Economic Thinking about the Environment – by Robert N. Stavins

Hand Holding Environment Cubes picture

Image courtesy of Suwit Ritjaroon / 

Communication about the natural environment among economists, other social scientists, natural scientists, and the general population can be challenging, and there are many myths about how economists think about the environment.  Fifteen years ago, my colleague Don Fullerton, a professor of economics at the University of Illinois, and I tried to puncture some of these myths in an article in Nature.  Now, in this essay for Edward Elgar Publishing, I return to this question by reflecting on three of the most prevalent myths.

Click here to listen to Professor Stavins talking about the background behind his new book.

A more comprehensive set of responses to this question is embodied in a book just published by Edward Elgar, Economics of Climate Change and Environmental Policy:  Selected Papers of Robert N. Stavins, 2000-2011, as well as in a predecessor to that volume, also published by Edward Elgar (2001), Environmental Economics and Public Policy: Selected Papers of Robert N. Stavins, 1988-1999.

The Myth of the Universal Market

The “first theorem of welfare economics” states that private markets are perfectly efficient on their own, with no interference from government, so long as certain conditions are met.  This theorem means that no one needs to tell producers of goods and services what to sell to which consumers.  Instead, producers and consumers meet in the market place, engage in trade, and thereby achieve the greatest good for the greatest number, as if “guided by an invisible hand,” as Adam Smith wrote in 1776 in The Wealth of Nations.  This is what economists mean by the “efficiency” of competitive markets.

By clarifying the conditions under which markets are efficient, the theorem also identifies the conditions under which they are not.  Private markets are efficient only if there are no public goods, externalities, monopoly buyers or sellers, increasing returns to scale, information problems, transactions costs, taxes, common property, or other distortions.

Those conditions are restrictive and rarely met simultaneously.  Environmental economists are interested in externalities, where some consequences of producing or consuming a good or service are external to the market, that is, not considered by producers or consumers.  With a negative externality, such as environmental pollution, the total social cost of production may exceed its value to consumers.  If the market is left to itself, there’s too much pollution to provide maximum general welfare.   In this case, laissez-faire markets are not efficient.

Natural resource economists are interested in common property or open-access resources, where anyone can extract or harvest the resource freely.  In this case, no one recognizes the full cost of using the resource; extractors consider only their own direct and immediate costs, not the costs to others of increased scarcity.  The result is that the resource is depleted too quickly.

So, the market by itself does not solve all problems.  Indeed, in the environmental domain, perfectly functioning markets are the exception, rather than the rule.  Governments can try to correct these market failures, for example by restricting pollutant emissions or limiting access to open-access resources.  If undertaken wisely, government interventions can improve welfare, that is, lead to greater efficiency.

The Myth of Simple Market Solutions

In some contexts, economists search for instruments of public policy that can fix one market by introducing another.  If pollution imposes large external costs, the government can establish a market for rights (a so-called “cap-and-trade” system) to limit the amount of pollution generated.  Such a market can be expected to work well if there are many buyers and sellers, and all are well informed.  Equivalently, producers can be required to pay a tax on their emissions.  Either way, the result — in theory — will be cost-effective pollution abatement.

A cap-and-trade system achieves this cost effectiveness through trades because any company with high abatement costs can buy permits from another with low abatement costs, thus reducing the total cost of reducing pollution.  These trades move the source of pollution from one source to another, which is not a problem when all emissions equally affect the whole trading area.  This “uniform mixing” assumption is certainly valid for global problems such as greenhouse gases and climate change.  But at the other extreme, some environmental problems might not be addressed appropriately by a simple, unconstrained cap-and-trade system.  A hazardous air pollutant that does not mix in the airshed can cause localized “hot spots.”

So, no particular form of government intervention, no individual policy instrument – whether market-based or conventional – is appropriate for all environmental problems.  There is no simple policy panacea.

The Myth of Market Prices

Should vehicle emissions be reduced by 10, 20, or 50 percent?  Economists frequently try to identify the most efficient degree of control – that which provides the greatest net benefits.  Both benefits and costs need to be evaluated.  Economists favor using market prices whenever possible to carry out such evaluations, because these prices reveal how people actually value scarce amenities and resources.  Economists are wary of asking people how much they value something, because respondents may not provide accurate assessments of their own valuations.  Instead, economists prefer to “watch what they do, not what they say,” as when individuals reveal their preferences by paying more for a house in a neighborhood with cleaner air, all else equal.

But economists are not concerned only with the financial value of things.  Indeed, the financial flows that make up the gross national product represent only a fraction of all economic flows.  The scope of economics encompasses the allocation and use of all scarce resources.  For example, the economic value of the human-health damages of environmental pollution is greater than the sum of health-care costs and lost wages (or lost productivity), as it includes what lawyers call “pain and suffering.”  Economists might use a market price indirectly to measure revealed rather than stated preferences, but the goal is to measure the total value of the loss that individuals incur.

The economic value of some parcel of the Amazon rain forest is not limited to its financial value as a repository of future pharmaceutical products or as a location for ecotourism.  Such “use value” may only be a small part of the properly defined economic valuation.  Economists recognize the potential importance of “non-use value” of environmental amenities such as wilderness areas or endangered species.  The public nature of these goods makes it particularly difficult to quantify the values empirically, as we cannot use market prices.  Benefit-cost analysis of environmental policies, almost by definition, cannot rely exclusively on market prices.

Economists try to convert all of these disparate values into monetary terms simply because a common unit of measure is needed in order to add them up.  How else can we combine the benefits of ten extra miles of visibility plus some amount of reduced morbidity, and then compare those total benefits with the total cost of installing scrubbers to clean stack gases at coal-fired power plants?  Monetary measures are no more or less than a convenient way to compare disparate goods and services.

So where does this leave us?  First, economists do not believe that the market solves all problems.  Indeed, many economists make a living out of analyzing market failures such as environmental pollution in which laissez faire policy leads not to social inefficiency.  Second, when economists identify problems, their tendency is to consider the feasibility of market solutions because of their potential cost-effectiveness, but market-based approaches to environmental protection are no panacea.  Third, when market or non-market solutions to environmental problems are assessed, economists do not limit their analysis to financial considerations, but use monetary equivalents in benefit-cost calculations in the absence of a more convenient unit.

My profession may bear some responsibility for the existence of misunderstandings about economics.  Like our colleagues in the other social and natural sciences, academic economists focus their greatest energies on communicating with their peers within their discipline.  Greater effort can certainly be given to improving communication across disciplinary boundaries.  My goal in my new book, Economics of Climate Change and Environmental Policy, is to communicate with all audiences, and to improve understanding regarding economic thinking about the environment.

Book jacket

In the introduction to Economics of Climate Change and Environmental Policy, Professor Stavins reflects on the professional path that has led to him becoming an Environmental Economist.  You can read more about this on his blog: An Economic View of the Environment.

Robert N. Stavins is the Albert Pratt Professor of Business and Government at the Harvard Robert N. Stavins photoKennedy School, Director of the Harvard Environmental Economics Program, Director of Graduate Studies for the Doctoral Programs in Public Policy and Political Economy & Government, Co‑Chair of the Harvard Business School‑Kennedy School Joint Degree Programs, and Director of the Harvard Project on Climate Agreements.  He is a University Fellow of Resources for the Future, a Research Associate of the National Bureau of Economic Research, a member of the Board of Directors of Resources for the Future, the Scientific Advisory Board of the Fondazione Eni Enrico Mattei, and numerous editorial boards, as well as Co-Editor of the Review of Environmental Economics and Policy, and an editor of the Journal of Wine Economics.  He was elected a Fellow of the Association of Environmental and Resource Economists in 2009.  He has been a member of the Board of Directors of the Association of Environmental and Resource Economists, the Chairman of the Environmental Economics Advisory Committee of the U.S. Environmental Protection Agency, a Lead Author of the Second and Third Assessment Reports and now a Coordinating Leading Author of the Fifth Assessment Report of the Intergovernmental Panel on Climate Change.  Professor Stavins’ research has focused on diverse areas of environmental economics and policy, and has appeared in more than a hundred journal articles and a dozen books.  Professor Stavins works closely with public officials on matters of national and international environmental policy, and has also been a consultant to numerous private foundations and firms.  He holds a B.A. in philosophy from Northwestern University, an M.S. in agricultural economics from Cornell, and a Ph.D. in economics from Harvard.

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  1. Virtual Book Tour – “Economics of Climate Change And Environmental Policy” | ELGARBLOG - April 25, 2013

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