Environmental Economics Research Paper

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On the political stage, environmental issues are usually placed at odds with economic issues. This is because environmental goods, such as clean air and clean water, are commonly viewed as priceless and not subject to economic consideration. However, the relationship between economics and the environment could not be more natural.

In its purest form, economics is the study of human choice. Because of this, economics sheds light on the choices that individual consumers and producers make with respect to numerous goods, services, and activities, including choices made with respect to environmental quality. Economics is able not only to identify the reasons that individuals choose to degrade the environment beyond what is most beneficial to society, but also to assist policy makers in developing environmental policy that will provide an efficient level of environmental quality.

Because environmental economics is interdisciplinary in nature, its scope is far-reaching. Environmental economists research topics ranging from energy to biodiversity and from invasive species to climate change. However, despite the breadth of the topics covered by the community of environmental economic researchers, a reliance on sound economic principles remains the constant.

This research paper outlines the basic concepts in environmental economics, including the ways in which environmental economists might estimate the value society holds for the natural environment. Further, the corrective instruments that environmental economists can employ to correct for situations in which markets fail to achieve an efficient outcome are closely examined. This research paper also stresses the important role economic analysis plays in today’s most pressing environmental issues.

Theory

Environmental goods are those aspects of the natural environment that hold value for individuals in society. Just as consumers value a jar of peanut butter or a can of soup, consumers of environmental goods value clean air, clean water, or even peace and quiet. The trouble with these types of goods is that though they are valuable to most individuals, there is not usually a market through which someone can acquire more of an environmental good. This lack of a market makes it difficult to determine the value that environmental goods hold for society; although the market price of a jar of peanut butter or a can of soup signal the value they hold for consumers, there is no price attached to environmental goods that can provide such a signal.

To some, it may seem unethical to try to place a dollar value on the natural environment. However, there are plenty of cases in which ethics demands just that. Indeed, in cases of extreme environmental damage, such as the 1989 Exxon Valdez oil spill, an unwillingness to apply a value to environmental loss could be considered equivalent to stating that environmental loss represents no loss to society at all. Because of this, the assessment of appropriate damages, fines, or both, in cases such as this often depends on the careful valuation of varying aspects of the environment.

In the case of environmental policy development, insufficient evidence pertaining to the benefit that environmental goods provide to society could easily skew the results of a cost-benefit analysis against environmental protection. This would, in effect, undermine the value that society holds for environmental goods and could possibly lead policy makers to believe that certain environmental regulations are not worth the costs they impose on society when, in fact, they are.

For these reasons, as well as for other reasons that are covered later in this research paper, economists have long endeavored to develop methods of accurately determining the value of environmental goods to society. This effort has led to the development of several valuation techniques.

Valuing the Environment

Contingent Valuation

Contingent valuation, or stated preferences, is a seemingly simple method of valuation that involves directly asking respondents about their values for a particular environmental good. This method is particularly useful in determining the value of environmental goods that individuals have yet to experience or may never actually experience themselves.

The Exxon Valdez oil spill is an example of a case in which contingent valuation provided a useful tool of valuation (Goodstein, 2008). In this case, contingent valuation was used to determine, among other things, the value that individuals place on simply knowing that a pristine Alaskan wilderness exists, even though many respondents may never actually experience this wilderness for themselves (this value is defined as existence value). More generally, contingent valuation methods are often used in policy development to determine the amount respondents would be willing to pay for a new, higher level of environmental quality.

However, despite its simple concept, the contingent valuation method carries with it a host of complex problems that must be taken into account for the results of a survey to be considered credible. These problems usually stem from one or more of the following: information bias, strategic bias, hypothetical bias, and starting point bias (Tietenberg, 2007). Because any type of bias can hinder the usefulness of a contingent valuation survey, special care must be taken to ensure that any bias in the answers provided by survey respondents is minimized.

With information bias, hypothetical bias, and starting point bias, respondents unintentionally misrepresent the value that they hold for an environmental good. With information bias, respondents lack enough information to form an accurate response. To avoid this type of bias, surveyors will usually provide a great deal of information to respondents pertaining to the topic of the survey.

Hypothetical bias occurs because individuals tend to respond differently to hypothetical scenarios than they do to the same scenarios in the real world. One solution to this problem is to conduct the contingent valuation surveys in a laboratory setting (Kolstad 2000). This solution provides the surveyor with an opportunity to remind respondents to consider the financial ramifications that their responses would produce in a real-world setting. It also allows the surveyor to use experimental techniques that mimic the conditions that respondents would face in a real-world situation.

Finally, starting point bias results when respondents are influenced by the set of responses made available to them by the contingent valuation survey. The solution to this problem requires significant pretesting of a survey to ensure that its design does not influence respondents to provide biased answers (Kolstad, 2000).

Unlike the other types of response bias that can occur in a contingent valuation survey, strategic bias occurs as respondents intentionally try to manipulate the outcome of a survey. It is not always possible to eliminate intentionally biased responses. However, in general, it is best to randomly survey a large number of individuals because this will decrease the likelihood that strategic bias will undermine the overall results of the survey.

Revealed Preferences

The revealed preferences method involves determining the value that consumers hold for an environmental good by observing their purchase of goods in the market that directly (or indirectly) relate to environmental quality. For example, the purchase of air fresheners, noise reducing materials, and water purification systems reveal the minimum amount individuals are willing to pay for improved air and water quality. This particular revealed preferences method is referred to as the household production approach.

Economists can also use revealed preferences to determine the value of clean air and clean water through differences in home prices across both pristine and polluted home locations. This particular revealed preferences method is referred to as the hedonic approach (Kolstad, 2000).

These approaches to valuing the environment have the advantage of relying on actual consumer choices to infer the value society holds for a particular environmental good, rather than relying on hypothetical scenarios. However, there are some environmental goods for which it can be nearly impossible to identify their value through market interactions. For example, using the revealed preferences method to determine the value that society holds for the survival of an endangered species would pose a tremendous challenge. In cases such as these, revealed preferences may not be the preferred method of valuation.

Valuation techniques are useful not only in cost-benefit analysis or in cases of extreme environmental damage but also in the more subtle cases of environmental degradation that occur as a result of market failure.

Market Failure

As was discussed in the previous section, individual consumers will often purchase goods with an environmental component to make up for their inability to directly purchase environmental goods, thus revealing the value they hold for certain aspects of environmental quality. For example, someone may buy a cabin on a lake in order to enjoy not only the home itself but also the pristine environment that comes with such a purchase. As long as this individual is able to exclusively incur the environmental benefits that come from owning a log cabin, the demand for log cabins will reflect the full value of both the home and the environmental goods it provides and the market for log cabins will be efficient.

Unfortunately, in the case of environmental goods, markets often fail to produce an efficient result because it is rare that any one individual can incur the full benefit (or cost) of a particular level of environmental quality. This is because environmental goods commonly suffer from the presence of externalities or a lack of property rights.

There are two types of externalities: negative and positive. Negative externalities exist when individuals in society bear a portion of the cost associated with the production of a good without having any influence over the related production decisions (Baumol & Oates, 1988). For example, parents may be required to pay higher health care costs related to pollution-induced asthma among children because of an increase in industrial activity in their neighborhood.

Because producers do not consider these costs in their production decisions, they produce higher quantities of goods with negative externalities than is efficient, leading to more than the socially desirable level of environmental degradation.

As with negative externalities, positive externalities also result in inefficient market outcomes. However, goods that suffer from positive externalities provide more value to individuals in society than is taken into account by those providing these goods. An example of a positive externality can be seen in the case of college roommates sharing an off-campus apartment. Though a clean kitchen may be valued by all individuals living in the apartment, the person that decides to finally wash the dishes and scrub the kitchen floor is not fully compensated for providing value not only to himself or herself but also to the apartment as a whole. Because of this, the decision to clean the kitchen undervalues the benefits of such an action and the kitchen will go uncleaned more often than is socially desirable.

Such is the case with environmental quality. Because markets tend to undervalue goods that suffer from positive externalities, market outcomes provide a level of environmental quality that is lower than is socially desirable.

Corrective Instruments

Once the market inefficiency relating to a particular environmental good is understood, policy makers can correct for this inefficiency by employing any number of policy instruments. Regardless of the instrument, the goal is to provide incentives to individual consumers and firms such that they will choose a more efficient level of emissions or environmental quality.

Command and Control

Command and control is a type of environmental regulation that allows policy makers to specifically regulate both the amount and the process by which a firm is to reduce emissions. This form of environmental regulation is very common and allows policy makers to regulate goods where a market-based approach is either not possible or not likely to be popular. However, these regulations limit the choices that individual firms can make regarding their pollution levels. Because of this, they do not provide firms with an incentive to develop new pollution-reducing technologies (Kolstad, 2000).

The Coase Theorem

Ronald Coase developed the Coase Theorem in 1960, which, although not necessarily a regulatory framework, paved the way for incentive-driven, or market-based, regulatory systems. According to the Coase Theorem, in the face of market inefficiencies resulting from externalities, private citizens (or firms) are able to negotiate a mutually beneficial, socially desirable solution as long as there are no costs associated with the negotiation process (Coase, 1960). This result is expected to hold regardless of whether the polluter has the right to pollute or the average affected bystander has a right to a clean environment.

Consider the negative externality example given previously, in which parents face soaring health care costs resulting from increased industrial activity. According to the Coase Theorem, the firm producing the pollution and the parents could negotiate a solution to this externalities issue, even without government intervention. In this example, if the legal framework in society gave the firm the right to produce pollution, the parents with sick children could possibly consider the amount they are spending on medical bills and offer a lesser sum to the firm in exchange for a reduced level of pollution. This would save the parents money (as compared with their health care costs), and the firm may find itself more than compensated for the increased costs that a reduction in emissions can bring.

If it is the parents, instead, that have a right to clean, safe air for their children (this is more typically the case), then the firm could offer the parents a sum of money in exchange for allowing a higher level of pollution in the area. As long as the sum offered is less than the cost of reducing emissions, the firm will be better off. As for the parents, if the sum of money more than compensates the health care costs they face with higher pollution levels, they may also find themselves preferring the negotiated outcome.

Unfortunately, because the fundamental assumption of the Coase Theorem (costless negotiation) often falls short, this theorem is not commonly applicable as a real-world solution. Despite this fact, the Coase Theorem is an important reminder that even in the case of complex environmental problems, there may be room for mutually beneficial compromises. This theorem also sheds light on cases in which firms are willing to voluntarily comply with environmental regulations as well as on possible solutions to complex international environmental agreements.

Taxation

In 1920, Arthur C. Pigou (1920) developed a taxation method for dealing with the goods suffering from externalities. The idea behind his tax, now known as the Pigouvian tax, is to force producers to pay a tax equal to the external damage caused by their production decisions in order to allow the market to take into consideration the full costs associated with the taxed goods. This process is often referred to as internalizing an externality.

This concept can also be applied to goods that suffer from positive externalities. However, in this case, a negative tax (or subsidy) is provided to allow an individual to gain an additional benefit from providing the subsidized good. A common example of this type of subsidy can be seen each time an individual receives a tax break for purchasing an Energy Star appliance.

Of course, because the amount of the tax (or subsidy) must equal the value of the external environmental damage (or benefit) in order to correct for market inefficiencies, the valuation techniques detailed previously are crucial in the development of a sound tax policy.

Permit Markets

The concept of using a permit market to control pollution levels was first developed by John Dales (1968). Through this method of regulation, pollution permits are issued to firms in an industry where a reduction in emissions is desired. These permits give each firm the right to produce emissions according to the number of permits it holds. However, the total number of permits issued is limited to the amount of pollution that is allowed industry wide. This means that some firms will not be able to pollute as much as they would like, and they will be forced to either reduce emissions or purchase permits from another firm in the industry (Barde, 2000).

Those firms able to reduce their emissions for the lowest possible cost benefit from this type of regulation. This is because these firms can sell their permits for an amount greater than or equal to the cost of their own emissions reduction, resulting in profits in the permit market. However, even firms for which it is very costly to reduce pollution experience a cost savings through this type of regulation because they are able to purchase pollution permits at a price that is less than or equal to the cost they would face if they were required to reduce emissions. Ultimately, permit markets make it less costly for an industry to comply with environmental regulations and, with the prospect of profits in the permit market, this type of regulation provides an incentive for firms to find less costly pollution reducing technologies.

Applications and Empirical Evidence

Valuing the Environment: Practical Applications

Both the methods of valuation and the corrective instruments described previously have been applied quite extensively to real-world environmental problems. In fact, according to Barry Field and Martha Field (2006), contingent valuation methods have been used to determine the amount respondents would be willing to pay for a myriad of environmental goods. For example, respondents have been surveyed to determine the value they would place on increased air visibility in places such as the White Mountains (located in New Hampshire) and the Grand Canyon (located in Arizona). Further, contingent valuation methods have been used to determine the value of old-growth forest preservation in the face of industrial expansion (Hagen, Vincent, & Welle, 1992).

Revealed preferences methods have increased in popularity in recent history and are commonly used by researchers to determine the value society holds for clean air and clean water. Though there are many recent cases in which researchers have used revealed preferences methods, Eban Goodstein (2008) provided a particularly useful example of the way in which this method has been used in a real-world setting.

The example given involves the decline in housing prices that occurred in the town of New Bedford, Massachusetts, in the early 1980s following severe contamination of the nearby harbor. Using the hedonic approach, economists were able to determine that those homes closest to the contamination experienced a $9000 reduction in value while the overall loss to homeowners in New Bedford was estimated to be approximately $36 million (Goodstein, 2008).

Although this type of analysis provides only a minimum value of the loss experienced due to the pollution of the harbor, it can be a valuable component in determining an appropriate fine for the firms responsible for the pollution. More generally, these results also shed light on the value that individuals place on clean water.

Corrective Instruments: Practical Application

Though many of the concepts in environmental economics predate the 1970s, the implementation of the Clean Air Act of 1970 represents the first major application of these concepts to government policy. Through these amendments, strict ambient air quality standards were set, and in some cases, specific technologies were required for compliance (Tietenberg, 2007). This regulatory framework is consistent with the command-and-control framework described previously.

However, since the Clean Air Act Amendments of 1990, pollution taxes and permit markets have taken center stage in terms of environmental regulation. In fact, though permit markets were used in the United States as early as the 1970s, the Clean Air Act Amendments of 1990 ushered in an era of increased popularity for this type of regulation by requiring the development of a nationwide permit market for sulfur dioxide emissions.

According to Jean-Philippe Barde (2000), the Environmental Protection Agency implemented a program in response to this requirement that was expected to result in a significant cost savings (20%-50%) as compared with other types of regulation. Further, Thomas Tietenberg (2007) asserted that the development of permit markets increased compliance with federally mandated pollution reduction requirements.

Additional programs have been used to reduce ozone-related emissions, including California’s Regional Clean Air Incentives Market (RECLAIM), established in the Los Angeles basin, and the Ozone Transport Commission NOX Budget Program, which spans approximately 10 states in the eastern United States. (Both of these programs were originally implemented in 1994. However, the NOX Budget Program has since undergone several program modifications, including slight changes to the program name.)

The Ozone Transportation Commission program aimed to reduce nitrogen oxide emissions in participating states in both 1999 and 2003 (U.S. Environmental Protection Agency [EPA], n.d.). The results of this program, as reported by the Environmental Protection Agency, have included a reduction in sulfur dioxide emissions (as compared with 1990 levels) of over 5 million tons, a reduction in nitrogen oxide emissions (as compared with 1990 levels) of over 3 million tons, and nearly 100% program compliance (EPA, 2004).

In terms of taxation programs aimed at reducing pollution levels, Finland, Sweden, Denmark, Switzerland, France, Italy, and the United Kingdom have all made changes to their tax systems in order to reduce environmental degradation. Some of these changes include the introduction of new taxes, such as Finland’s implementation of the 1990 carbon tax; other changes involve using tax revenue to increase environmental quality, such as Denmark’s use of tax revenue to fund investment in energy-saving technologies (Barde, 2000).

In the United States, local grocery markets are at the center of a large tax system aimed at reducing environmental degradation: the deposit-refund system. This system effectively rewards individuals willing to return bottles and cans to an authorized recycling center. Such an incentive represents a negative tax (or subsidy) to individuals in exchange for recycling behavior that benefits society as a whole.

Policy Implications

The policy implications of work done by environmental economists are far-reaching. As countries deal with issues such as water quality, air quality, open space, and global climate change, the methodologies developed in environmental economics are key to providing efficient, cost-effective solutions.

Although command and control remains a common form of regulation, the previous sections detail the ways that countries have begun to use market-based approaches such as taxation and permit markets within the regulatory framework.

Examples of these types of programs continue to develop. For example, in an attempt to comply with the provisions of the Kyoto Protocol, which was implemented to control greenhouse gas emissions, the European Union has established a carbon dioxide permit market aimed at reducing greenhouse gases (Keohane & Olmstead, 2007).

Even the Coase Theorem comes into play as global environmental problems demand mutually beneficial agreements to be voluntarily negotiated across countries. In fact, the Montreal Protocol, which was implemented to control emissions of ozone-depleting chemicals, makes use of a multilateral fund that compensates developing countries for the costs incurred in phasing out ozone-depleting chemicals (Field & Field, 2006). This is very similar to the example in which parents in a community may find it beneficial to compensate a polluting firm in order to induce a reduction in emissions.

Future Directions

Because of the interdisciplinary nature of environmental economics, the discipline constantly presses forward in many directions. Many of the most pressing environmental issues involve both local and global pollutants. These range from local water quality issues to the reduction of greenhouse gas emissions.

In terms of local, regional, and national environmental issues, the application of currently available corrective instruments is quite feasible. However, an evaluation of the value of regulated environmental goods as well as the proposed regulatory instruments is still the topic of ongoing research.

In terms of global issues, such as global climate change, there is still much work to be done regarding the economic impact of changes to the earth’s climate. In addition, solutions relying on government enforcement are less possible when it comes to global climate change. This means that there is likely to be more emphasis placed on voluntary compliance.

For example, in the wake of the Kyoto Protocol, there have been regional agreements that have been formed that have a reduction in greenhouse emissions as a primary goal. One such agreement, known as the Western Climate Initiative, was developed in February 2007. This initiative is a voluntary agreement between seven U.S. states and four Canadian provinces. Its goal is to reduce greenhouse gas emissions by 15% (as compared with 2005 emissions levels) by the year 2020 (Western Climate Initiative, n.d.).

Finally, countries have long suffered from the production decisions of their neighbors. However, since the availability of clean water in the border regions of developing countries remains an issue, solutions to these problems (and similar transborder problems) remain the focus of ongoing research.

Conclusion

Environmental economics provides a set of tools that are crucial in understanding today’s most pressing environmental problems. Through the use of valuation techniques such as contingent valuation and revealed preferences, economists are able to estimate the value society holds for a variety of environmental goods. These values allow policy analysts to consider the impact that a proposed public policy might have on the natural environment. Economists are also able to use these techniques to provide an accurate description of the loss that occurs in cases of both extreme environmental damage and more subtle environmental degradation that occurs daily.

Environmental economics explains the role that externalities play in excessive environmental degradation because the failure of markets to capture the full value of environmental goods consistently results in the overproduction of those goods that can damage the environment and an underprovision of those goods that improve environmental quality. Further, through corrective instruments developed by economists such as Pigou (1920), Coase (1960), and Dales (1968), environmental economics has provided society with innovative solutions to excessive environmental degradation resulting from market failure.

Finally, the application of the techniques developed by environmental economists has become increasingly popular as concern over environmental issues has become a common staple in public policy. As environmental problems continue to become increasingly complex, environmental economists continue to press forward, applying the solutions provided by the fundamentals of economics to these problems.

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