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Spring 2015
Assoc. Prof. Mahmut Tekçe
Environmental Economics
primary focus is how to use or manage
the natural environment (air, water,
landmass) as a valuable resource for
the disposal of waste.
Environmental Economics
• originated in the 1960s
• one of the fastest-growing fields of study in
• increasing recognition of the significant roles
that nature plays in the economic process as
well as in the formation of economic value.
Environmental Economics
• Dates back to the Classical economists.
– Analysis of limited land and natural resources by
Smith and Ricardo
– Mill: land not only has agricultural and extractive
uses, but it is also a source of amenity values.
– Analysis of externalities and market mailures by
Marshall, Pigou, etc.
• Natural resource economics
• Environmental economics
• Ecological economics
• The modern sub-disciplines of natural
resource economics and environmental
economics have largely distinct roots in the
core of modern mainstream economics.
• Natural resource economics emerged mainly
out of neoclassical growth economics
• Environmental economics out of welfare
economics and the study of market failure.
• Ecological economics is a relatively new (1980s)
and interdisciplinary (ecology and economics)
• ‘Eco’ comes from ‘oikos’ (household)
• Ecology is the study of nature’s housekeeping,
while economics is the study of human
• Ecological economics: study of how these two
sets of housekeeping are related to one another.
Fundamental issues in the economic
approach to resource and
environmental issues
• Property rights, efficiency and government
• The role, and the limits, of valuation, in
achieving efficiency
• The time dimension of economic decisions
• Substitutability and irreversibility
Economy and Environment
economy is assumed to depend on the natural
• the extraction of nonrenewable resources and the
harvest of renewable resources
• the disposal and assimilation of wastes
• the consumption of environmental amenities
Economy and Environment
• Economic activity draws resources from the
environment, and provides flows back into the
• These flows must satisfy the laws of
• First law: Conservation of mass/energy (materials
balance principle)
• Second law: Entropy is non-increasing
Economy and Environment
Natural Resources
all the ‘original’ elements that comprise
the Earth’s natural endowments or lifesupport systems: air, water, the Earth’s
crust, and radiation from the Sun.
Arable land, wilderness areas, mineral fuels and nonfuel
minerals, watersheds, and the ability of the natural
environment to degrade waste and absorb ultraviolet light
from the Sun.
Natural Resources
• Renewable
Non- renewable
Renewable Resources
capable of regenerating themselves
within a relatively short period.
plants, fish, forests, soil, solar radiation, wind, tides, etc.
Renewable Resources
Stock (Biological)
Flow resources
various species of plants and
can be irreparably damaged if
they are exploited beyond
a certain critical threshold
solar radiation, wind, tides,
and water streams
Nonrenewable Resources
either exist in fixed supply or are renewable only on a geological
timescale, whose regenerative capacity can be assumed to be
zero for all practical human purposes.
Nonrenewable Resources
metallic minerals
(iron, aluminum,
copper, and uranium)
fossil fuels
Neoclassical Approach
• Natural resources are ‘essential’ factors of
• Natural resources are scarce.
• The economic value of natural resources is
determined by consumers’ preferences, and
these preferences are best expressed by a
freely operating private market system.
Neoclassical Approach
• Market price can be used as an indicator of resource
• Natural resources can always be replaced (partially or
fully) by the use of other resources that are
manufactured or natural.
• Technological advances continually augment the
scarcity of natural resources.
• natural ecosystem is treated as being outside the
human economy and exogenously determined
Neoclassical Approach
Key issues:
the market as a provider of information about
resource scarcity
resource (factor) substitution
scarcity augmenting technological advance
the nature of the relationships between the
human economy and the natural environment
Neoclassical Economics
• “Invisible Hand” theorem: idealized capitalist
market economy
• Freedom of choice based on self-interest
• Perfect information
• Competition
• Mobility of resources
• Ownership rights
Price signals
– Free good – no price
– Scarce good – positive price
Price as a signal of
emerging resource scarcity
decreasing resource scarcity over time
• Factor substitution
– one kind of resource can be freely replaced by another in
the production process.
• Input substitutability
– Constant factor substitution possibilities
– Diminishing factor substitution possibilities: the
opportunity cost of using natural capital increases at an
increasing rate as natural capital becomes scarce
– No factor substitution possibilities: to produce a given level
of output a certain minimum of natural capital input is
• Technological Advance
– the ability to produce a given amount of output by
using less of all inputs
– conservation of resources
– the amount of resource conservation depend on
the impact that technological advance has on the
relative productivity of each of the inputs
The human economy
and the natural world
• the human economy is composed of three
entities: people, social institutions and
• the value of resources is assumed to emanate
exclusively from their usefulness to human
• matter and energy from the natural
environment are continuously transformed to
create an immaterial flow of value and utility
Ecological Perspective
• Environmental resources of the biosphere are
• Mutual interdependencies: everything is
related to everything else
• Biosphere is characterized by a continuous
transformation of matter and energy
Ecological Perspective
• Material recycling is essential for the growth
and revitalization of all the subsystems of the
• Nothing remains constant in nature
• The human economy is a subsystem of the
• the human economy is completely and
unambiguously dependent on natural
ecological systems for its material needs
• the growth of the economic subsystem is
‘bounded’ by a nongrowing and finite
ecological sphere
• nature acts as both a source of and a limiting
factor on the basic material requirements for
the human economy
studies the
between living
organisms and the
physical and
environment in
which they live.
• living organisms in a specified physical
• the interactions among the organisms,
• the nonbiological factors in the physical
environment that limit their growth and
of the
Dynamic interaction between abiotic and
biotic components
Abiotic components
• habitat for organisms.
• reservoir of the six most important elements
for life (C, H, O, N, S, P).
Biotic components
• Producers: organisms capable of
• Consumers: organisms whose survival
depends on the organic materials
manufactured by the producers.
• Decomposers: micro-organisms and many
other small animals that rely on dead
organisms for their survival
• A functioning natural ecosystem is
characterized by a constant transformation of
matter and energy.
• Material recycling is essential for the growth
and revitalization of all the components of the
Energy and thermodynamics
• The first law of thermodynamics: principle of
conservation of energy - matter and energy
can neither be created nor destroyed, only
• The second law of thermodynamics: energy
transformations – in every energy conversion
some useful energy is converted to useless
(heat) energy (entropy)
• In all conversion of energy to work, there will
always be a certain waste or loss of energy
• Useful energy cannot be recycled
• Natural ecosystems require continual energy
flows from an external source
Ecology and the human economy
• The human economy is a subsystem of the
• Natural resources cannot be viewed merely as
factors of production
• Humans lead to;
– Simplification of ecosystems
– Creation of industrial pollution (waste)
• waste-absorptive capacity of the natural
environment: ecological threshold
• trade-off between economic goods and
environmental quality
Assimilative capacity of the natural
• the assimilative capacity of the environment is
• the assimilative capacity of the natural
environment depends on the flexibility of the
ecosystem and the nature of the waste.
• pollution reduces the capacity of an
environmental medium to withstand further
Assume a linear relationship between waste and
economic activity
W = f (X, t)
: level of waste generated
: production of goods and services
: technological and ecological factors
if t assumed constant;
W = βX
Market Economy and
Allocation of Environmental Resources
Ownership of a resource:
• ownership rights are completely specified
• the rights are completely exclusive
• the ownership rights are transferable
• ownership is enforceable
• When these four conditions are met, selfinterest based behavior of individuals will
ensure that resources are used where they are
most valued.
• Environmental resources tend to be common
property resources.
• The ownership of environmental resources
cannot be clearly defined.
• for the common property resources, economic
pursuit on the basis of individual self-interest
would not lead to what is best for society as a
• the use of commons needs to be regulated by
a ‘visible hand’
• Positive and Negative
• In the presence of real externalities, there will
be a divergence between private and social
evaluations of costs and benefits
Negative Externality
• A negative externality is a cost that is suffered
by a third party as a result of an economic
In a transaction, the producer and consumer
are the first and second parties, and third
parties include any individual, organisation,
property owner, or resource that is indirectly
Positive Externality:
Social benefits = Private benefits + External benefits
External benefits > 0
Social benefits > Private benefits
Negative Externality:
Social costs = Private costs + External costs
External costs > 0
Social costs > Private costs
Market Economy and
Environmental Resources
Fundamental question:
Why may markets fail to allocate environmental
resources optimally?
– Externalities
Macroeconomic Effects of Environmental
• Environmental externalities cause a
misallocation of resources.
• Policies needed
– Taxes, penalties
– Risk of inflation and unemployment
– Job destroying and job creating effects
– “cleaning up the environment creates more jobs
than it destroys”
Macroeconomic Effects of Environmental
‘Porter hypothesis’
Strictly enforced environmental policy could
have the effect of forcing firms to adopt more
efficient production technologies.
In the long run, the effect of this would be a
reduction in production costs and a further
stimulus to the economy
Macroeconomic Effects of Environmental
Debate: Regulation vs Deregulation
• Effect of environmental regulations on longrun economic performance
• Expenditure on pollution control limited