1. Environmental Economics and the Cost-Benefit Analysis
Miller (2003): Chapter 2

2. Economy and Economics
An economy = a system of production, distribution, and consumption of goods and services that satisfy people’s wants or needs
Economics = the science that studies the choices that people make when demand (need) > supply
Scarcity = our inability to satisfy our demand (need)
All economic problems arise from scarcity
Remember, living sustainably means living off interest and not the capital that supplies the interest.

3. Resource Allocation
Resource allocation: all nations and societies must allocate their resources in order to meet their needs
When allocating limited resources
Need to make choices
The cost of these choices = opportunity cost (the cost associated with giving up an opportunity)
Some basic economic questions to ask when dealing with scarcity and efficiency in resource allocation:
What goods and services to produce?
How to produce them?
How to distribute them?
For whom to produce them?

4. Economic Systems Two major types: Pure command economic system
Market economic system

5. Pure Command Economic System
This theoretical ideal has no markets - government makes all economic decisions:
No person may independently decide to open and run any kind of business
The government decides what goods and services are to be produced
The government sells these goods and services
The government decides how the talents and skills of its workers are to be used

6. Market Economic System
This theoretical ideal has no governments - markets are used to make all economic decisions:
A nation's economic decisions are the result of individual decisions by buyers and sellers in the marketplace (all buying and selling is based purely on competition)
For example, U.S. has a market economic system:
People there may go to work where they choose
They are free to go into business on their own
The price that the sellers charge for their goods or services will depend on the prices charged by the competitors

7. In theory, economic decisions could be undertaken exclusively through markets or governments.
In reality, all economies rely on a mix of both markets and governments for economic decisions - mixed economy.

8. Economic Growth
Virtually all economies strive for economic growth, usually by maximising the flow of matter and energy resources by means of
More population growth (i.e. more consumers), and/or
More consumption per person
All economic goods and services have both internal and external costs.

9. Internal Costs
For example, the price a consumer pays for a new car reflects the costs of
Factory
Raw materials
Labour
Marketing
Distribution
Mark up (profit)
Running costs
All these direct and indirect costs, which are paid for by the seller and the buyer of an economic good = internal costs

10. Hidden External Costs
However, extracting and processing raw materials to make and run cars:
Deplete non-renewable energy and mineral resources
Produce solid and hazardous wastes
Disturb land
Pollute air and water
Contribute to global climate change
Reduce biodiversity
These harmful effects passed on to the workers, the public, the environment, and in some cases future generations = external costs

11. External costs (the harmful costs): not included in market price
People do not connect them with car ownership
Still, everyone pays these hidden costs sooner or later, in the form of
Poorer health
Higher costs for health care and health insurance
Higher taxes for pollution control

12. Internalizing External Costs
For most economists, the solution to the harmful costs of goods and services
= Include such costs in the market prices of goods and services
= Internalizing external costs
However, internalizing external costs will not occur unless required by government regulation.
Why?

13. Environmental Costs
By internalizing external costs (e.g. voluntarily install pollution controls)
 Need to sell goods and services at higher price (compared to competitors who do not care about external costs of their goods and services)
 At competitive disadvantage
 Profits decline
How can the government help about this?

14. Government can:
Impose taxes
Pass laws
Provide subsidies
Use other strategies that encourage or force producers to include external costs in market prices
Market price = full costs of goods and services

15. Full-Cost Pricing Full-cost pricing = Internalizing external costs
At full-cost pricing,
Market price = Internal costs + External costs (short- and long-term)
Must have government action: few companies will willingly increase their cost of business and raise consumer prices (competitive disadvantage)

16. Good News about Internalizing External Costs
Internalizing external costs of pollution and degradation would make:
Preventing pollution more profitable than cleaning it up
Waste reduction, recycling, and reuse more profitable than burying or burning most of the waste produced
Consumers accessible to information about environmental and health effects of goods and services

17. To internalize external costs, governments must also:
Reduce income, payroll, and other taxes
Withdraw subsidies and tax breaks that encourage environmentally harmful businesses
(e.g. the government subsidies for unsustainable forestry, for overfishing, and for using non-renewable fossil fuels, which discourage energy conservation and development of less harmful renewable energy alternatives)
Otherwise, consumers will have to pay higher market prices without tax relief  policy guaranteed to fail!

18. More Good News about Internalizing External Costs
Some goods and services may cost less because internalizing external costs encourages producers to:
Find ways to cut costs by inventing more resource-efficient and less-polluting methods of production
Offer more environmentally beneficial (sustainable) products – i.e. “green” products

19. What is Cost-Benefit Analysis (CBA)?
A widely used tool for making economic decisions about how to control pollution and manage resources
Comparing the estimated short- and long-term costs (losses) with the estimated benefits (gains) of a proposal (e.g. whether a wetland should be filled)
Often used to decide whether to proceed with a given project
All costs and benefits are given monetary values and compared by means of a cost-benefit ratio
A favourable ratio for a project
 Benefits of project > Costs
 Project is cost-effective

20. “Zero Pollution” For more extreme environmentalists “Zero pollution”
Ideally, yes – but in the real world, not necessarily!
Natural processes can handle some of our wastes
We can tolerate low air pollution levels
Pollution control costs money
 We cannot afford to get to zero pollution!
Beyond a certain point
Clean-up costs > Harmful costs of pollution
Businesses go bankrupt
People lose their jobs

21. Increasing cost of cleaning up
Case Study: Cleaning Up Air Pollution 25 50 75
100
As more pollutants are removed, cost of removing each additional unit increases.
Increasing cost of cleaning up
pollutant removed ($)
Cost per unit of
Percentage of pollutants removed (%)
Very expensive to get to zero pollution
The cost of removing each additional unit of pollution rises exponentially
 Cheaper to prevent it than to clean it up (See Fig 2-6, Miller (2003))

22. The Benefits Of Clean Air25 50 75
100
Benefits ($ value)
Percentage of pollutants removed (%)
Additional benefits to be derived from pollution control tend to level off and become negligible as pollutants are reduced.

23. Value of benefits derived Cost of pollution control
Cost-Effectiveness 25 50 75
100
Benefits ($ value)
Percentage of pollutants removed (%)
Value of benefits derived
Cost of pollution control
Costs > benefits
Area of optimum cost-effectiveness
Optimum (most favourable) cost-effectiveness is achieved at <100% pollution control. Spending more to achieve maximum reduction may yield little benefit and hence may be cost-ineffective.

24. Most cost-effective effort
Optimum Level Of Pollution 25 50 75
100
Costs ($)
Pollutants remaining (%)
Minimal
effort
Better
Most cost-effective effort
Costs to society
Cleanup costs
This curve is the sum of the two bottom curves = total costs
High
Low
To find the break-even point, economists plot (1) estimated costs of cleaning up and (2) estimated social costs of pollution (harmful external costs of pollution to society), then add the two curves to get a third curve - the total costs. Lowest point on the third curve (the breakeven point) = optimum level of pollution. This graph shows the optimum level at 50%, but the actual level varies with the pollutant. (See Fig. 2-7, Miller (2003))

25. Limitations about CBA
There are several controversies about CBA, one involves the discount rate:
Discount rate = An estimate of a resource’s future economic value compared with its present value
Size of the discount rate: a primary factor affecting the outcome of any CBA

26. Discount Rates
At a zero discount rate, a forest of redwood trees worth $1 million today will still worth $1 million in 50 years – so no need to cut them down.
However, at a 10% annual discount rate (typically used by businesses, U.S. Office of Management and Budget, World Bank), the same trees = $10,000 in 50 years.
 Makes sense from short-term economic standpoint to cut the trees down as quickly as possible and invest the money in something else.

27. High Or Low Discount Rates?
Supporters of high discount rates (5-10%) argue that inflation will reduce the value of their earnings
 Encourage rapid exploitation of resources for immediate profits
 Impossible for sustainable use of potentially renewable resources
Critics suggest
0% (or negative) discount rate
 Should be used to protect unique and scarce resources
1-3% discount rates
 Encourage more sustainable use of resources

28. Who Benefits And Who Is Harmed?
In U.S.: ~100,000 people die each year from exposure to hazardous chemicals and other safety hazards at work
In many developing countries: even worse
Critical Thinking:
(1) Is it a necessary or unnecessary cost of doing business?
(2) How do you put a value (price tag) on good health, clean air and water, wildlife habitats, endangered species?