2002-2003 Essay Contest Topic

Primer: Economics and the Environment

Essay Contest Topic:

Select a major problem concerning the ecological environment. Using economic analysis, show how this problem could be addressed.

Throughout history, people have improved their standard of living by consuming natural resources. Producers transform materials like timber, minerals and oil into products that increase human efficiency and comfort. However, the benefits of production are not without a price, for the consumption of natural resources also imposes costs on the ecological environment. These costs—whether they be the loss of animal habitat, the erosion of hillsides or the pollution of our land, air and water—create a trade-off with the benefits of production. For example:

  • The factories of the Industrial Revolution made consumer goods available to millions but also blanketed cities with soot.
  • Modern farming methods have greatly increased crop production in developed countries, yet they have also caused the release of harmful chemicals into water supplies.

There are many ways to analyze problems facing the environment. In this year's contest students are asked to use the tools of an economist to evaluate an issue facing the environment. Economics can help reveal the role of markets in environmental issues and the costs and benefits of choices policymakers face in finding solutions. The following primer will provide students with the tools to evaluate these important issues as they prepare to write their essays.

Role of markets

In general, markets efficiently allocate resources. Markets provide the opportunity for producers and consumers to meet to sell and purchase goods and services. When Adam Smith wrote The Wealth of Nations in 1776, he described an "invisible hand" that guides the movement of goods and services from those who produce them to those who want or need them. Markets make it possible for producers to transform natural resources into goods and services consumers want or need. For example, a loaf of bread can be sold to a buyer after a farmer grows the grain, a miller produces the flour, and the baker bakes the bread.

However, there are times when markets don't efficiently allocate resources; these are called market failures. The concept of market failure, explained below, is helpful in analyzing problems facing the environment.

Sometimes costs and benefits "spill over"

Profit is the incentive for individual producers to make a product; they will make a product only if the revenue to be gained by selling the product is greater than the private cost to make it. Private costs are those that are actually paid for by the producer. Potential product revenue is determined by the market's price.

Consumers only demand products that give them benefit. In economics, benefit is a term that signifies all of the good things that a product bestows. A product might give one the benefit of happiness, or comfort, knowledge, entertainment, efficiency, etc. Private benefits are those benefits from a product that confer directly to the consumer who pays for them.

However, not all costs and benefits are private. Sometimes costs or benefits spill over onto someone other than the immediate buyer or seller. These spillover costs and benefits are called externalities.

Here is an example of private and spillover costs that relates to the environment:

A factory pays private costs for the materials it uses. However, perhaps it also dumps its waste into the local river. This action has no cost to the factory, but other citizens, who drink, fish and swim in the river, suffer spillover costs. Therefore, the factory is not paying all the costs of its production. Instead, some of these costs—the pollution of its waste—are being passed on to others.

Since the factory pays only its private costs of production, it gains more profits than it would if it realized its true total costs. The result is an over-allocation of resources to making this product.

Education is a good example of spillover benefits. Education provides private benefits to the individual: a generally higher future wage, among other things. However, it also provides benefits to others—to society in general. Education provides a better working democracy with more involved citizens and results in less crime. However, the market demand reflects only private benefits, so there will be a smaller demand, and ultimately an under allocation of resources to providing education.

Thus when externalities exist, there is a market failure, in the form of an over- or under-allocation of resources to a product. Producers and consumers generally don't base their decisions on what the true costs and benefits of a product are; they base their actions only on the private costs and benefits that they individually realize. If there are spillover costs in a market, there will be an over allocation of resources to the creation of the product. Conversely, if there are spillover benefits, there will be an under allocation of resources to the product.

Externalities often appear when the ownership of resources, that is property rights, are not clearly defined, such as in the case of oceans, lakes, rivers, air and even land. Since these resources are held "in common" by society, no one suffers private costs when using them, so often they are overused and degraded or polluted. This idea is called the tragedy of the commons.

Role of government

The government or other organizations can attempt to correct market failures created by externalities. The government might use regulation, taxes or subsidies, among other tools, to try to correct externalities in any given situation.

In the illustration of the factory above, the government might pass a law requiring manufacturers to treat and neutralize their waste. Thus the costs of the pollution would be returned to the factory. The factory, now realizing its full costs, would likely increase the price of its product and/or reduce output.

On the other hand, the government may subsidize or directly provide goods and services with large spillover benefits.

The federal government protects wetland and wilderness areas and maintains National Parks. The benefits of these areas spill over onto surrounding communities and visitors to the region.

In general, government attempts to provide a mix of regulations and incentives so that the quantity of particular goods and services produced reflects actual costs and benefits.

It is useful to consider proposed government solutions, or any solutions, to an environmental issue using cost-benefit analyses. Mitigating externalities or other problems has costs, and it is important to remember that the choice and size of the best solution depends upon the proposed solutions' costs and benefits.

Policymakers should select the solution that has the highest
benefit-to-cost ratio, but only if the benefits outweigh the costs. When a solution isn't available in which benefits outweigh costs, an environmental problem is outside the ability of government to solve it. However, when externalities exist, there is often a role for government or other organizations to play in addressing the market failure.

Source

McConnell, Campbell R., and Stanley L. Brue. Economics: Principles, Problems, and Policies. New York: McGraw-Hill Inc., 2002.

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