1 of 34
Economic Rationale in Caring for the Environment
Objectives
After reading this module, you should:
Be aware of the issue of resource scarcity;
Understand the main factors leading to
misestimating of environmental values;
Familiarize with the methodological
approaches to valuation of environmental
goods and services.
1 of 15
2 of 34
Economic Rationale in Caring for the Environment
The scarcity of environmental resources
2 of 15
There are powerful economic arguments in caring for the environment
at all levels of the economic system.
In fact, the balance between:
• use of raw materials, production and consumption processes, and
• the capacity of the ecosystem to absorb the wastes produced by the
economic system
could impact both positively and negatively on welfare and the natural
resource base.
EXAMPLE
Use of a depletable resource for a given purpose
may preclude its use elsewhere or for future
generations.
Environmental costs may also be involved where
a potentially renewable resource is used or
treated in a manner that reduces its quantity or
quality.
3 of 34
Economic Rationale in Caring for the Environment
3 of 15
The scarcity of environmental resources
The various schools of thought all acknowledge that :
problems of scarcity and declining quality of environmental resources
have increased dramatically in the last few decades, particularly in the
developing countries. Therefore, environmental considerations in decisionmaking today are of far greater economic significance than had been the
case in the past.
Environmental Ecosystem
RM
RM
S
E
SE
P

C
ECONOMIC
SUBSYSTEM
P

C
R
R
W
W
SE = Solar energy
R = Recycling
W = Wastes
RM = Raw Materials (exhaustible and non exhaustible)
P = Production
C = Consumption
Growing Economic System compared to the Environmental Ecosystem
4 of 34
Economic Rationale in Caring for the Environment
Two Views on Finite Availability of Natural Resources
4 of 15
There are two main views on finite availability of Natural Resources.
Let’s look at them.
1. The economic growth conflicts with environmentally sustainable
development.
An expanding economic subsystem relative to environmental goods and
services provided by the ecosystem, is putting environmental resources under
stress. Supply then becomes limiting in relation to the demand.
Although some of these limits can be overcome (for example, substitution of
solar energy for oil based energy), many of them are not (for example,
landfills) and will pose a real threat to welfare improvement.
Bibl. information in the notes
5 of 34
Economic Rationale in Caring for the Environment
Two Views on Finite Availability of Natural Resources
5 of 15
2. Economic growth remains possible without
necessarily exhausting natural resources.
This is because:
• Technological progress allows the replacement of
renewable resources for exhaustible ones (as well as
the reduction of the quantity of natural resources
required per unit of economic output);
• There is possibility of substitution of man-made
capital for natural capital, though within some limits;
and
• New sources of exploration are possible.
More information in the notes
6 of 34
Economic Rationale in Caring for the Environment
6 of 15
The concept of welfare
The term welfare is often used interchangeably with well-being and is related
to the concept of utility.
An important basis from which to assess policy decisions is concerned with the
concept of total welfare of society, as developed by Pigou and Hicks.
Important assumptions implicit in the approach are:
• Society welfare is the sum of individual welfare;
• Individual welfare can be measured, as reflected in prices paid for goods
and services;
• Individuals maximize their welfare by choosing the combination of goods,
services and savings that yields the largest possible sum of total utility,
subject to income constraints.
Bibl. information in the notes
7 of 34
Economic Rationale in Caring for the Environment
7 of 15
The concept of utility and welfare
Utility and welfare can be obtained from goods and services even if they are
provided free or at minimum cost.
“TOTAL UTILITY” is the combination of the amount paid for the good or
service plus any consumer’s surplus.
“CONSUMER SURPLUS”, therefore, will be the difference between the amount
paid (for a good or service) and the total utility enjoyed.
TOTAL UTILITY
-
AMOUNT PAID
=
CONSUMER SURPLUS
8 of 34
Economic Rationale in Caring for the Environment
8 of 15
A method to measure welfare
Welfare can be related to Hicks’ definition of income:
“a man’s income can be defined as the maximum value, which he can
consume during a week, and still expect to be as well off at the end of
the week as he was at the beginning” .
AMOUNT OF GOODS AND
SERVICES CONSUMED BY
HOUSEHOLDS IN ONE YEAR
=
CONSUMTPION
PER CAPITA
POPULATION
Therefore: if consumption per capita increases, then the average member
of the population is better off (i.e., welfare improves).
Bibl. information in the notes
9 of 34
Economic Rationale in Caring for the Environment
Objections to this method
9 of 15
Various objections have been raised to this measure of welfare.
The two most important are that:
1.
the standard national account system, from which consumption indicators
are derived, fails to account for the depreciation of natural capital, and;
2.
it does not account for equity or income distribution, thus leading
policymakers to undertake unsustainable development strategies.
10 of 34
Economic Rationale in Caring for the Environment
Efforts to correct limitations in the system of national accounts
10 of 15
Many countries in recent years have attempted
to correct for such limitations in the system of
national accounts.
However, for most countries environmental
accounting of physical and monetary flows
related to the overall economy is hampered by
inadequate data systems, and by the lack
of agreement on methodologies for
estimating the depletion of natural capital.
Despite these difficulties at the macro level of
the national economy, at the micro and local
levels the scope and prospects of undertaking
environmental analysis based on economic
principles are considerably better.
More information in the notes
11 of 34
Economic Rationale in Caring for the Environment
Reasons for misestimating Environmental Values
11 of 15
Environment is seldom considered in policy appraisal.
The reason is that environmental goods and services are not marketed.
Therefore, they do not have prices that can be comparable with development
costs and benefits.
There are two main reasons for this absence of markets:
1. market failure; and
2. policy failure.
12 of 34
Economic Rationale in Caring for the Environment
Definition of Market failures.
12 of 15
According to the dominant economic theory,
free and perfectly competitive markets will
lead to optimal allocation of resources,
including environmental goods and services,
or to economic efficiency.
Based on this assumption, Market failures
are defined as:
those circumstances that prevent the
perfect competition, and therefore
economic efficiency, from being achieved.
More information in the notes
13 of 34
Economic Rationale in Caring for the Environment
Definition of Market failures.
The major sources of market failures
related to natural resources are:
• Presence of externalities
• Nature of public goods
• Lack of property rights
• Ignorance, uncertainty and short-sightedness
• Irreversibility of use
We will look at each one in detail.
13 of 15
14 of 34
Economic Rationale in Caring for the Environment
Market failures: 1. Presence of externalities
14 of 15
Externalities occur when an economic activity affects technology, consumption,
or preferences of someone who is neither the producer nor the consumer (i.e. a
third party). These effects can be either positive or negative.
In neither case externalities will be included in the financial price paid for the
good produced. In other words, the market does not signal the costs/benefits of
externalities to the perpetrator, who will therefore not change his/her behaviour
accordingly.
EXAMPLE
An example of negative environmental externality is when the aerial
dispersion of chemical sprays applied by farmers contaminate
nearby livestock operations, increasing their production costs in the
form of additional veterinarian’s bills and medication. The
perpetrator of environmental costs will not be informed by the
market about the costs generated to livestock producers, so he/she
will not receive incentives to reduce pollution.
More information in the notes
15 of 34
Economic Rationale in Caring for the Environment
15 of 15
Market failures: 2. Nature of public goods
Before considering the nature of public goods, it is important to keep in mind the
classification of goods:
EXCLUDABILITY
High
RIVALRY
Low
High
Private Goods
Common Pool
Goods
Low
Toll Goods
Public Goods
More information in the notes
16 of 34
Economic Rationale in Caring for the Environment
Market failures: 2. Nature of public goods
16 of 15
Environmental goods and services are often thought of as:
•public goods (non-excludable and non-rival); or
•common pool goods (non-excludable but rival)
Belonging to one or another category of goods may however vary according to
the circumstances.
EXAMPLE
To the category of public goods belong, for example:
• sunlight, weather, biodiversity, flood control services of forests and coral
reefs.
Other environmental services are also generally classified as public goods:
• scenery, clean air, clean water.
However, the latter services can be subject to increasing rivalry or
excludability as they approach a congestion point. Then, they may assume
the characteristics of either common pool, toll, or private goods and services.
17 of 34
Economic Rationale in Caring for the Environment
17 of 15
Market failures: 2. Nature of public goods
Common pool goods include all the renewable natural resources:
forests, water, wildlife, fisheries.
Conceptually, common pool goods are associated to the common property
system, that is a system based on a property right regime regulating the access
and use of the natural resources.
An extreme situation of the common property system is the open access
system. This happens when either there are no common rules at all regarding
the access to and use of common pool resources or the rules have been
disrupted.
Therefore, the degree of exploitation and degradation of common pool goods
very much depends on whether a property rights regime exists or not, and on
the effectiveness of the rules and rights established.
More examples in the notes
18 of 34
Economic Rationale in Caring for the Environment
Market failures: 3. Lack of property rights
18 of 15
Property rights are any kind of legal acts defining the rights of individuals to
use natural resources.
These rights can be:
ownership rights, lease, or use rights conferred by law (e.g. the right to use
water passing over one’s property).
Well defined and clear property rights allow to create markets for public
goods and externalities, and consequently to place an economic value (price)
on them.
If these conditions are not met, like in the open access situation, the incentives
to conserve, protect, and manage natural resources in a sustainable manner will
be undermined.
More examples in the notes
19 of 34
Economic Rationale in Caring for the Environment
Market failures: 4. Ignorance, uncertainty and short-sightedness
19 of 15
• Ignorance and uncertainty may also hinder the functioning of markets.
The limited knowledge and of some environmental processes does not help
providing the users of natural resources with the required information on the
possible impacts in terms of quantity, quality and time of occurrence. This can be
exacerbated by an unequal distribution of information.
• Short-sightedness can also cause market failures.
Often individuals or countries (particularly lower income ones) have short time
horizons, thus preferring investments yielding benefits in the short to medium
term rather than in the long term. This is one of the reasons why
environmental investments are seldom put first on the development
agenda. A simple mathematical demonstration is provided on the next slide.
20 of 34
Economic Rationale in Caring for the Environment
Market failures: 4. Ignorance, uncertainty and short-sightedness
20 of 15
This technique calculates the velocity of loss of value of money in the future.
The larger the discount rate, the higher the velocity of loss of value.
So, for example, a discount rate of 10 percent to a benefit of US$10 received in
10 years time will be worth US$3.85 now. If the discount rate is 3 percent, the
same amount of money received in 10 years time will be worth US$ 7.44 now.
The formula to calculate the present value (the value now) of the benefits
received in the future is:
A*1/(1+i)n
where: A = amount of money received; i = discount rate used and; n = the year
the amount will be received from now.
In the examples above, the formulas will be:
US$10*1/(1+0.1)10 = US$3.85 and US$10*1/(1+0.03)10 = US$7.44
More examples in the notes
21 of 34
Economic Rationale in Caring for the Environment
Market failures: 5. Irreversibility of use
Irreversibility is a typical element of
environmental market failure.
Some development investments may
determine the irreversible loss of
natural assets both for the present and
future generations. This will reduce the
options available to future generations
to use the asset in question.
However, since preferences of future
generations cannot be known, it is
difficult to state whether it is worth
destroying a resource or to conserve it
indefinitely.
21 of 15
22 of 34
Economic Rationale in Caring for the Environment
Policy failures
22 of 15
Government intervention should aim to correct the various forms of market
failure. Failure to intervene in situations of market failure means environmental
problems are perpetuated.
This is one obvious form of policy failure.
EXAMPLE
Governments can intervene:
• to achieve efficiency objectives (internalizing externalities in the production
processes or defining property rights, for instance);
• in relation to objectives not related to efficiency, such as poverty alleviation,
income redistribution between social groups and regions (equity objectives);
• in controlling proliferation of ‘unethical’ goods, such as construction of
materials hazardous to human health or genetically modified seed varieties
(ethical objectives); or
• stockpiling strategic food stocks (strategic objectives).
23 of 34
Economic Rationale in Caring for the Environment
Policy failures
23 of 15
Where no market failure is apparent, the policy interventions can distort an
otherwise well functioning market.
Also, government interventions can sometimes contribute to and even
exacerbate the mismanagement of natural resource by giving the wrong
signals to individuals and firms.
EXAMPLE
Some examples of possible policy failures affecting the environment in
developing countries include:
•
Low tariffs of environmental resources’ use, such as irrigation water;
•
Subsidized energy-intensive inputs, such as fertilizers and pesticides;
•
Poorly defined property rights;
•
Poorly designed investments;
•
Subsidies for environmentally depleting activities (e.g. ranching);
•
Low royalties charged on natural resource mining.
More examples in the notes
24 of 34
Economic Rationale in Caring for the Environment
Concept of Total economic value
We just said that environmental
resources are generally not priced.
In addition, their value is generally
underestimated due to lack of scientific
information on the various possible
services they can supply.
We also considered that absence of price
signals as to the true value of natural
resources can lead to policy decisions
that are detrimental to the environment.
What can be done to deal with this
problem?
24 of 15
25 of 34
Economic Rationale in Caring for the Environment
25 of 15
Concept of Total economic value
We must refer to the field of environmental economics, and consider the concept
of total economic value of environmental resources.
Environmental economists in the 1960s proposed a classification of economic
values, which encompass some of the major externalities of natural resources
exploitation. They identified two broad categories of values (Use Values and Non
use Values) and one related category (Option Value):
USE VALUES
Those benefits that
derive from the actual
use of the natural
resources.
They are often divided
into:
• Primary Values
• Secondary values
NON USE VALUES
Those benefits which do not
imply a contact between
the consumers and the good.
Non-use values are by many
authors also defined
"existence value".
The arguments behind
existence value are:
• Intrinsic value
• Bequest motive
OPTION VALUE
It is the value placed on
environmental assets by
those people who want
to secure the use of the
good or service in the
future.
Option values can be
either positive or
negative.
More Information and examples
in the notes
26 of 34
Economic Rationale in Caring for the Environment
26 of 15
Concept of Total economic value
The total value of an environmental asset is therefore obtained by summing up
all the value components.
Total Economic Value
Here is an example:
Use Value
Existence Value
Direct
Indirect
Direct
Consumption of
Primary Goods
Secondary Goods
and Services,
Including
Ecological
Future
Consumption of
Goods and Services
No Consumption of
Goods and Services














Timber
Fruits, nut ,
herbs, latex,
gum arabic,
litter, etc.
Fuelwood
Forage and
fodder
Developed
recreat ion
and hunting






Scenery
Recreation
Community
integrity
Wildlife
Climate
mitigation
Air quality
Soil quality
Water cycle
Biodiversity
Option


Biodiversity
Wildlife
Community
integrity
Scenery
recreation
Air, soil and
water quality
Existence
Biodiversity
Scenery
Wildlife
Others
Bequest values





Biodiversity
Scenery
Recreation
Wildlife
Air, soil and
water quality
The analyst
should be sure
that the values to
be counted are
not mutually
exclusive or that
they are not
already captured
by other value
components.
More examples in the notes
27 of 34
Economic Rationale in Caring for the Environment
Methodological approaches to monetary valuation
Ideally all these values should be
expressed in monetary terms so that
they can be compared with all the other
costs and benefits of policy decisions.
However, in practice, many environmental
goods and services cannot be priced as
already mentioned.
In the past decades, several tools and
techniques have been developed to
measure the total economic value of
natural resources. We will now look at
different methodological approaches
based on monetary valuation of
environmental goods and services.
27 of 15
28 of 34
Economic Rationale in Caring for the Environment
28 of 15
Methodological approaches. Basic concept. Willingness to pay or accept
The monetary valuation of an environmental good is usually based on the
monetary value individuals place on it. The maximum amount of money an
individual is willing to pay for obtaining a benefit or avoiding a loss in most
situations reflects the intensity of its preferences for such a benefit or loss.
The maximum willingness to pay (WTP) can be considered therefore an
expression of the individual’s values.
Analogously, the minimum Willingness To Accept (WTA) an amount of money
as compensation for foregoing a benefit or for incurring a loss, reflects the
value of such a benefit or loss.
More information in the notes
29 of 34
Economic Rationale in Caring for the Environment
29 of 15
Methodological approaches. Basic concept. Willingness to pay or accept
When an individual buys an asset
paying for it the market price, the
price paid directly reveals a lower
bound of his maximum
willingness to pay. It indeed
reveals that the willingness to pay
for such an asset is "at least"
equal to the price paid.
EXAMPLE
If we observe an individual paying 10
monetary units for a kilogram of sugar, this
means that he is willing to pay at least 10
monetary units for each kilogram of sugar of
that quality, otherwise he would not buy it at
that price. His/her maximum WTP must be
equal to or greater than 10 MU.
30 of 34
Economic Rationale in Caring for the Environment
Methodological approaches. Revealed and stated preferences
30 of 15
When there is no market for an asset, obviously there is no market price that
reveals the lower bound of individual’s maximum WTP and the upper bound of the
minimum WTA. Here are some methodologies to evaluate people's WTP or WTA.
One of the major issues in welfare economics is how to derive the measures of
change in welfare. Two main approaches are practicable:
REVEALED PREFERENCES
The analyst recovers from the
actual behaviour the
consumer’s preferences, and
uses this information to work
out money measures of the
consumer’s welfare changes.
STATED PREFERENCES
The analyst uses information
that is based on what the
consumer states when directly
asked to express his value
judgement.
In either case, reactions of the consumer to changes in prices or quantities of
environmental goods or services provide the basis for approximating the
economic values attached.
31 of 34
Economic Rationale in Caring for the Environment
31 of 15
Methodological approaches. Environmental valuation using market prices
Where market prices exist the valuation of the
environmental impact can be assessed using fairly
conventional economic tools.
These are related primarily to cost-benefit or cost
effectiveness analysis approaches, as commonly used
in project appraisal.
The most well known techniques include incorporating
loss of earnings or changes in productivity into
assessment of the costs and benefits of a given action,
project or programme.
The implicit assumption in using market prices to
determine value is that these prices reflect economic
scarcity and are hence efficiency prices. If there are
distortions in the market prices (for example from taxes,
subsidies or exchange rate policies), these will need to be
adjusted and ‘shadow’ or accounting prices used instead.
32 of 34
Economic Rationale in Caring for the Environment
32 of 15
Methodological approaches. Environmental valuation in absence of markets
Many environmental goods are public or common pool goods in nature.
As such, market prices are often not available.
The value of an increase or decrease in supply is then equal to the sum of
the marginal willingness to pay or accept.
Information on these may not be easy to obtain. In the absence of complete
markets, a number of different techniques for placing a value on non-marketed
goods and services may be used, depending on circumstances. These techniques
have been classified in several ways, according to the objective pursued.
A possible classification distinguishes three approaches:
(i) conventional market;
(ii) implicit market; and
(iii) constructed market.
More information in the notes
33 of 34
Economic Rationale in Caring for the Environment
33 of 15
Methodological approaches. Environmental valuation in absence of markets
A number of tools of varying degrees of sophistication, based on the above
classification are listed in this table.
Conventional market*
Productivity change
method
Preventive or defensive
expenditures
Replacement costs
Restoration or reclamation
costs
Opportunity cost method?
Shadow projects
Substitute costs method
Implicit Market
Travel cost method
Wage differential
Hedonic pricing
Constructed Market
Artificial market
Contingent valuation
method
Source: Adapted from Munasinghe (1993).
More information on this table in
the notes
34 of 34
Economic Rationale in Caring for the Environment
Methodological approaches. Further readings
Detailed treatment of a number of
analytical tools, including illustration
with numerical exercises, is provided
in other modules of the training path,
as follows:
• Revealed preference, direct proxy:
Productivity Change Method (PCM)
and Substitute Cost Method (SCM):
Module 3.1.1
• Revealed preference, indirect proxy:
Travel Cost Method (TCM): Module
3.1.2
• Stated preference: Contingency
Valuation Method (CVM): Module
3.1.3
Also, please refer to Appendix 2 for further readings.
34 of 15