Environmental Economics Class 6

Concepts Static efficiency Dynamic efficiency Static efficiency allows us to evaluate those circumstances where time is not a crucial aspect of the allocation problem. Allocating water or solar energy... Dynamic efficiency is a suitable concept for circumstances where time is crucial. Allocation of depletable resources.

Treatment of future generations. Temporal allocation Intertemporal allocation Two period model Objective: Balance present and future uses of the resource by maximizing the benefits derived from the use of these resources Dynamic efficiency: Allocation of depletable resources Demand is constant in two periods.

Figure 5.1 Figure 5.2

Sustainable Development: Defining the Concept The nature of normative decision making: How much should we leave for future generations? What is the appropriate rate of discount? How do we make decisions for a group of people that are not around to negotiate for themselves? “sustainability criterion” holds that future generations should be left no worse off than current generations and should perhaps be left better off.

Are Efficient Allocations Fair? With a discount rate greater than zero, an economically efficient allocation will allocate more of a resource to the first period than the second. Net benefits will be greater in the first period than the second. The sustainability criterion can still be met if the first period sets aside sufficient net benefits for the second period.

Applying the Sustainability Criterion The sustainability criterion is difficult to implement as it requires knowing something about the preferences of the future generation. A more operational criterion is called “Hartwick’s Rule.” The usefulness of Hartwick’s rule depends on how substitutable physical capital and natural capital are. Hartwick’s Rule suggests that if all scarcity rent is invested in capital, then a constant level of consumption could be maintained in perpetuity. If all scarcity rent is invested in capital, the value of the total capital stock will not decline. If the principal or the value of total capital is declining, the allocation is not sustainable.

Total capital is defined as physical capital plus natural capital. These are assumed to be substitutable under Hartwick’s Rule. Physical capital consists of buildings, equipment and infrastructure. Natural capital refers to environmental and natural resources. Complete substitutability between physical and natural capital is an extremely strong assumption.

The maintenance of total capital is termed “weak substitutability.” Weak substitutability suggests that resource use by previous generations should not exceed a level that prevents future generations from achieving at least the same level of well-being. An alternative definition of sustainable allocation is called “strong sustainability.”

Strong sustainability implies that the value of the stock of natural capital is maintained. Strong sustainability assumes that there is little or no substitution between physical and natural capital and emphasizes preserving natural capital as opposed to total capital. Again, the focus is on preserving value and on preserving an aggregate of natural capital.

Implications for environmental policy Not all efficient allocations are sustainable. Not all sustainable allocations are efficient. Market allocations may be either efficient or inefficient and either sustainable or unsustainable. Given a number of sustainable allocation possibilities, choose the one that maximizes either static or dynamic efficiency (net benefits or the present value of net benefits), e.g. maximize wealth, subject to a sustainability criterion.

Why do discount rates matter? Higher discount rates… …favor more rapid depletion of nonrenewables and lower stock levels of renewables …can make investments to improve environmental quality relatively less attractive compared to those in the private sector Conrad, J.M. Resource Economics

Discount rate justification 7% is approximately the real return to investment in large companies over the period 1926–1990 and is the rate currently recommended by the US Office of Management and Budget for standard cost–benefit analysis For the relatively short-term (~<30 yrs), plausible might mean 2-7%. Depends on perspective (firm, individual), assets/endowments, risk preferences, etc R.G. Newell, W.A. Pizer / Energy Policy 32 (2004) 519–529

Green Accounting Systematic presentation of data on environmentally important stocks and flows (e.g. stocks of life-sustaining natural resources, flows of pollutants), accompanying conventional economic accounts (e.g. measures of gross domestic product) with the ultimate objective of providing a comprehensive measure of the environmental consequences of economic activity. (Euroean Environment Agency)