Environmental Economics

What is Environmental Economics?

Environmental economics is a discipline of economics that studies the economic effects of environmental policies around the world. Its main focus is on the efficient allocation of environmental and natural resources and how alternative environmental policies deal with environmental damage, such as air pollution, water quality, toxic substances, solid waste, and global warming.

Origins of Environmental Economics

The origins of environmental economics date back to the 1960s, when industrialization was experiencing a boom, particularly in the western world, and pollution from industrial activity became an increasing concern. Environmental activism also started to increase due to the perceived negative consequences of environmental degradation. The world became aware of rapid economic growth and its consequences to the environment.

Environmental economists see the environment as a form of natural capital that provides amenities and life support functions to the earth’s inhabitants. Environmental economics was premised on the neoclassical approach dealing with issues such as inefficient natural resource allocation, market failure, negative externalities, and management of public goods.

As the movement developed over time, other intricate details on the relationship between the environment and the economy became apparent. The study brought about powerful environmental arguments and propositions, which gave rise to contemporary environmental policies and regulations around the world. It led to the establishment of new environmental bodies – chief among them, the United Nations Environment Programme (UNEP) in 1972.

Scope of Environmental Economics

The role of environmental economics in the design of environmental policies and their implementation is the major concern of the discipline. Three important questions arise in environmental economics:

• What causes environmental challenges in terms of economic and institutional affairs? The question explores the concept of market failure, which is premised on the fact that there are either non-existence or incomplete markets for environmental goods, such as unpolluted air, clean environment, scenic nature views, etc.; hence, there is likely to be no efficient allocation of environmental resources.
• What is the monetary value of environmental degradation through pollution and other agents, as well as the value of developments in the prevention and eradication of environmental harm? The methods of measurement and estimation of the variables are an important aspect of environmental economics.
• How can economic incentives and environmental policies be effectively designed to improve environmental quality and deter environmental damage? Critical evaluation of economic incentives and environmental policies and regulations is crucial to find out if they are yielding the intended objectives.

Environmental economics encompasses the following concepts:

1. Sustainable Development

Sustainable development is defined by UNEP as “development that meets the needs of the present without compromising the ability of future generations to meet their own needs.” The concept analyzes the role of economic development in supporting sustainable development.

The four basic components of sustainable development are economic growth, environmental protection, social equity, and institutional capacity.

2. Market Failure

Market failure occurs if the functioning of a perfect market is compromised; hence, it is unable to efficiently allocate scarce resources at a given price as conditions for laws of demand and supply are not met.

An example can be an environmental good such as clean oceans. It is difficult to price the value of clean seas and oceans, and there exist no markets for clean water bodies where it is traded depending on the degree of cleanliness. It is a standard case of market failure.

3. Externalities

Externalities are inadvertent consequences of economic activity that affect people over and above those directly involved in it. Externalities are also another form of market failure. They can either be negative or positive.

A negative externality creates unplanned outcomes that are harmful to the environment or directly to the general public. An example can be pollution through industrial production, which results in unclean air and water and other health risks. The polluting entities may not incur any costs to address the pollution, even though their activities harm the environment and negatively affect the surrounding community.

A positive externality is a benefit to other people not directly involved in its generation. A community nature park can benefit people outside the community who visit family and friends in the area and would not have contributed to its development. People who benefit from an economic resource without contributing to its establishment are called “free riders.”

4. Valuation

Valuation is an important aspect of environmental economics, as it helps to evaluate a variety of options in managing challenges with the use of environmental and natural resources. The valuation of ecological resources is a complex process, as it is difficult to assign value to intangible benefits, such as clean air and an unpolluted environment.

Resources that offer multiple benefits are difficult to value – for example, mountains may prevent flooding, provide scenic beauty, direct river flow patterns, and provide fertile soils for agriculture.

Environmental resources can be assigned values depending on use and non-use methods. It’s easier to assign value to a product in use by observing what consumers are willing to pay.

Opportunity cost pricing, replacement cost, and hedonic pricing techniques can be employed in the “use” method. The contingent valuation technique is used for the “non-use” method by measuring what consumers are willing to pay for a product they do not use or enjoy.

5. Cost-Benefit Analysis

Cost-benefit analysis (CBA) involves weighing the benefits arising from a policy against the perceived benefits. Hence, the best policy is one in which there is the greatest surplus of benefits over costs.

CBA starts with a base policy where no changes are made to the status quo. A time horizon is selected where the perceived costs and benefits are expected to be realized. Benefits are instances where human well-being is improved, and costs decrease human well-being.

Costs and benefits to be realized in the future are discounted using a discount factor to cater to the time value of money. Benefits include extra income, improved quality of life, clean water, and beaches, and costs include opportunity costs, internal and external costs, and externalities.

Related Readings

CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

• Corporate Social Responsibility (CSR)
• Environmental, Social, and Governance (ESG)
• Non-Renewable Resource
• Sustainability
• See all economics resources