What is environmental economics?

If economics is the study of how society allocates scarce resources to satisfy human wants, then environmental economics considers this statement in light of how economic activity impacts the environment. We know from our study of market failure, that the external costs resulting from consumption and production in free, unregulated markets have a negative effect on the environment and that governments along with international organisations have an important role in correcting these failures.  

This section of the textbook looks in detail at the impact common pool resources have on environmental economics. It considers how government policy and international agreements look to correct the market failures associated with common access resources and make economic activity more sustainable.

Common pool (access) resources and sustainability

What is a common pool resource?

Common pool resources are natural resources that firms and individuals can access in society without restriction. Common pool applies to resources like forests for timber, the sea for fish and areas of land for mineral deposits. 

Characteristics of common pool resources

Common pool resources are associated with two characteristics:

• Common pool resources are non-excludable because they occur naturally in the environment, and without government intervention, it is very difficult to limit access to them. Anyone can access fish in the sea and cut down trees in a forest if there is no legal system to prevent people from doing this

• Common pool resources are rivalrous because the consumption of them by one individual does reduce their availability to others. If someone takes fish from the sea or cuts down a tree it is not available for someone else.

Property rights

Property rights exist when an individual or a firm has ownership of a resource. When a farmer owns a field they have property rights over that field and have the legal right to control its use. They can put a fence around it and other people cannot legally use the field. Common pool resources do not have property rights assigned to them and nobody owns them. For example, there are no property rights on the open sea. The lack of property rights makes common pool resources non-excludable.

Sustainability

This is where the use of resources in the economy meets the needs of the present generation without adversely affecting the needs of future generations. Unsustainable economic activity is often associated with the over-consumption of common pool resources which reduces their availability to people in future. They are also often associated with external costs which have a negative impact on people in the present and also people in the future. The way the burning of fossil fuels impact the atmosphere as a common pool resource is an important example of this.

Common pool resources and market failure

Non-excludability and zero price

The non-excludable nature of common pool resources means there is no price attached to their consumption. In many cases common pool resources are also used in production, so free access to them at zero price means they are a zero cost to producers who use them.  This leads to their exploitation. If an area of land can be freely accessed to cut down trees, people will clear a forest in an unrestricted way until significant deforestation has taken place and there is no forest for future generations to benefit from. The exploitation of common pool resources means they are being used in an unsustainable way.

External costs

When common pool resources are over-consumed there will often be significant external costs as well. Deforestation negatively affects third parties because it adds to climate change and reduces biodiversity. You can also make the externality argument when the use of common access resources now reduces their availability to future generations. Over-fishing now means fish will not be available to people in the future who would be considered a third party. 

Diagram 2.51 illustrates the external costs of overfishing the sea. The market output is at Q which is above the socially efficient output of Q*. There is an over-allocation of resources and the yellow shaded area represents the welfare loss to society.

Developing countries

The exploitation of common pool resources often takes place in less developed countries where property rights are not established effectively. People in poverty are often forced to exploit cheap resources available to them. Lots of deforestation takes place in developing countries when people are involved in illegal logging and mining to make enough income to survive.

Tragedy of the commons

Garrett Hardin: Tragedy of the Commons

The theory of the tragedy of the commons was put forward by an ecologist called Garrett Hardin. He argued that the use of common pool resources leads to a ‘shared-resource system’ where people over-produce goods using common pool resources because it is in their self-interest to do so. If a resource can be accessed at zero price then it is in the producer’s self-interest to make as much profit as they can from using a zero priced resource.  People are likely to over-fish the sea or cut down a rain forest because of the profit they can make doing this. The tragedy of the commons shows how common pool resources are a market failure and are not sustainable.

Free rider problem

The free-rider problem also applies to common pool resources where some people choose to benefit from other people’s actions. All people in the fishing industry might accept there is a need to reduce fishing in the present to preserve stocks for the future and agree to cut current fishing. But as a voluntary agreement, some producers might keep fishing at the same level and free ride off the reduced fishing of others.

Policy approach to common access resources

Common access resources need government intervention because their use leads to an over-allocation of resources. This depletes resources for the future which is unsustainable and the over-use of common pool resources leads to negative externalities.

Assigning property rights

Economists often look at the problem of common pool resources as a property rights issue.  A property right is an individual’s right to control what they own and to be compensated when that right has been infringed.  If someone takes flowers from your garden, you can take legal action against the person who has taken them.  The use of common pool resources is un-controlled because there are no property rights assigned to them. Anyone can access a piece of common land, a river or a lake and extra resources without any legal restriction.  By assigning property rights to a forest people who cut down trees have to pay the owner who can use the income to plant new trees.  Without property rights, people will cut down trees and not replant them which means deforestation will take place.

Advantages of property rights:

• Property rights provide a market solution to the common pool resources problem. By allocating property rights common pool resources now have owners and can be made excludable.
• Owners of common pool resources have an incentive to manage them sustainably or there will not be a long-term source of income from them.
• Allocating property rights is a relatively low-cost way of dealing with the common pool resource problem.

Disadvantages of property rights:

• The owner might not have social efficiency as an objective of their ownership of a common pool resource. An owner of a forest might allow deforestation.
• Some common pool resources are areas of natural beauty that society wants to be maintained in a particular way. National parks, for example, are owned and controlled by governments.
• The legal costs associated with the resolution of property rights disputes can be significant.
• It is not always practical to assign property rights. Many external costs are ‘air-borne' and it is not possible for people to own the airspace around them.

Command-and-control regulation

Endangered Species Act (ESA)

The aim of command-and-control regulations is for government to set specific limits on environmental pollution. The regulations also set out how technology can be used to control pollution. Examples of command and control regulations come from the US in the form of The Clean Water Act, Endangered Species Act and The Clean Air Act. For example, the US has government-imposed regulations on power plants to use cleaning technology in their smokestacks that removed pollutants like sulphur dioxide. There is also an Endangered Species Act that prevents the hunting of certain wild animals.

Advantages of command and control regulation

• By using the law, it forces firms to take action that reduces the negative externalities of production that occur with the exploitation of common pool resources
• It provides a set of regulations to form a national framework that reduces the environmental costs that are associated with common pool resources
• Strict command and control regulations can induce firms to develop technology that allows them to meet the regulations set. This is known as the Porter Hypothesis, named after the economist, Michael Porter.

Disadvantages of command and control regulation

• There are no incentives for businesses to improve the quality of the environment beyond the standard set by the law.  Firms do not need to improve their production methods if they are within the regulations set.
• The regulations do not distinguish between firms that find it easy to meet the standards set and those that do not.  For those that find it difficult, the regulations will come with a significant cost and those firms may even go out of business which will lead to unemployment.
• Like any regulation, they will increase production costs which could cause unemployment and lead to higher prices for consumers.

Collective self-governance

The collective self-governance approach to the negative environmental consequences of common pool resources is based on the work of Nobel Prize-winning Economist, Elinor Ostrom. Her theory viewed government-directed regulation as bureaucratic and less effective at achieving their environmental aims as ordinary citizens working together to solve environmental problems.

Ostrom found evidence across the world of local people working together to solve the environmental costs associated with the tragedy of the commons. Left to themselves the local population would find solutions to environmental problems that met their own needs rather than those of a detached government imposing them from some distance away.

An example of self-governance is Maine’s fishing community that specialises in lobster. In Main’s fishing towns the local people make and monitor their own rules and have their own set of punishments for people who break the rules. The fishing territory for lobster is broken up into set boundaries decided on by the fishing community and groups known as ‘harbour gangs’ are only allowed to fish in their allocated area. This approach to dealing with common pool resources is backed by formal government regulation on catching lobsters.

Advantages of collective self-governance

• This approach allows for the needs of local communities who know and understand the specific issues they face from common pool resources and are more likely to follow their own regulations rather than those imposed on them.
• By working at a local level, the negative externalities associated with the common access resources can be targeted specifically rather than a ‘one size fits all’ national approach.
• Collective agreements are more flexible than national regulations and can change as the environmental situation changes. If the lobster population suddenly declines the catch regulations can be tightened quickly.

Disadvantages of collective self-governance

• Without legal backing, the enforcement of rules relating to common pool resources relies on the goodwill of participants and this may not always be present. What happens if one business in Maine decides to catch lobsters outside of its area and refuses to follow local rules?
• Collective self-governance might work in the present but may not consider the future in the same way. If the incomes of people in the lobster industry start to fall, there would be pressure to catch more now which reduces the sustainability of the industry
• Many common pool resource issues are global and cannot the effectively managed at a local level.  

Carbon tax

Carbon taxes are imposed on the use of fossil fuels such as coal, oil and gas. Carbon taxes focus precisely on one of the most significant causes of climate change by directly trying to reduce CO2 emissions from the use of fossil fuels. The tax is levied on firms based on the amount of carbon they use to produce their good or service. The tax aims to get businesses and consumers to switch to energy generated by renewable sources such as solar and wind power. Some of the taxes levied on businesses would increase the price the consumer pays, but this could be repaid to consumers through a tax credit paid from the tax revenue collected by the government.

Diagram 2.52 illustrates how a carbon tax affects the market for electricity. The tax causes the supply curve to shift to the left and cause the market price to rise to P1 and output Q to shift to Q1 which is closer to the socially efficient output at Q*. The welfare loss triangle is reduced from the yellow shaded triangle to the smaller green triangle.

Advantages of a carbon tax

• The tax focuses on a major source of climate change and acts as an incentive for firms to switch to renewable sources of energy.
• Revenue raised by the tax can be used to subsidise innovation in the development of renewable energy.

Disadvantages of a carbon tax

• A tax will increase the price of energy to consumers if producers pass on the tax increase. This could have a significant impact on low-income households.
• As business costs are increased by the tax it reduces their profits which leaves businesses less money to invest in developing low-emission technology.
• Higher production costs resulting from the tax could lead to a reduction in output and cause unemployment.

Tradeable permits

The use of tradeable permits or carbon training is seen as an important ‘incentive based’ method for businesses to reduce CO2 carbon emissions. Air is a common access resource and tradeable permits create a market that introduces a limit to the amount of CO2 pollution that can be emitted into the air.

For detailed coverage of this policy see chapter 2.8(2) on policies to deal with external costs.