- ing our model are that costs increase at an increasing rate and that benefits increase at a decreasing rate—in other words, that the total cost function C(X ) is convex and the total benefit function B(X ) is concave, like those drawn in figures 2.1 through 2.3. In some cases, these assumptions do not hold. For example, think of litter along a hiking path in a wilderness area. One piece of trash may ruin an otherwise pristine area nearly as much as ten or twenty pieces would. In this case, the marginal benefit of environmental quality does not fall as the amount of trash gets smaller (until the trash goes away completely). Hence the efficient level of litter might well be zero. A particularly important exception to the conventional rule “equate marginal benefit and cost” arises when the marginal cost of cleanup falls (instead of rising) as more cleanup is done. Cost functions with this char- acteristic are said to exhibit economies of scale. For example, cleaning up hazardous waste sites typically requires digging up the soil and incin- erating it to remove the pollution. The cost of such a cleanup depends mostly on the area of the site rather than how contaminated it is or how much pollution is removed. In such a case, pollution control may be an all-or-nothing exercise: If it makes sense to clean up a site at all, then it makes sense to clean it up completely. Over time, this policy would look very different from that of the standard case of increasing marginal cost. Rather than seeking to maintain environmental quality at the level where marginal cost and benefit are equal, the optimal policy would let quality decline over time and then periodically clean things up to a very high level of quality.2 Even if the cost and benefit functions have their typical shapes, of course, one can draw particular examples in which the maximum level of abatement is reached before net benefits start declining—or, conversely, in which net benefits are highest when abatement is zero. (Imagine taking 22 markets and the environment the curves drawn in figure 2.3 and A very useful way to describe the shifting them rightward or leftward costs and benefits of pollution while holding the axes and the loca- tion of maximum abatement fixed.) control is in terms of marginal—that However, there are good reasons to is, incremental—costs and benefits. view these instances as special cases, as we have already seen. The model of convex costs and concave benefits presented here is widely accepted as the conventional general model of the costs and benefits of pollution control (and of environmental protection more generally). Equating Benefits and Costs on the Margin So far, we have discussed the total costs and benefits of pollution control. An alternative and very useful way to describe the costs and benefits of pollution control is in terms of marginal costs and benefits. By marginal cost we simply mean the cost of an incremental unit of abatement. If we have abated one hundred tons, the marginal cost is the cost of the one- hundredth ton. (Note the contrast with average cost, which takes into account all of the abatement done rather than only the last unit.) Like- wise, marginal benefit refers to the benefit from the last unit of abatement. Recall that efficiency corresponds to maximizing the difference between total benefits and costs. It turns out that this difference is greatest when marginal benefit and marginal cost are equal. Marginal Costs and Marginal Benefits Let’s start by considering the relationship between total cost and marginal cost. Because marginal cost measures the cost of one more unit of abate- ment, it corresponds to the slope of the total cost function. To see why this makes sense, consider the cost function depicted in figure 2.1. At low levels of abatement, where the total cost function is nearly flat, the height of the curve changes little as pollution control increases. Therefore, each additional unit of pollution control adds a small amount to the total cost. In other words, the marginal cost of pollution control is small. At higher levels of abatement, the total cost function is steep, so that the cost rises rapidly as abatement increases. This means that the incremental cost of pollution control—the marginal cost—is high.3 Figure 2.4 plots the marginal cost function corresponding to a total cost function like that in figure 2.1. As before, abatement is on the horizontal axis, but now the vertical axis measures marginal rather than total cost. Thus the height of the curve MC(X ) at any given point represents the Thinking on the Margin: Pollution Abatement at Aracruz Celulose, S.A.4 One of the mainstays of economic reasoning is learning to think in terms of marginal changes when making decisions. To find the level of production that maximizes its profits, for example, a firm needs to compare the revenue from selling one more unit of the good with the cost of making it. Similarly, to find the amount of abatement that maximizes net social benefits, we must compare the marginal benefit from controlling another ton of pollution with the marginal cost. To make the concept of marginal cost (in particular) more concrete, con- sider the case of pollution abatement at pulp mills owned by Aracruz Celulose, S.A., a leading Brazilian pulp producer and exporter. Among the major pol- lutants in effluent from pulp mills are chlorinated organic compounds, known as adsorbable organic halides (AOX). These compounds—dioxin is among the most infamous—are produced when chlorine-containing chemicals used in bleaching react with wood fiber. In the early 1990s, Aracruz was considering whether to upgrade its envi- ronmental controls in order to market its pulp to environmentally conscious customers in Europe. The company had three primary options: continuing to produce standard pulp using chlorine, switching to “elemental chlorine free” (ECF) methods using chlorine dioxide, and eliminating chlorine entirely (“to- tally chlorine free” [TCF] ) by using peroxide as a bleaching agent. These were cumulative efforts: The investments needed to produce ECF pulp were a nec- essary prerequisite to TCF bleaching. The following table shows the pollution level associated with each option, the corresponding abatement, the total cost, and the marginal cost—that is, the cost per additional unit of abatement. As the table shows, switching to ECF pulp cuts pollution by 80 percent at a fairly low cost. Converting to TCF could cut pollution by an additional 95 percent, but the cost per ton increases significantly. Increase Marginal Pollution Incremental Total in total cost (per kg (AOX, in abatement annual annual additional Alternative kg/year) (kg/year) cost cost abatement) 1. Standard pulp No (baseline) 2,000,000 reduction $0 $0 $0 2. ECF pulp 400,000 1,600,000 $575,000 $575,000 $0.36 $5.325 $4.75 3. TCF pulp 20,000 380,000 million million $12.50 24 markets and the environment Figure 2.4  Representative marginal abatement cost function. cost of each additional unit of abatement. Saying that abatement cost increases at an increasing rate is the same thing as saying that abatement has increasing marginal costs: Each ton of pollution abatement costs slightly more than the one that preceded it. As a result, the marginal cost function in figure 2.4 slopes upward. In a similar fashion, we can derive a marginal benefit function that cor- responds to the incremental benefits of additional abatement. Marginal benefit corresponds to the slope of the total benefit function. If the ben- efit function is concave, as in figure 2.2, then the marginal benefit func- tion will be downward sloping: Each additional ton of abatement brings smaller additional benefits. We have drawn a representative function, la- beled MB(X ), in figure 2.6. Efficiency and the Equimarginal Rule Let’s take another look at figure 2.3, where we plotted the benefit and cost functions and found the efficient level of abatement X*. Notice that as abatement increases up to X*, the benefits of pollution control rise faster than the costs. That is, the B(X ) curve is steeper than the C(X ) curve. As a result, net benefits increase with each additional ton of pollution control over this range. On the other hand, beyond the efficient point, the costs rise faster than the benefits, so that net benefits diminish. Putting these The Costs of Protecting the California Condor With a wingspan of nine-and-a-half feet, the California condor (Gymnogyps californianus) is the largest bird in North America.5 Until the mid-nineteenth century the condor’s range extended as far north as the Columbia River Gorge and south into Baja California. Indeed, the diaries of Meriwether Lewis and William Clark report several sightings of the “Buzzard of the Columbia” in 1805 and 1806. Throughout the twentieth century the wild population declined pre- cipitously, falling from approximately one hundred birds in the 1940s to only nine by 1985. The decline appears to have been caused by reduced reproduc- tion (perhaps a result of DDT) and human-created mortality, including lead poi- soning from bullets in game carcasses, shooting of the condors themselves, and hazards from human-made structures such as power lines. In the late 1980s, the U.S. Fish and Wildlife Service captured the remain- ing wild birds and embarked on a captive breeding program, with the hopes of eventually reintroducing the species into the wild. In 1992, the first two captive-bred juveniles were released into the Sespe Condor Sanctuary in Los Padres National Forest. By October 2003, the wild population had climbed to eighty-three birds, including one chick hatched in the wild. With the condors back in the wild, measures must be taken to protect the condor populations from threats. From an economic point of view, we can think of these protective measures as “abatement”—in this case, abatement of the causes of condor mortality. Abatement measures include the protection of suit- able habitat, provision of food carcasses such as stillborn calves (to prevent lead exposure), promotion of alternatives to lead ammunition, prohibitions on shooting the condors, and modification of power lines and other human struc- tures to reduce injuries to condors. One study has estimated the costs of abatement using information con- tained in the Recovery Plan written by the U.S. Fish and Wildlife Service. For each abatement action, the number of condors saved per year was estimated taking into account historical rates of decline in the condor population and the priority accorded that action by the U.S. Fish and Wildlife Service. Unit cost (per condor per year) was then calculated by dividing the cost by number of condors saved. Arranging the unit costs in increasing order produces a marginal cost function, as illustrated by figure 2.5. The figure illustrates two key points. First, note the wide range in the mar- ginal costs of various techniques: from as little as $7 per condor saved per year to protect habitat in low-lying areas to more than $200 per condor per year to modify power lines and step up law enforcement. Second, note that it is the marginal cost, rather than the total cost, that determines which measures should be pursued first. Thus, although the annual cost of heightened law enforcement is only a quarter of the cost of removing contaminants ($5,000 versus $20,000), contaminant removal would save more than thirty times as many condors and hence is a much more cost-effective means of protecting the species. 26 markets and the environment Figure 2.5   Marginal cost graph for condor example. Each “step” on the dashed line corresponds to a specific protection measure, arranged from lowest to highest unit cost. The boxes highlight four specific actions among over two dozen considered. The solid line represents a smooth approximation to the “staircase” function. observations together, we conclude that at the efficient level of abatement, the benefit and cost curves must have the same slope. This suggests a way to find the efficient level of pollution control by looking at the marginal benefits and costs. In particular, we can state the equimarginal rule: The efficient level of abatement X* occurs where marginal benefit equals marginal cost, that is, MB(X*) = MC(X*). In plain English, this says that the efficient level of pollution control is where the extra benefit of the last unit of abatement done equals its extra cost. Beyond that point, the incremental costs of any further abatement will outweigh the incremental benefits. This result is illustrated by figure 2.7. The top panel is the same as figure 2.3. The bottom panel draws the corresponding marginal benefit and cost curves. The efficient point X* is easily identified: It is where the MB and MC curves cross.  economic efficiency and environmental protection 27 Figure 2.6  Representative marginal abatement benefit function. This equimarginal condition will show up again and again in our anal- yses of markets and policy design, so it is worth going over the intuition behind the result. Suppose we pick a low level of abatement, where MB is greater than MC—say the point XL on figure 2.7. Now let’s imagine increasing abatement by 1 ton. What happens to net benefits? Because the resulting increase in benefits (equal to the marginal benefit) is greater than the increase in cost (= marginal cost), net benefits would increase. Thus at XL efficiency increases with more abatement, as indicated by the arrow on the figure. Now suppose that we increase abatement all the way to some high level, such as XH on the figure, where MB lies below MC. Here, one more ton of abatement increases costs by more than it increases benefits; there- fore, the incremental net benefit is negative. Indeed, at such a point we could increase net benefits by reducing abatement by one unit, because costs would fall by MC, but benefits would decline by only MB. Thus, at XH we have overshot the efficient level of abatement. Of course, we could repeat these arguments for any values of abate- ment above or below the point where the marginal curves cross. Only The Benefits of Mitigating Stratospheric Ozone Depletion Whereas tropospheric or ground-level ozone is a local air pollutant that causes human health damages including respiratory and cardiovascular ailments, stratospheric ozone (the “ozone layer” in the atmosphere, from 6 to 30 miles above the earth’s surface) protects the earth from some of the sun’s harm- ful ultraviolet radiation. In 1974, two chemists published research suggesting that the ozone layer could be destroyed by the release of chlorofluorocarbons (CFCs), ubiquitous chemicals used (at the time) in applications as diverse as air conditioning, asthma inhalers, hairspray, and styrofoam coffee cups. Dam- aging effects of this phenomenon included increased incidence of skin cancer and cataracts and reductions in the productivity of farms and fisheries. Some countries restricted consumption and production of CFCs in the late 1970s and early 1980s, but a 1985 report by the British Antarctic Survey that observed 40 percent thinning of the ozone layer over Antarctica between 1977 and 1985 stunned the world and led to the 1987 Montreal Protocol on Substances That Deplete the Ozone Layer.6 Countries including the United States and Canada performed their own analyses of the domestic benefits and costs of compliance with the Montreal Protocol, as well as other CFC abatement choices. Independent U.S. analyses were performed by the Environmental Protection Agency (EPA) and the Council of Economic Advisors under President Ronald Reagan, with similar results. The EPA study considered the benefits and costs to the United States of a global freeze on CFC production and consumption, as well as global reductions of 20 percent, 50 percent, and 80 percent.7 The EPA study monetized the value of avoided cases of cataracts and fatal and nonfatal skin cancers, avoided crop damage, avoided reductions in commercial fish harvests, and other anticipated impacts, although about 98 percent of the monetized benefits were associated with avoided skin cancer mortality. In Chapter 3, we’ll describe the methods used for monetizing these types of benefits in detail. But an examination of the benefits EPA estimated at varying levels of CFC reduction, described in the following table, provides a helpful illustration of the relationship between total and marginal benefits. Total U.S. Incremental Marginal benefit benefits (billions abatement (billions of Policy Alternative of $1985) (percentage change) $1985) 1. Global CFC freeze 5,995 — — 2. Global CFC 20% reduction 6,132 20 6.85 3. Global CFC 50% reduction 6,299 30 5.57 4. Global CFC 80% reduction 6,400 30 3.37  The Benefits of Mitigating Stratospheric Ozone Depletion continued Notice that the total benefits of CFC abatement increase monotonically as we move from zero to 80 percent. It is also clear that these benefits increase at a decreasing rate; as we reduce emissions more and more, the incremental benefit of further reductions shrinks. This is seen more clearly in the marginal benefit column, which simply divides the change in total benefit by the percent change in abatement for each alternative. Like the representative function in figure 2.6, the marginal benefit of CFC reductions decreases with abatement. Figure 2.7 The efficient level of abatement, represented in terms of total costs and benefits (top panel) and marginal costs and benefits (bottom panel). 30 markets and the environment at the efficient point X*, where MB = MC, is the difference between benefits and costs at its maximum. Relating Marginal Benefits and Costs to Total Benefits and Costs We have just seen how marginal benefits and costs correspond to the slopes of the total benefit and cost functions. Conversely, total benefits and costs can be represented as the areas under the marginal benefit and cost curves. Recall that the height of the marginal benefit curve (for example) at a given level of abatement represents the additional benefit derived from that unit of abatement. Imagine drawing a rectangle with a width equal to one unit of abatement and height equal to the height of the MB curve. The area of that rectangle would be equal to the marginal benefit of the corresponding unit of abatement. Now imagine drawing a series of such rectangles, one for each unit of abatement, starting from zero and going up to XL. Because the area of each rectangle represents the additional benefit from a certain unit of abatement, their areas must sum to the total benefit from XL units of abatement. But the sum of the areas of the rectangles is also equal to the area under the curve.8 Thus the area under the marginal benefit curve from zero to any point equals the total benefit from that amount of abate- ment. Similarly, the area under the marginal cost curve from zero to any point is the corresponding total abatement cost. This relationship between marginals and totals can give us another perspective on the equimarginal condition for efficiency. Let’s return to the bottom panel of figure 2.7. At the efficient level of abatement (the point X*), total benefits equal the area under the MB curve, and total costs are the area under the MC curve. Subtracting costs from benefits leaves total net benefits (the shaded triangle to the left of the intersection of the two curves).You can see right away that no other level of abatement pro- vides as much net benefit as X*. Less abatement leaves some net benefits unrealized. At XL, for example, net benefits are smaller than at X* by the area of the triangle labeled abc on the figure. Beyond X*, the extra costs outweigh the extra benefits. At XH, net benefits are smaller than they are at X* by the triangle cde. Dynamic Efficiency and Environmental Policy So far, we have discussed the efficiency rule—set marginal costs equal to marginal benefits—in terms of maximizing the net benefits of a resource  economic efficiency and environmental protection 31 (such as clean air or water) at a particular point in time. But projects and policies often have streams of benefits and costs occurring at many dif- ferent points in time. For example, if we choose to set aside a large tract of land, such as the Arctic National Wildlife Refuge in Alaska, disallowing commercial uses in favor of wilderness and recreation, society will receive benefits and incur costs from this designation over many years, or even in perpetuity. When benefits and costs vary over time, economic analysis must apply the rules of dynamic efficiency.9 For example, so-called stock pollutants that accumulate in the environment—such as carbon dioxide in the earth’s atmosphere or polychlorinated biphenyls (PCBs) in a riverbed—involve streams of benefits and costs over a very long period of time. Dynamic efficiency plays a particularly important role in the management of natu- ral resources. Some resources, such as petroleum, do not regenerate at all (at least over time scales relevant to human activity); for others (such as fisheries), natural regeneration must be balanced against extraction and consumption. In both cases, the limited availability of the resources means that the amount available tomorrow depends on what we consume today. In order to apply the concept of efficiency in a dynamic setting, we must introduce the concept of discounting. Discounting and Present Value The introduction of a time dimension requires an additional step in thinking about efficiency. In the static analysis earlier in this chapter, we maximized net benefits. In a dynamic setting, an efficient policy maxi- mizes the present value of net benefits to society. That is, we must convert all the benefits and costs of a potential environmental policy, no matter when they occur, into their dollar value today before summing them up. In this way, we use a common yardstick to measure benefits and costs oc- curring at different points in time. To see why the value of a dollar today is not the same as the value of a dollar received next year, consider the following thought experiment. Suppose we offered you the choice of being paid $100 today or the same amount a year from now. Which option would you choose? What if the choice were between $100 today and $105 a year from now? $110? If When benefits and costs vary over you are like most of our students, you time, economic analysis must would take $100 today over the same apply the rules of dynamic efficiency. amount a year from now.You would 32 markets and the environment probably also prefer $100 today to $105 in a year, although as the future amount increased, you would find it more attractive to wait. Now ask yourself: Why do you prefer money today to the same or even a slightly larger amount in the future? You can probably come up with several reasons. First, you might prefer money today because you can get the immediate benefit of spending it on something you value (a ticket to a concert or the theater, a piece of clothing, a meal at a good restaurant). Second, you might prefer money today because you anticipate having more money in the future, making an extra dollar today worth more. (Although that might not be a factor in our simple thought experiment of getting paid now or in a year, it probably is relevant to how much you would value money now rather than in 10 or 20 years.) Third, you might prefer money today because you could invest it today and earn a rate of return, whether from a savings account or by investing in the stock market. Each of these reasons illustrates a different facet of the time value of money.10 The time value of money is the reason that we discount costs and benefits expected to occur in the future. You are probably familiar with the power of compound interest. Discounting entails thinking in reverse. To see how this works, consider a simple example. Suppose you invested $100 at an annual interest rate of 5 percent; how much would that invest- ment be worth in 50 years? We can calculate the future value (FV ) as fol- lows, where PV is the present value, r is the interest rate, and t is the year. FV = PV(1+r)t = 100(1+.05)50 = $1,146.74. This equation simply says that $100, growing at an annual rate of 5 percent, will yield $1,146.74 in 50 years. Applying that logic in reverse, if we asked how much we needed to invest today at a 5 percent interest rate to have $1,146.74 in 50 years, the answer would be $100. That sug- gests that $1,146.74 in 50 years, given a discount rate of 5 percent, has a present value of $100. You have probably already realized that the choice of discount rate is crucial. The discount rate reflects how much weight we put on future costs and benefits relative to those that occur today: The higher the dis- count rate, the less weight is put on the future. There is a rich literature in economics, with a wide range of views, on the correct discount rate to use in assessing public policies, especially those with long time horizons (such as policies to reduce greenhouse gas emissions to mitigate future climate change).11  economic efficiency and environmental protection 33 The Incredible Shrinking PV: The Influence of the Discount Rate The choice of discount rate can have a surprisingly large effect on the present value (PV) of future costs or benefits, especially when those costs or benefits come many years in the future. The following table illustrates this point. For example, the PV of $1,000 received 100 years from now is $138 using a dis- count rate of 2 percent but barely more than a dollar using a discount rate of 7 percent. Present value of $1,000 T years from now Discount rate T = 10 T = 50 T = 100 T = 200 1% $905 $608 $370 $137 2% $820 $372 $138 $19 3% $744 $228 $52 $2.7 5% $614 $87 $7.6 $0.06 7% $508 $34 $1.2 $0.001 10% $386 $8.5 $0.07 $0.00001 Broadly speaking, one school of thought holds that in evaluating pub- lic policies, analysts should use discount rates based on the returns to alternative investments that could, in principle, be made instead. In this view, discounting effectively asks whether the returns to a project, policy, or other investment, such as a greenhouse gas emission regulation, the establishment of a new national park, or the decision to pump ground- water from a nonrenewable aquifer, are greater or less than the returns to investing in education, building a new hospital, or simply placing an equivalent amount of funds in an interest-bearing asset such as Treasury bills. If the answer to this question is “no,” we can do better by choosing that alternative investment today and letting future generations decide how to invest the returns. Another school of thought views the discount rate as a normative de- cision that should take into account deliberative judgments about ap- propriate rates of time preference, equity between present and future generations, and so on. We do not take a position here, except to note that good practice in policy analysis is to apply a range of discount rates rather than to choose a single one. 34 markets and the environment The Equimarginal Rule in a Dynamic Setting The equimarginal rule we discussed previously still applies in the dynamic setting, although we must convert marginal benefits and marginal costs into present value terms in order to compare the magnitude of streams of benefits and costs over time. In a dynamic context, efficient environmen- tal policy equates the present value of marginal benefits with the present value of marginal costs. We will explore real-world applications of the dynamic equimarginal rule in Chapter 6, when we approach the problem of non- renewable resource extraction, and in Chapter 7, when we discuss the economics of forests and fisheries. Conclusion This chapter has laid the groundwork for everything that follows. When economists talk of efficiency, they have something very specific in mind: maximizing net benefits. As we have seen, in a static setting net benefits are largest (in general) when the benefits and costs of environmental pro- tection are equal on the margin. In a dynamic setting, net benefits are largest when we equate marginal benefits and marginal costs in present value. This equimarginal condition is a powerful tool for making decisions. In many instances, the benefits of taking some action (controlling pollution, say, or providing habitat for endangered species) are increasing at a de- creasing rate, while the costs rise more and more rapidly. If so, the proper response—at least if we want to maximize net benefits—is to act until the benefit of one more unit of environmental quality just equals the incre- mental cost. In many cases, moreover, the benefits from pursuing “perfect” policies—such as zero pollution—often do not outweigh the costs. As a result, zero pollution is typically not an efficient outcome (although the same can also be said for zero pollution control). The discussion in this chapter has abstracted from many of the chal- lenges in using efficiency as a guide to policy. In particular, we have as- sumed that the costs and benefits of environmental protection are known, and we have taken for granted that maximizing net benefits is a reasonable goal to pursue. The next chapter tackles these challenges head-on.  3 The Benefits and Costs of Environmental Protection The previous chapter proposed a destination—economic efficiency—for our journey, but it didn’t give us a road map or even a compass. Imagine you are a policymaker deciding whether to approve construction of a hy- droelectric dam on a wild river. Even if you embrace the idea of maximiz- ing net benefits to society, how can you measure the costs and benefits of the project? How can you weigh a cheap, clean source of electricity against the damage to fish populations and the loss of rapids for rafting? How should you decide whether to build the dam or let the river run wild? A first step is to define the costs and benefits of each option. To com- pare these costs and benefits, you need to measure them on a common yardstick. Then you can decide which option offers the greatest net ben- efit, although you may still want to ask why maximizing net benefits is what you should care about in the first place. This chapter tackles these issues. We start by considering how econo- mists think about the costs and benefits of environmental protection and how those might be measured. Although determining costs is relatively straightforward, measuring benefits takes extra effort, as we shall see. We then consider how efficiency is implemented in practice, through benefit– cost analysis. That discussion culminates in an investigation into why ef- ficiency might (or might not) be a desirable goal for policy. Measuring Costs How are costs defined and measured? In economic terms, the true costs of any activity are the opportunity costs—what you give up by doing one thing instead of another. For example, the true cost of going to graduate school Nathaniel O. Keohane and Sheila M. Olmstead, Markets and the Environment, 35 DOI 10.5822/ 978-1-61091-608-0_3, © 2016 Nathaniel O. Keohane and Sheila M. Olmstead. 36 markets and the environment is not simply the tuition plus the cost of room and board but also (and crucially) the forgone income from 2 or more years out of work. More broadly, the prices of inputs such as capital, labor, and materials reflect their values in alternative uses.To produce electricity requires capital to pay for the construction of the generating unit (money that could have gone into alternative investments), labor to operate the plant (workers who could earn wages in other jobs), and fuel to produce steam (fuel that could have been used by other companies and that required expending other resources in extraction and transportation). The same principle applies to reducing pollution: Scrubbing sulfur dioxide out of flue gases requires capital to build the scrubber and labor and materials to operate it. Devot- ing these resources to pollution control leaves less to spend on other op- portunities, such as improving the plant’s operation or increasing output. Economics offers another valuable insight into the costs of environ- mental protection: They are ultimately borne by individuals, whether taxpayers, shareholders, or consumers. It is tempting to think that the benefits of clean air are enjoyed by society as a whole, whereas the costs of pollution control are paid out of corporate profits. In reality, of course, the costs of pollution control—even when they are “paid for” by corpo- rations or electric utilities—end up being borne largely by consumers of the goods and services that cause the pollution. For example, electric utili- ties typically recover much of the cost of pollution control by charging higher rates for electricity. Even if abatement costs also reduce the utili- ties’ profits, much of that loss is felt by shareholders, who include retired pensioners as well as wealthy investors. Several categories of costs are important in assessing environmental regulations: private compliance costs, government sector costs, social wel- fare costs, and transitional effects. What do these terms mean? Private compliance costs include most of the costs we have mentioned thus far in the book: capital costs for pollution control equipment and other in- frastructure required to comply with a new regulation, changes in inputs (such as a power plant’s increased costs of switching from high-sulfur to low-sulfur coal to reduce sulfur dioxide emissions or from coal to natural gas to reduce carbon dioxide emissions), and the costs of capturing In economic terms, the true costs of regulated waste products for treat- any activity are the opportunity ment and disposal.1 Estimating com- costs—what you give up by doing pliance costs can be a challenge in one thing instead of another. a market economy, because most of this information is private, and firms  the benefits and costs of environmental protection 37 are reluctant to share it because it directly affects competitiveness. In a pinch, analysts can use published estimates of costs for standard technolo- gies and processes—the “engineering cost” approach.2 Outside of pollution control, the “compliance costs” analogous to abatement costs are often less obvious but no less important to consider. For example, let’s think about endangered species protection.The costs of protecting an endangered species might include money spent on preserv- ing habitat, enforcing prohibitions on hunting or poaching, and educating landowners and the public at large. As we saw in the example of the Cali- fornia condor in Chapter 2, some of these costs involve public expendi- tures—such as increased law enforcement—not just private expenditures, as for the pollution abatement compliance costs described earlier. These kinds of government expenditures make up the second category of regu- latory costs that must be included in weighing the costs of a regulation against its benefits. Relevant government costs include those for training, monitoring and reporting, permitting, and litigation. The third category—social welfare costs—is more complicated. These costs are incurred when regulations increase the prices of goods and ser- vices in the regulated sector and beyond. If you have taken an introduc- tory microeconomics course, you will be used to thinking about these costs as changes in consumer and producer surplus. If not, just think about the ways in which regulating emissions from power plants might affect prices. When firms face higher production costs from switching fuels or removing constituents from their waste stream, they may raise electricity prices in response.3 This price increase hurts consumers; they must now pay more for each kilowatt of electricity they purchase than they paid be- fore the regulation, and this negative effect can be an important regulatory cost. In reaction to an electricity price increase, some consumers will pur- chase less electricity: they may change their behavior (turning down their thermostat in the winter, for example, and wearing a sweater indoors) or invest in energy efficiency measures that cut their electricity use. This substitution effect—spending less on electricity and more on sweaters or insulation—cushions consumers from the impact of the price change and thus dampens the social welfare costs of the regulation. That is, if we cal- culated the reduction in consumer surplus from the new power plant pol- lution regulation but failed to take into account how consumers would react to the increased price of electricity, we would overestimate the costs of the regulation.4 Thus, the first step in estimating a regulation’s social welfare costs is to consider the impacts of any expected price increase for the regulated good or service on consumers, accounting for consumers’ Estimating the Costs of Mitigating Greenhouse Gas Emissions In the mid-2000s, as global interest in climate change was increasing, the prominent consulting firm McKinsey & Company carried out analyses of the costs of reducing greenhouse gas emissions, both at a global level and in specific countries. In p