Sustainability:

A Neoclassical View

Introduction

In the next two chapters, move beyond our efficiency versus safety debate over pollution control standards, and consider long-run impacts

Shift focus from allowable standards for pollution to right targets for the exploitation of natural capital

Natural Capital Natural capital includes:

Resources (Sources) that are inputs into the economy○ Renewable: water, wood, fish, and soil○ Nonrenewable: minerals, oil, the genetic code

in speciesEnvironmental waste sinks

○ Land, air, water, human body

Stock and Flow Pollutants Stock pollutants: Pollutants that

accumulate in the environmentExamples: CO2, nuclear waste

Flow pollutants: Pollutants that do their damage relatively quickly and are then either diluted to harmless levels or transformed into harmless substancesExamples: acid rain, smog, and noise or heat

pollution

Environmental Sinks

Just like depletion of sources, stock pollutants exhaust natural capital by filling up environmental sinks. We all carry in our fat cells residues of the

pesticide DDT even though it was banned in the early 1970’s

Chlorofluorocarbons released into the atmosphere today will contribute to ozone depletion for decades

Some high-level nuclear wastes retain their toxicity for tens of thousands of years

Sustainability A responsibility to future generations to

manage the planet’s resources and control our emissions of stock pollutants

Definition: Providing the typical person alive in the future with a standard of living, including both material and environmental welfare, at least as high as that enjoyed by the typical person alive today

Neoclassical vs. Ecological

Sustainability discussions have divided economists into two broad groups:NeoclassicalEcological

Key Difference: To what extent can created capital, or human made capital, substitute for natural capital?

The Neoclassical View

Natural and created capital are substitutes in the production process

Technological optimists: as resources become scarce, prices will rise, and human innovation will yield high-quality substitutes

Nature is resilient: pressure on ecosystems will lead to marginal, predictable degradation, but no surprises

The global spread of market-based economies provides a powerful foundation for achieving a sustainable future

The Ecological View Natural and created capital are

fundamentally complements Technological pessimists: as sinks and

sources are exhausted, human welfare will decline, perhaps dramatically.

Nature can lose its resilience; collapse of some of the ecological foundations of the economy are becoming more likely.

Globalizing world economy is unsustainable. Needed: a largely expanded role for government to aggressively protect our dwindling stock of natural capital

Measuring Sustainability:Gross Domestic Product GDP is the government’s measure of the

final value of all goods and services produced and consumed in the market each year; it also equals the income earned and spent by consumers

GDP is a bad measure of sustainability: whether the typical person is better off or not in the long run

Problems With GDP

fails to include the value of nonmarket production

fails to subtract the costs of growth fails to account for the depreciation of the

capital (human-created and natural) used up in production

reflects the experience of the “average” rather than the “typical” person

An Alternative: Net National Welfare

Neoclassicals andNet National Welfare

Neoclassicals assume that NNW for the median individual has been rising over time and that we are thus living in a sustainable economy

They argue for achieving the maximum NNW over time, a goal known as “dynamic efficiency”

Calculating Net National Welfare Externality Costs: Chapter 8 Costs of Clean-up and Abatement:

Chapter 9 Depreciation of Natural Capital: Next

couple of slides!

Natural Capital Depreciation Depreciation is a measure of how much

capital is used up in the production process Recall that resource rents develop when

access to resources are restricted, and prices get bid up above the economic cost of production

Productive Investment of resource rents is critical to provide future generations with a higher standard of living

Mr. Bill in Billsville Mr. Bill has an oil field containing 100

barrels of oil on his property. He can hire a firm from a neighboring town

to pump his oil at an economic cost of $1 per barrel, but because it is scarce, the price of oil is $2 per barrel, well above cost.

Scarcity of the oil means that Mr. Bill can earn a resource rent of $1 per barrel from its production.

Mr Bill in Billsville

1. How much will Mr. Bill’s net income (economic profits) rise for the year?

2. If Mr. Bill spends all the income on a new giant screen TV (which he keepslocked up in his bedroom), how much worse off are his children?

3. If Mr. Bill’s family were the sole residents of the country of Billsville, how much would Billsville GDP rise?

4. How much would Billsville NNW rise?

The Depreciation Rule

Depreciation of oil equals the measured value of the resource rent

The resource rent is what future generations are losing by our exploitation of natural capital today

It is also the amount that must be saved and invested if resource depletion is to be sustainable

Investing Resource Rents:Alaska

Alaska, an oil-rich state has exploited its natural resources and invested the resource rents into a giant investment fund called the Permanent Fund

Each year, earnings from this fund are paid out to all Alaskans, totaling about $1,000 per person per year

Alaska has also invested in roads, telecommunications, and better education

This may not fully compensate future generations for the exploitation of resources, but it does suggest how the current generation can substitute created wealth for natural wealth

Measuring Resource Rent

A Problem With the Depreciation Rule

Resource rent is measure using today’s prices. But prices today may not accurately reflect the fair value that future generations are liable to place on natural capital. Market systems may account for this if producers expect the prices of natural capital to rise at a rapid rate due to future shortages; they will hold off exploiting their holdings in order to reap greater profits

Profit-Based Conservation

Problems with Profit-BasedConservation

Property rights in developing countries are often uncertain, leading to “use it or lose it” behavior

Uncertainty about future needs and preferences

People prefer current over future consumption

Bottom line: resource rent reflects a lower bound of the true reduction in wealth due to the drawdown in the stock of natural capital

The Usefulness of NNWIndicator of progress

○ A rising NNW would tell us that society would be better off because current increases in welfare would not come at the expense of future generations

Sustainable resource use○ The difference between GDP and NNW that

results from resource depletion must be productively invested in order to insure sustainability

Genuine Progress Indicator One attempt to calculate NNW: the

Genuine Progress Indicator (GPI) The formula again:

NNW = GDP + non-market output- externality and clean-up costs- depreciation of natural capital- depreciation of created capital

Growth in per Capita GDP vs. per Capita GPI

No correlation between GPI growth and GDP growth

New Topic: Future Benefits and Discounting

From a social point of view, there is a major opportunity cost to foregone, productive investment

Investment of $100 today is worth more than the same investment in the future (not because of inflation– because the investment is productive!)

PDV of Savings from Compact Fluorescents

Cash Outlays for Investing in Lighting

Discounting When future benefits are not weighed as

heavily as current benefits, we say that the future benefits are “discounted”Due to the interest or profit that might be earned,

cash resources on hand today are more valuable than cash resources available at a later date

The amount we would put aside today to grow to a certain benefit in the future is the present discounted value (PDV) of that benefit

PDV Formula PDV = $X/(1+r)T

The PDV of $X received in T years is the amount of money one would need to invest in the present to just receive $X in T years, at a specified rate of interest, or discount rate, r

Application: Clean up or Invest Elsewhere?

Assume no environmental bond Discount future benefits and costs at

rate of growth of NNW to determine which outcome is dynamically efficient

As always, at the efficient outcome, victims could be fully compensated, but generally won’t be

Application: Clean up or Invest Elsewhere?

Private Profit Rates vs.Public Discount Rates

The Office of Management and Budget requires a uniform 5% discount rate

The EPA typically uses a 3% discount rate Private firms often require 15%-20% profit

rates for investmentThis is higher for two reasons

○ They reflect only private benefits of investment○ High returns are required to induce people to

save and invest rather than to consume today (what economists call positive time preference)

What is the “right” discount rate? For private sector actors, use the private

opportunity cost of investment funds: the expected rate of profit on an investment of comparable risk.

For social decisions, use the social opportunity cost of investment funds: the rate of growth of NNW!

Studies suggest that over the long term, this is from 0% to 2%.

Evaluating sustainability: The Project Level

Although neoclassicals belive that system wide, the economy is sustainable, individual projects may be unsustainable.

To decide, apply benefit-analysis, discounting future net benefits at the rate of growth of NNW.

Evaluating sustainability: Project Level Example

Replant a forest: Costs today $10m Future benefits in 20 years: $20 m in

resource rent from harvest, $5 m in recreational and ecosystem benefits.

Is not replanting more profitable at a 15% profit rate? Is not replanting sustainable, discounting at 1%?

Evaluating sustainability: Project Level Example

Project Costs: $10 m Project benefits at 15%: $1.53 m Replanting not profitable Project benefits at 1%: $20.48 m Replanting sustainable

Government should require replanting under a sustainability rule.

High Market Discount Rates

Using high discount rates dramatically shortens the time horizons of investors: a 20% discount rate implies an expected payback period of only 5 years.

Along with open access to common property, high market discount rates explain why our actions today might penalize the welfare of future generations: market actors seldom look more than 5-8 years into the future.

Neoclassical vs. Ecological

Neoclassicals: in spite of open access and high discount rates, we are still making enough investments to insure overall sustainability. Due to rapid technological progress, NNW is rising

Ecologicals: open access and high discount rates have already led to the unsustainable exploitation of natural capital

Nonrenewable Resource

Economics 101

The Hotelling Model

Earlier, we introduced the concept of profit-based conservation

Economists use a simple model, originally credited to Harold Hotelling to derive the predicted relationship between resource stocks and prices over time

Billite Equilibrium

Suppose 100 tons of a brand new mineral, Billite, is discovered

Billite entrepreneurs intend to sell all their Billite either this year or next

What happens to the price of Billite over time?

Assumptions

Billite is produced at a constant marginal cost of $10, up to the supply limit of 100 tons

The Billite industry is competitive (100 small producers each with one ton each)

Investors can earn a 10% interest rate elsewhere in the economy

The inverse demand curve for Billite is the same in both periods: P = $80 - q

Billite Supply and Demand, Two Periods

Equilibrium?

Assume half selling their Billite during period 1, and the other half selling their Billite during period 2. This is not an equilibrium.

One producer can shift their sales from period 2 to period 1; this lowers the period 1 price, but allows the producer to earn enough interest on her period 1 profit to earn more than she would have had she sold her goods in the second period.

Equilibrium

By “guess and check”, the equilibrium is:Period 1: Q = 51, P = $31Period 2: Q = 49, P = $29

Hotelling Outcomes Given a positive discount rate, the stock

will eventually all be sold, even if additional periods are added to the model; the price will rise to the choke price ($80): just high enough to eliminate all demand

Since this market is competitive, the outcome is dynamically efficient and maximizes the present value of the net benefits to producers and consumers

Equilibrium in the Hotelling Model In equilibrium, note that the resource rent

rises between the two periods by a figure very close to the discount rate

Thus the equilibrium condition for the Hotelling Model isRR2 = (1 + r)RR1

The Hotelling Model provides a precise forecast of the growth path of resource rent and thus nonrenewable resource prices

Testing the Model Over the last 40 years, most non-

renewable resource prices have shown no signs of rising at all

There are two possible explanations for thisMarket actors see no long term shortfalls of

these basic commodities within a relevant time frame

Mining and processing technology has enabled the mining of lower grade ores

Related Issue: Intergenerational Distribution of Natural Capital

Because the wealth represented by natural resources has been endowed 100% to the current generation, we have dictatorial power over resource decisions

Since we own all of the resources today, our perceived wealth is increased

Higher perceived wealth increases demand, and leads to greater levels of exploitation

Dictatorial Power, Prices, and Resource Rent