The economics of the 'economic argument for environmental protection'

Doubtlessly few of this blog’s readers have taken a course in environmental economics, but as the commentaries on this blog indicate, grounding in the principles of environmental economics would be very helpful in wading through proposals for or against environmental protection.

And given how numerous, contradictory, and contentious the conversations can be—whether about fracking regulations, protecting water bodies, or the EPA’s Clean Power Plan—I thought that discussing a few principles might make decoding the debates a bit more palatable.

What is environmental economics? Environmental economics is a sub-discipline of economics, so it shares all the key principles of economics, but focuses on the identification, measurement, and correction of market failures around environmental issues. Its overarching goal is to maximize social welfare—where the aggregate economic well-being of society is as high as it can be, or is at least made higher by a policy, regulation, or activity.  

For instance: in considering a new regulation on fracking, the effects of the regulation on raising costs of natural gas and even consumer electricity prices should be considered along with the reduction in environmental and health risks and damages.

The overarching operating principle of environmental economics is the marginal principle. This means that rarely does banning a practice, such as fracking, maximize social welfare. The idea is to equate the marginal benefits of a tighter regulation with the marginal cost of that tighter regulation. A ban makes that principle inoperative and ignores the positive economic effect of the oil and gas industry and consequences for energy prices.

The overarching limit of economics is ignoring the equity implications of a regulation or action (other than to describe them), focusing normatively on efficiency. The idea is to “make the pie larger,” although economics has no guiding principles to proscribe how the pie is shared, much less as to how to trade off efficiency for equity.

Turning to environmental economics per se, identifying a market failure can be a tricky business.

Air or water pollution from a factory is a common example, because clean air and water (into which pollution flows) are usually unpriced in a market. They are free to all (a common resource) and will, thus often overused and abused as a sink for pollution.

Policies can fix these failures (or internalize these externalities, if you will), however, by creating a price on the use of the environment. This is what a tax on pollution or a tradable pollution permit market does, and at least partly explains while economists favor them. Prices provide signals for polluters to adjust their pollution production and mitigation activities, which generally leads to a lower cost way of reducing pollution than an overly bureaucratic, command-and-control solution.

Where does the trickiness come in? Negative side effects of regulation occur all the time, but they are not necessarily a market failure/externality, and don't necessarily merit government intervention.

Do we label as an externality the rising price of grain and bread caused by government mandates to blend ethanol into gasoline for environmental purposes? No. We might not be happy about this side effect of the regulation, but it is not a market failure—and environmental economists therefore wouldn’t call on policy to correct it.

This leaves the measurement issues. Environmental economists in particular specialize in measuring in monetary terms the seemingly unmeasurable, e.g., the value of improving the protection of the Amazon rain forest, reducing the risk of death caused by air pollution, or reducing the risk to fish caused by water pollution.

This valuation is done in two broad ways: (1) using statistical means to translate people’s behavior when confronted by pollution into monetary terms, called revealed preference analysis; and, (2) using surveys to ask people how much they value risk changes like those noted above, called stated preference analysis.

Once these values are available, they can then be compared with the costs of reducing the pollution so a judgment can be made about the regulation’s efficiency: do the benefits outweigh the costs? If so, the regulation is justified on economic efficiency grounds. If not, it might still be worthwhile to pursue the regulation, but one would need other types of justifications.

Among the most controversial measurements made by environmental economists is the value of statistical life. Right off the bat, we in the profession need to apologize for this term. It makes people think we are valuing human life. Thank goodness we are not even trying to do that! What we are valuing is how much people are willing to pay to reduce their risks of death by a little bit. People reveal this willingness to pay (or not pay) all the time: they pay extra for airbags and bicycle helmets, or they pay in time (which is easily translated to money), say by crossing in the middle of the block to save a minute when it's safer (but slower) to cross the street at the light.

If on average people are willing to pay $100 to reduce their risks of death by 1 in 10,000, let's say, that translates into a value of a statistical life of $1 million (i.e., $100/(1/10,000)). With this handy number, a regulation that saves 1,000 lives (according to an epidemiological analysis) provides a monetary benefit of $1 billion. When this benefit of a regulation is added to other benefits, whether market or non-market, and subtracted from the regulation's costs, a judgment can be made about the economic efficiency of the regulation: whether it raises social welfare on net.

This is the fundamentally business of environmental economics: determining whether a particular action or policy raises social welfare on net—or, to be a bit cheesier about it, to determine whether the action or policy makes the world a better place, based on a number of key economic metrics—as well as using economic insights and principles to develop the policy options in the first place.

In a world where every decision has trade-offs, I would argue that environmental economics has a particularly valuable role to play in guiding decisionmaking and improving public understanding of government actions on the environment. 

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Dr. Alan Krupnick is senior fellow and co-director, Resources for the Future’s Center for Energy and Climate Economics. His research focuses on the benefits, costs, and design of pollution and energy policies. He also leads research on the risks, regulation, and economics associated with shale gas development. Krupnick served as senior economist on the President's Council of Economic Advisers, advising the Clinton administration on environmental and natural resource policy issues. He also consults with state governments, federal agencies, private corporations, the Canadian government, the European Union, the Asian Development Bank, the World Health Organization, and the World Bank. He received a Ph.D. in economics from the University of Maryland.

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The views expressed by contributors to the Cynthia and George Mitchell Foundation's blogging initiative, "The Economic Argument for Environmental Protection," are those of the authors and do not necessarily represent the views of the foundation.

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