---

ACE8021: SUSTAINABLE DEVELOPMENT & ENVIRONMENTAL CHANGE

---

Aim:    to identify,  examine and discuss the critical economic features of the concept of sustainability.

Objective:    to develop an appreciation and general understanding of:

• the importance of economics (and social behaviour) for sustainability,
• the insights an economical approach offers to concepts of sustainability
• the key problems and issues arising from the economics of sustainability.

Index of topics covered in these notes & this session:

• First Principles of Economic Systems
1. The Laws of thermodynamics
2. Ecology: Man is an Animal
3. The Circular Flow of Income
4. Principles of Trade and Specialisation
• Economic Meaning of Sustainability
1. Meaning?
2. Possibilities?
• Market Failure Problems:  - externalities and public goods -> valuation and transaction cost problems
• Problems of Substitution between physical (man-made) and natural capital -> valuation problems again
• Identification and Valuation: of non-market goods and services
• Capital Problems: choices between now and the future (the tyranny of the discount rate)
• Problems of Efficiency versus Equity (markets versus democracy)
• Conclusions and lessons learned?

1. Materials Balance Princple: Neither matter nor energy can be created or destroyed: total mass-energy is fixed:  all apparent changes are conversions of one form into others. So, the more matter and energy an economy (people) uses, the more natural resource depletion and waste it will generate.
2. The Entropy Principle: where entropy is a measure of disorder. In a closed system, the use of mass-energy results in a one way flow from low entropy resources (mass-energy) to high entropy resources, from order to disorder. Perpetual motion is impossible - use of energy leads to dissipation of energy into unusable forms (disorder), all we can do is release order, and generate disorder. All closed systems tend to run down and dissipate to disorder, towards maximum entropy. NO CLOSED SYSTEM IS ULTIMATELY SUSTAINABLE. (Though the earth is not closed - it continually receives enrgy from the sun - the solar system is (for practical purposes), closed, and the sun is runnning down.) So, any discussion of sustainability has to recognise that sustainability is a relative, not absolute concept. Are some processes and activities more or less sustainable than others?

2.    Ecology: Man is an Animal: whose population will expand to exhaust its local food supplies or life support systems, and then contract (through disease, starvation etc, and, in the case of man alone, wars and conflicts) to a sustainable level, consistent with the local environment - the Malthusian Principle. The world population has grown from 0.5bn in 1600 to 1.6bn in 1900, to 6 bn. in 2000, and is on track to grow to 9 billion or perhaps more by 2100, with the population explosion coinciding with the advent of the industrial revolution. It has achieved this through making massively more use of the planets resources, and creating more waste as a consequence.  There must be a limit to the human carrying capacity of the planet - but where is this limit?
Back to Index.

3.    The Circular Flow of Income describes the economic system:  One persons' spending is anothers' income.  There is no such thing as a free lunch (someone, somewhere is paying for it).  Income (and wealth, which is simply stored income) can only ultimately be created by using labour, land, solar energy (either directly or in stored form) and natural resources. 

However, as economic development (increased incomes and economic activity) occurs, most economic activity is concerned with further processing and delivery of final goods and services, and typically an increasing amount of service and secondary activity.  Each of these processes within the system is a process of adding value to the basic mix of land, labour (including management) capital (stored productive capacity in the form of machines and tools, etc.).  It is this added-value which provides peoples' incomes, based on their ownership of the basic factors (land, labour and capital). The key differentiation between developed economies and developing economies is the amount of capital per head employed by the economic system, though the quantity and quality of land also matters.

For those more at home with ecological and biological concepts, I suggest it helps to think of economic processes in much the same way as ecological and biological cycles, with income cycles similar to carbon, oxygen and water cycles. As these cycles operate, so biological growth and replication happens.  Innovation serves the same function within economics as mutation serves within biological cycles, and the survival of the fittest criterion for survival and continued replication in economics is simply that - the continued ability to make or scratch a living.  See here for a little more detail on this conception of the economic system.
Back to Index.

4.    Principles of Trade and Specialisation (Adam Smith's invisible hand) - the 'mechanics' of the economic process. No one can easily be entirely self-sufficient - to do so requires that we (as a household, village, or region) do everything for ourselves.  Adam Smith's account of the Wealth of Nations (1776) still remains as the foundation account of the market mechanism. The process is driven by four fundamental ideas:

• each individual pursues his or her own self-interest;
• but people are in natural competition with one another for their livelihoods (as any organism is in a natural environment);
• it is impossible to do or be everything one wants to be - capacity to do things and be things is limited compared with near infinite wants and desires - so choices and trade-offs have to be made.
• people can become better-off than otherwise by specialising in what they do best, relative to what else they might do, and trading the products (or services) with others.

If there are too many butchers - the supply of meat from the butchers is too great in the face of demand by customers -  then the prices they can charge will fall so low that some (at least) do not make enough to live on, and some will give up and seek something else to do. Prices and incomes for those remaining will then rise.

In the end, the market system should settle down so that each makes as great an income as possible, which is at least as much as each could make doing something else - in their next best alternative form of occupation (their opportunity costs). In so doing, customers (consumers) will find that they are supplied with as much as they are willing to buy (given their income) at a price which they are willing to pay. If not, there will be profit opportunities available for someone to increase supplies of those things which consumers want in greater quantities than are presently available.  If consumers are willing to pay more than it costs to produce something, then someone will find it profitable to increase supplies.

Because people are different, some people are better at doing one thing than another. In addition, people have different resources to work with - their land and capital (plant and equipment) is different.  As a result, it will generally pay people to specialise in production of one thing - the thing they are good at relative to what else they themselves might do - and then trade this output with others (producing different things), so making everyone better off than they would be if they all tried to be self-sufficient. 

Notice, especially, that specialisation makes sense even for those who are absolutely worse at doing everything than their neighbour or potential trader.  Even these people (or groups or regions) will be better at doing some things than others.  They will be comparatively good at something - compared with the other things they themselves could do.  They should specialise in their own comparative advantage, regardless of their absolute advantage.

If this proposition is not immediately convincing, just consider how busy you would be, and how little leisure time you would have, if you tried to be totally self-sufficient. Would you consider yourself to be better-off without the possibility of trade and exchange?  If so, why are you not already practicing complete self-sufficiency? I know you are not, because if you were, you would not be reading this.

Once again, the parallels with biological and ecological evolutionary systems are strong.  Individual people are similar to genes (thought of according the selfish gene concept (Dawkins)), while the organisms of biology are similar to the organisations (firms, households, political parties etc.), with the same gene (person) expressing itself in different ways according to the organism and the environment in which it finds itself.  People survive and replicate according to their ability to find and express themselves in surviving and replicating organisms (organisations).

This brief outline of the story of economic competition according to Adam Smith introduces (albeit breifly) eight key economic concepts:

• supply - the quantities of products and services producers are prepared to provide and the prices they are willing to accept - to cover their costs and provide an income comparable with what they could earn doing something else;
• demand - the quantities of products and services customers (consumers) are willing to buy and the prices they are willing to pay for them;
• markets - the processes through which suppliers and producers exchange their products with customers and consumers - that is, a broader and more inclusive concept than simply market places or market halls.
• market equilibrium - achieved when supplies are balanced with demands at a common price accepted by both sides (suppliers and customers) as being reasonable (or unavoidable);
• circular flow of income - one person's spending becomes another's revenue (and thus income) through the activity of trade and exchange through markets.
• opportunity cost - the cost of being in one occupation (or doing one thing) rather than another. If the opportunity cost is not covered by the revenues earned (or benefits gained), in addition to the direct or cash costs of the activity, then we can expect people to change what they do in favour of the alternative - the next best opportunity.
• gains from trade (or exchange) and comparative advantage - that people (or localities, regions or countries) can be better-off by specialising in what they are relatively good at, compared with what else they themselves might do, and trading with each other, rather than seeking to be entirely self-sufficient.  People will be better off if they specialise according to their comparative advantage, and trade with each other.
• Production possibilities: the extent to which any community (region, country, etc) can produce anything - the limit of total output and income given the land, labour, and capital which the community has.

Back to Index.

1.    Meaning?

1. From a simple economist's perspective, sustainability might be taken as the ability to maintain wealth, income, consumption and lifestyles indefinitely.
2. Since the generation of income and wealth requires the use (exploitation) of both renewable and non-renewable natural and physical resources, and also generates waste and pollution, while at least part of peoples utility and enjoyment derives from appreciation and use of the natural environment and physical character of the planet, sustainability requires that the damage and depletion of the earth's natural resources and environment must be made good somehow, otherwise the processes of income generation will eventually run down. A common way of expressing this requirement is that human activity should be organised as if the human race had a full repairing lease on the planet -> sustainability translates into maintaining the productive capacity of the planet and all its parts: maintaining social, natural, physical and human capital stocks. (see, e.g. Arrow et.al.) - also the UN IHDP's 2012 Inclusive Wealth Report (highlighted by the Economist), which raise the question about  substitutability between different sorts of capital (human, social, natural and physical (produced))
   
3. However, once stated in this way, most people (economists included) might well wish to add that the present distribution of wealth, income, consumption and living standards (quality of life) leaves a lot to be desired, and hence is socially (even morally) unsustainable.  So sustainability should also include the provision to improve welfare, especially of those currently less well-off.
4. Once again, however, adding this proviso raises several more practical issues -
• raising the welfare of those less well-off either involves a redistribution of income and wealth from the rich to the poor, or increasing the income and wealth of the total population, or a combination of the two.  Since there is little evidence from either history or logic that the rich are willing to redistribute their wealth or incomes to generate an acceptable improvement in the welfare of the poor, it is practical to presume that satisfaction of this social ambition necessarily requires continued growth in income and wealth. Hence, the common (near ubiquitous) ambitions of most societies are expressed as both wealth creation and welfare improvement.
• history strongly suggests that pursuit of wealth creation increases, rather than reduces, the ecological and environmental footprint of man (and woman) on the planet, and generates greater depletion of and damage to the planet's natural resources and environment.
• the only counteracting forces to this increase in damage and depletion appear to be:
• improved technologies (including, importantly, improved management and organisation and governance of human transactions and actitivies), allowing more to be produced (and consumed) for less - an improvement in the efficiency of use of the life support system (the planet's natural resources) - so developed economies now consume considerably less energy per pound (or dollar) of national income than they used to, for instance.
• increased incomes and wealth appear to generate increased values for natural environments and increased efforts to reduce pollution, at least in specific localities and for specific aspects of the environment, which leads to an increased willingness to pay for environmental and resource conservation.
• increased income and wealth, especially if associated with increased security (especially for the elderly) appears to be associated with reduced population growth rates (lower birth rates especially). Western Europe, for instance, now has a declining population (except for inward migration).
• Changes in consumption patterns - towards less resource intensive/environmentally polluting goods, services and experiences.
5. Sustainability is typically taken to embrace or comprise three major axes: Social; Environmental; Economic.  This conception seems to imply that the major choices, decisions and judgements to be made about sustainability have to be made outside this three dimensional system (with some external/superior reference point?) - by the political institutions of the planet?  And, is technology irrelevant, even though it is arguably what got us into this state?

---

2.    Possibilities?

---

i.    Market Failure Problems:  - externalities and public goods -> valuation and transaction cost problems

• prices signalling accurately both willingness to pay from consumers and users, and willingness to continue providing from suppliers (firms) - otherwise markets have no chance to balance willingness to pay (demand) with willingness to provide (supply) - some markets, especially at their birth and during their early growth, are too thin (too little trade) to establish reliable signals about supply and demand to the participants. Such markets may also be plagued by monopolistic problems, where single producers charage what the market will bear, and rip consumers and users off as a consequence.
• prices reflecting the social (rather than simply the private) costs and benefits.  When social costs and benefits of economic activities are different from the sum of the private costs and benefits (as expressed in market prices), then there are important externalities. Externalities arise when the activity of one person, household or firm causes a loss or a gain to another, and where these losses or gains are uncompensated or unrewarded. If the gain or loss effects are compensated or rewarded, then we have a normal market transaction - externalities are those effects which are outside (external to) the market mechanisms of payments and contracts. If these exist (pollution is the classic example) - then the market system will fail to take proper account of the social costs and benefits. - see here for a more extensive discussion of these problems and issues.
• products (goods and services) being competitive (rival in consumption) - so that my consumption or use denies you the use of the same units).  If, however, we have a public good - such as a pretty landscape, or a lighthouse, or street lighting, or a particular natural environment, or national defense system, or global warming - once this good (or bad) is provided for one, it is provided for everyone at the same time (it is non-rival in consumption), and no-one can be excluded from taking advantage or gaining benefit (or suffering) from it (it is also non-excludable) - see here for a more extensive discussion of these issues.  These goods cannot easily be provided by the market system, because the suppliers cannot gurantee to be paid for their efforts by the users or beneficiaries - if the good is a public good, then everyone gets to enjoy it if it is provided at all, so what incentive is there for any one individual to consent to paying their share of the costs of provision?  Public goods thus suffer from the free rider problem - with not enough reward being provided for their supply, so not enough of the public goods are provided.  As the additional notes above indicate, the usual answer is for governments to provide these public goods through tax revenues, to which everyone is required to contribute according to their means.  However, people also behave altruistically (for the good of society as well as, or even in competition with, their own self-interests) and do contribute voluntarily towards the provision of some public goods. So, an alternative to the direct provision of these goods by the government would be for the government to subsidise these voluntary efforts (thus encouraging more voluntary contributions).

• Transactions Costs: for both externalities and public goods, the negotiations necessary between suppliers and users/beneficiaries (or sufferers in the case of public bads or negative externalities) are complicated, typically because there are many people affected, and the good or activity affects many different people in different ways.  Because transactions are economic activities (they take time, effort and resources to do), these transactions are in competition with other uses for these resources, time and effort, and will not be undertaken unless the rewards from successul transactions more than outweigh the costs of making the transaction.  In many cases, there have not been in the past sufficient rewards from the solution to externality or public good problems for people to make the effort to solve the transactions problems.
• Property Rights. Even when transaction cost problems can be overcome economically, there is often a further factor giving rise to problems - who owns the property rights - who has the right to expect benefits (or expect reductions in damage or depletion)?  Who owns the sea, or the atmosphere, or the view, or the natural environment?  We all do - which means everyone does, and anyone could represent these interests, but since anyone could, no one actually does.  It becomes a problem of governance - which is especially difficult for global externalities and public goods, because we do not have a world government (though see here for an example of an effort in this direction).
• Pricing & Valuation Problems:  by definition, externalities and public goods are not freely traded between people, so no one has any experience of trading these effects, benefits etc. off against other things.  In general people put value on things or effects for three major reasons:
• Use Values - the thing or effect is valuable because it is useful in providing either productive capacity or consumption benefits
• Option Values - things are valuable because they may become useful sometime in the future (or in different circumstances) - so it worth having them about as an insurance policy
• Existence Value - things are valuable in their own right - it is nice to have them about.

ii.    Problems of Substitution between physical (man-made) and natural capital -> valuation problems again

As stocks of Kn are used up, so they will become scarcer, and thus more valuable (more expensive) - which will both encourage more efficient and economical use of the remaining stock, and encourage the search for and use of alternatives (renewables). We are already seeing some of these natural reactions, as renewable energy sources and energy efficiency measures become more attractive (energy use per £ of GDP is now considerably lower than it was), while we are becoming more concerned about waste disposal as the costs of damage become more obvious and the value of the natural environment increases (less of it per £ of GDP). However, there are 2 major problems with this natural (market) reaction to depletion of natural capital, each of which can compromise the resilience of market systems to cope with unforseen catastrophes.

1. uncertainty and technological lags:  Increasing man made capital (Kk) is investing in the future - providing increased capacity to produce and consume at future dates. The future is uncertain.  The more uncertain it is, the lower the incentive to invest, since the probabilities of sufficient returns being generated to repay the investments are lower.  Furthermore, the greater the technical problems of developing alternatives, the longer the lag between recognising the need to invest and the provision of the alternative, and thus the greater the uncertainty and the lower the incentive. Long lead times, and large technological gaps mitigate against simply rational investment decisions - where simply rational means relying on probabilities of outcomes, and treating beneficial outcomes with the same weights as detrimental outcomes. We end up doing too little too late, because we are myopic, except that we don't always.
2. irreversibility: the simple economic mechanisms tend to assume that economic processes are reversible - if we make mistakes, we can rectify them later. Burning up fossil fuel reserves which took 300 million years to accumulate in 300 years or so is nearly certain to have significant effects on global carbon balances and hence on global climate. But what will be the effects?  We remain uncertain, and we certainly don't know that they will be all bad, though there will be some bad effects.  It is tempting to suppose that we can make good, or at least make do and mend, if we fail to make the appropriate decisions now to limit (or even reduce) carbon emissions - that we can live with our mistakes. But this may turn out to be impossible, or impossibly expensive.  So surely it is more sensible to be cautious now - to adopt the precautionary principle (PP): if we don't know what the effects of certain actions will be, better to avoid them altogether, especially if the possible effects include serious and irreversible damage.  But universal adoption of this principle would eliminate many innovations and many experiments (trials by error), and limit our ability to cope with the future.  In the end, regardless of whether we are economists or not, we take decisions based on guesses about the relative merits - a balance between some guess about the possible benefits versus the possible costs. The PP really only amounts to the identification of those cases where the possible costs sufficiently exceed the possible benefits as to make the case (decision) daft. Deciding on these cases necesarily involves judgements about relative values of costs and benefits.

iii.    Identification and Valuation of non-market goods and services

Is this point (S) the sustainable point of intensity?
Identification of this point requires that the following critical components be identified:

1. The biophysical consequences of particular land use decisions and practices for the rural environment ? the shapes and locations of the various curves (relationships) in physical terms as intensity is increased (and as production practices are changed).
2. The behaviour of land managers and users in response to market or policy signals - showing what they will do under different market and policy conditions, and the decisions they will make about land use.
3. The social valuations of the care (conservation, amenity, recreation and environmental) goods and services themselves - these are typically non-market goods and services, and it is difficult, but not impossible, to estimate peoples willingness to pay for these attributes and services. See here for some brief notes on the approaches.

• get the price of biomass “right” (without distorting and supporting it, which shifts the biomass curve upwards and to the right);
• “properly” reflect the public or social values of the care goods (including pollution) back to the landowners and users.

Notice, however, that this characterisation of the problem is:

1. Spatially heterogenous - there will be different curves (relationships) for different parcels of land
2. Temporarly dynamic - these relationships will change through time as new techologies appear and as preferences and social valuations change
3. Behaviourally heterogeneous - different people, as land onwers and land users, will respond differently to the same market and policy signals.

iv.    Capital: Choices between now and the future (the tyranny of the discount rate)

But, we will discover that the biophysical attributes of the environment will be changed according to which land use we choose - the natural capital stock will change through time. So, too will the values people attach to these attributes (both individually and collectively). And, we may imagine, we could do better if we had and used different technologies.  In short, if we did things differently NOW, we would live in a different world in the FUTURE.  But, in order to decide whether or not we should do things differently now, we need to be able to compare the value of the different future conditions we generate with the costs of doing things differently now. Furthermore, the future is a stream of (annual) net benefits or costs, while NOW is a single value.

In simple terms, the value of the future might seem to be simply the sum of all the annual net benefits (NB(t), for each year t in the future) from a particular course of action, which can be compared with the current costs (K) of achieving this net benefit stream, where K is the investment necessary to achieve the future benefit stream.  But, for how long in the future - for ever?  Then any positive net benefit stream, however small the future benefits, will always outweigh the current costs, however large these may be, simply because the sum of an infinite stream is infinite. So this is clearly quite impractical as a guide to decision making.

It is also socially unsustainable - we do not behave as if the future were of exactly equivalent value as the present.

• We only save (invest) if we think the extra returns will pay us to wait (will pay us to curb our natural impatience) - we need to be rewarded for saving - we express a personal time preference rate (p) as the rate of return (5% say, so p = 0.05) we are willing to accept to delay our consumption and enjoyment.
• Furthermore, we (as banks, or pension funds etc.) will only lend our own income to finance such investments (incurring costs now for some future benefit) if we are promised repayments which include a reward for waiting - and at least match the returns we could earn by investing in something else.  The returns we could earn by investing in something else is the opportunity cost of capital - r. So, if we invest £100 in the bank now, at an interest rate of 5%, (r = 0.05) we will get back £105 next year, with the £5 being both our reward for waiting, and the return we get for lending our income to the bank (who then lend it on to someone else to use now).  If we could earn a higher rate of return by lending to someone else (a local small business, or investing in the stock market) then we would be wise to do so. This opportunity cost of capital then represents the returns to be earned on alterntive forms of investment - the returns we get from incurring present costs to do something else rather than the current object of our investigation - the project under consideration.
• But, of course, there is a risk associated with these alternatives - we may not get the return we expect or hope for, we may even suffer a loss. So, we will demand a risk premium (m) to compensate us for this uncertainty.  The higher the uncertainty about a future return, the greater the risk premium we demand.
  
• If we expect inflation in the future, we will also require our future return to compensate for the loss in value of the money caused by inflation.  The opportunity cost of capital will therefore include appropriate adjustments for the risk associated with alternative investments.

Now we can compare current costs (K) with a future stream of net benefits (NBt).  NB1 - the net benefit we expect to get by the end of year 1, will need to be greater than our cost of securing this benefit now by at least the rate of interest, to make the current investment worthwhile.  So, if we invest £100 now, we need to be sure that our NB1 is at least £105 at a 5% interest rate (= £100 *(1.05)).  In other words, the Present Value (PV) (£100) is equivalent to a Future Value (FV) of £105)

So: FV1 = PV(1+i); or PV = FV1/(1+i).  This is the principle of discounting, where the interest rate is used as a discount rate - discounting the future value to its equivalent present value.  Repeating the same logic for year 2 gives FV2 = [PV(1+i)](1+i)] = PV(1+i²), so for year 2, PV = FV2/(1+i²), and so on as t increases.

The further into the future, the lower is the present value of the future benefit. This discounting of the future is even more severe if there is any uncertainty about our future return, since this uncertainty adds a risk premium to the discount rate.  The greater the uncertainty, the higher the risk premium.  Our behaviour is necessarily myopic - we could not make decisions over time unless this were the case.

Most modern mixed economies operate at a base interest rate (excluding inflation) of about 3 to 6%.  Simple arithmetic - the tyranny of discounting - quickly reduces anticipated future benefits to rather low present value at these rates of interest. For instance, £1000 in 30 years time is only worth £167 today, at a 5% discount or interest rate, and is only worth £333 today at a 2% discount rate.  Predecitions of general catastrophy in 50 years time, coupled with a considerable amount of uncertainty surrounding the nature of this catastrophe, does not warrent very large investments NOW.  Try getting people to pay for avoiding them, and see both the logic and the evidence of this.

The converse also applies:  to get £1000 in 30 years time, so long as there is no risk or uncertainty, we only have to invest £167 now, at 5%.  At 2% return, we will need to invest £333 now.  A little spent now might generate considerable returns in the future.

v.    Problems of Efficiency versus Equity (choices between us and them) (markets versus democracy)

However, as humane societies, we also worry about caring for the less well off, at least some of the time, and expect our governments (and NGOs) to look after the poor on our behalf.  We might, therefore, be prepared to weight the interests of the poor (the benefits they may get) rather more highly than the interests of the rich?  Similarly, we may want to count the costs more highly if they are suffered by the poor rather than by the rich.  To do so requires that we use our governments, through democracy, to exercise these social and caring judgements on our behalf.

Does this mean that we should count future generations welfare at a higher level than our own?  Won't they be richer than us, providing our recent history of economic growth can be sustained?  Won't they be cleverer than us?

Does this mean that we should care more about the very poor, who live a long way away from us, than we care about the relatively poor on our own doorstep?

Questions of sustainability also raise these uncomfortable questions, which cannot be resolved through the market place, but need to be resolved through our governments, through collective action of some sort.

See, also:
Dan Bromley:  "The poverty of sustainability: rescuing economics from platitudes."  Paper to International Association of Agricultural Economists, Durban, SA, August, 2003
DRH:  "Agri-environmental Relationships & Multifunctionality: Further Considerations", World Economy, 26 (5), May, 2003, 705 - 725
See here for notes on Climate Change.

Comments and Suggestions??