P122 Natural Resource Economics

Home , Natural resource, Resource, Resource allocation

Centre for Development, Environment and Policy

Prepared by:

Emmanuelle Quillérou, Laurence Smith and Michael Stockbridge

Based on earlier versions by Jamie Morrison and Michael Warner

ABOUT THIS MODULE

This module develops a rationale for, and explains the methodologies used in, the application of economic theory to the allocation of natural resources. The main emphasis is placed on enhancing the learner’s ability to evaluate critically a rapidly growing, but technical, area of the economic literature. In order to achieve this, the rationale for the use of economic concepts, theory and models is first developed. Using a series of resource sectors as examples, a number of economic models are then explained in detail in a way that is intended to raise the learner’s confidence in the interpretation and assessment of various policy insights that are derived from the models. Practical policy applications are used throughout the module in order to bridge the gap between theory and practice. Also whilst developing and applying the microeconomic applications in depth, a number of ‘departures’ from basic models are explored throughout the module in the context of the ‘sustainable development’ debate.

STRUCTURE OF THE MODULE

This module starts by introducing key concepts in natural resource economics. After a brief classification of natural resources we look at the concept of sustainability and the intellectual foundations of natural resource economics, identifying what distinguishes the discipline from environmental economics and ecological economics. This is followed by an examination of the interconnections between the economy and the environment, including the services that the environment supplies to the economy. When applied in research and policy analysis natural resource economics relies on empirical evidence and is a quantitative discipline. Thus the second unit of the module takes time to introduce and refresh the methods and tools of natural resource economics thoroughly including the application of mathematics and spreadsheet-based modelling. Next the module examines the concepts of sustainability and sustainable development and reflects upon the various debates and arguments that surround these contentious concepts. The first section of Unit 3 provides a broad introduction to the subject noting the difficulties of defining sustainability and highlighting the different perspectives from which the concept can be studied and analysed. The next section narrows the focus down to an economic perspective, looking at some basic economic models of sustainability, including models of optimal growth. The final section concludes by looking at how sustainability is conceived and measured in the ecological sciences and considers what insights ecology might hold for the limits to growth. The theoretical foundations that underpin most of the economic analysis that takes place in relation to natural resource management originate from welfare economics. The module reviews some of the key philosophical assumptions that inform economic approaches to welfare analysis and builds on this by explaining what economists typically mean by efficiency and how efficiency relates to the concept of welfare and equity. It also looks at why competitive markets are viewed as a benchmark for achieving efficiency and also at why markets are not always able to deliver efficiency. This leads to a consideration of alternative non-market arrangements for allocating resources, in particular, other institutions and an assessment of how they compare in efficiency terms.

The concepts and tools examined in the first parts of the module are then applied to analysis of the exploitation and management of different natural resources. First the focus falls on the economic characteristics of non-renewable natural resources and what distinguishes them from renewable resources. Key concepts and ideas reviewed include resource rents and dynamic efficiency, and the Hotelling model which serves as the foundation for much of the economic analysis in this module. Conclusions are drawn about the concept of economic scarcity and its drivers for the non-renewables sector. Moving on, the module then explores the bio-economic characteristics of critical zone renewable natural resources. It examines the complex relationships that policy-makers need to take into account in developing policy that ensures efficient resource allocation. For this, static and dynamic models that aid the formulation of appropriate policy are examined, along with their key limitations. Continuing the analysis of renewable resources, the module covers the resources provided by forests and other wooded land. Plantation forests are renewable resources but have a range of characteristics that differentiate their assessment, management and utilisation from other renewable resources such as fisheries. Natural and undisturbed forests provide a resource that has conventionally been regarded as a renewable resource in the past, but when multiple non-timber benefits and ecosystem services are considered discussion centres on what is irreplaceable and thus a non-renewable resource, at least in the short and medium term. Consideration is given to the policy mix necessary to achieve more socially optimal management of forest resources in meeting the long-term goals and needs of society. Finally, the module critically assesses the attempts that have been made by economists to modify national income accounting conventions so as to create a measure of sustainable income. The resulting guidelines for ‘environmental accounting’, also known as ‘natural resource accounting’ and ‘green accounting’ are summarised and assessed in relation to the goal of sustainable development. Alternative measures of ‘genuine saving’ or ‘genuine investment’ that have been proposed as indicators of sustainable national income and welfare are also reviewed. Thus the last unit considers how economists have explored whether measurement of wealth can be made more holistic by taking into account all forms of capital, including natural, human and social capital. Parallel approaches that involve the compilation and use of biophysical indicators of sustainability without integration into national economic accounts are also considered.

WHAT YOU WILL LEARN

Module Aims

The specific aims of the module are:  To explain the rationale for the use of economics in informing natural resource allocation decisions.  To develop skills in using economic theory to analyse critically natural resource problems.  To give confidence in accessing a specialised literature and quantitative approaches, in particular in applying spreadsheet applications for the latter.  To assess the limitations of, and possibilities for, extending the orthodox applications of economic theory by comparing the outcomes with insights derived from alternative paradigms.  To explain the economic approach to the measurement of sustainable development and the incorporation of sustainability criteria in economic policy.

Module Learning Outcomes

By the end of this module, students should be able to:  discuss the extent of and critically appraise factors contributing to, natural resource scarcity  develop and argue a rationale for the use of natural resource economics theory and methods  critically apply the insights gained from the economic methods used in the temporal and inter-temporal theories of resource allocation to the analysis of natural resource use problems  critically examine how an economist can contribute to the development of policy that supports sustainable development  assess critically the limitations of the neoclassical paradigm in the allocation of resources and demonstrate an in-depth understanding of how current research initiatives are attempting to overcome these limitations.

ASSESSMENT

This module is assessed by:  an examined assignment (EA) worth 40%  a written examination worth 60%. Since the EA is an element of the formal examination process, please note the following: (a) The EA questions and submission date will be available on the Virtual Learning Environment (VLE). (b) The EA is submitted by uploading it to the VLE. (c) The EA is marked by the module tutor and students will receive a percentage mark and feedback. (d) Answers submitted must be entirely the student’s own work and not a product of collaboration. For this reason, the VLE is not an appropriate forum for queries about the EA. (e) Plagiarism is a breach of regulations. To ensure compliance with the specific University of London regulations, all students are advised to read the guidelines on referencing the work of other people. For more detailed information, see the FAQ on the VLE.

STUDY MATERIALS

There are two textbooks for this module.

❖ Perman, R., Ma, Y., Common, M., Maddison, D. &, McGilvray, J. (2011) Natural Resource and Environmental Economics. 4th edition. Pearson Education.

❖ Conrad, J. (2010) Resource Economics. 2nd edition. Cambridge University Press.

For each of the module units, the following are provided.

Key Study Materials

Key readings are drawn mainly from the textbooks, relevant academic journals and internationally respected reports. They are provided to add breadth and depth to the unit materials and are required reading as they contain material on which you may be examined. Readings are supplied as digital copies and ebooks via the SOAS Online Library. For information on how to access the Library, please see the VLE. For some units, multimedia links have also been provided. You will be invited to access these as part of an exercise or activity within the unit, and to discuss their implications with other students and the tutor.

Further Study Materials

These texts and multimedia are not provided in hard copy, but, weblinks have been included where possible. Further Resources are NOT examinable and are provided to enable students to pursue their own areas of interest.

Weblinks and Portals

Weblinks and portals that are relevant to each unit may be suggested by the module tutor during the study year. These can be a resource for students who would like to explore a topic even further through their own research and investigation. Such further study may usefully contribute examples and critical commentary to examination answers but as noted, the study guide and key readings are considered sufficient to provide for core examinable content and relevant critical analysis, discussion and examples.

Spreadsheet Exercises/Examples

The following Excel spreadsheets are available on the e-study guide.

Unit File name

2 NRE_unit_02_unitSAQ_activity_answer.xlsx

7 NRE_unit_07_section_5_template.xls

8 NRE_unit_08_section_5_template.xls

References

Each unit contains a full list of all material cited in the text. All references cited in the unit text are listed in the relevant units. However, this is primarily a matter of good academic practice: to show where points made in the text can be substantiated. Students are not expected to consult these references as part of their study of this module.

Self-Assessment Questions

Often, you will find a set of Self-Assessment Questions at the end of each section within a unit. It is important that you work through all of these. Their purpose is threefold:  to check your understanding of basic concepts and ideas  to verify your ability to execute technical procedures in practice  to develop your skills in interpreting the results of empirical analysis. Also, you will find additional Unit Self-Assessment Questions at the end of each unit, which aim to help you assess your broader understanding of the unit material. Answers to the Self-Assessment Questions are provided in the Answer Booklet.

In-text Questions

 This icon invites you to answer a question for which an answer is provided. Try not to look at the answer immediately; first write down what you think is a reasonable answer to the question before reading on. This is equivalent to lecturers asking a question of their class and using the answers as a springboard for further explanation.

In-text Activities

 This symbol invites you to halt and consider an issue or engage in a practical activity.

Key Terms and Concepts

At the end of each unit you are provided with a list of Key Terms and Concepts which have been introduced in the unit. The first time these appear in the text guide they are Bold Italicised. Some key words are very likely to be used in examination questions, and an explanation of the meaning of relevant key words will nearly always attract credit in your answers.

Acronyms and Abbreviations

As you progress through the module you may need to check unfamiliar acronyms that are used. A full list of these is provided for you in your study guide.

TUTORIAL SUPPORT

There are two opportunities for receiving support from tutors during your study. These opportunities involve: (a) participating in the Virtual Learning Environment (VLE) (b) completing the examined assignment (EA).

Virtual Learning Environment (VLE)

The Virtual Learning Environment provides an opportunity for you to interact with other students and tutors. A discussion forum is provided through which you can post questions regarding any study topic that you have difficulty with, or for which you require further clarification. You can also discuss more general issues on the News Forum within the CeDEP Programme Area.

INDICATIVE STUDY CALENDAR

Part/unit Unit title Study time (hours)

Unit 1 Key Concepts 10

Unit 2 Approaches and Methods 10

Unit 3 Sustainability 10

Unit 4 Welfare Economics I: Concepts and Efficiency 15

Unit 5 Welfare Economics II: Markets and Institutions 15

Unit 6 Non-renewable Resources 15

Unit 7 Static Models of Renewable Resource Allocation: the Fishery 15

Unit 8 Fisheries Revisited: Dynamic Optimisation Approaches 15

Unit 9 Forest Resources 15

Unit 10 Environmental Accounting 15

Examined Assignment 15 Check the VLE for submission deadline

Examination entry July

Revision and examination preparation Jul—Sep

late Sep— End-of-module examination early Oct

Unit Information 2 Unit Overview 2 Unit Aims 2 Unit Learning Outcomes 2 Unit Interdependencies 2

Key Study Materials 3

1.0 Introduction 4 Section Overview 4 Section Learning Outcomes 4 1.1 Classifying natural resources 4 1.2 Sustainability 6 1.3 Origins and related disciplines 8 Section 1 Self-Assessment Questions 12

2.0 Economy and environment 13 Section Overview 13 Section Learning Outcomes 13 2.1 Interdependence 13 2.2 Services 15 Section 2 Self-Assessment Questions 19

Unit Summary 20

Unit Self-Assessment Questions 21

Key Terms and Concepts 23

Further Study Materials 24

References 24

Natural Resource Economics Unit 1

UNIT INFORMATION

Unit Overview

This unit introduces key concepts in natural resource economics. The introductory section begins with a short classification of natural resources, before looking briefly at the concept of sustainability. We look at the intellectual foundations of natural resource economics and what distinguishes the discipline from environmental economics and ecological economics, before moving on, in Section 2, to examine the interconnections between the economy and the environment, including the services that the environment supplies to the economy.

Unit Aims

• To define natural resources and natural resource economics. • To outline the interconnections between the economy and the environment.

Unit Learning Outcomes

By the end of this unit, students should be able to: • distinguish between different types of natural resources and explain the difference between natural resource economics and related disciplines • discuss the interconnections between the economy and the environment.

Unit Interdependencies

This unit is an introductory unit that sets the scene for all of the following units. Consequently, you will find yourself being introduced to ideas and concepts that aren’t always fully explained, but which will become clearer in later units. Sustainability, for example (see Section 1.2) will be examined in much greater detail in Unit 3, welfare economics (see Section 1.3) is the subject of Units 4 and 5, and natural resource scarcity (see Section 1.2) will be examined in more detail in Unit 6.

KEY STUDY MATERIALS

Section 1

 Horwitz, S. (28 February 2011) Are we Running out of Resources? [Video]. Institute for Humane Studies, LearnLiberty.org. Duration 4:07 minutes. Available from: http://www.youtube.com/watch?v=AcWkN4ngR2Y An optimistic view from Professor Steve Horwitz in which he discusses economic reasons why we may never run out of many resources. In a free market system, prices signal scarcity and as a resource becomes more scarce it usually becomes more expensive. This can reduce demand and create incentives to develop alternatives or to find and exploit new reserves of that resource previously undiscovered or too costly to exploit. Market incentives and innovation are necessary for this to succeed.

 Meadows, D. (2009) Growth versus Development. [Video]. World Resources Forum 2009, 14–16 September 2009, Davos, Switzerland. Duration 8:34 minutes. Available from: http://www.youtube.com/watch?v=gSPHzkAHwqY Dennis Meadows, co-author of ‘The Limits to Growth’ (1972), on natural resources, growth, and development.

 Perman, R., Ma, Y., Common, M., Maddison, D. & McGilvray, J. (2011) An introduction to natural resource and environmental economics. In: Natural Resource and Environmental Economics. 4th edition. Pearson Education. pp. 1–15. This reading is the introductory chapter to the textbook by Perman et al. It looks at the origins of natural resource economics and introduces some key concepts. You might want to revisit the discussion of efficiency and optimality after reading both Units 1 and 2 as you will find further clarification there.

Section 2

 Perman, R., Ma, Y., Common, M., Maddison, D. & McGilvray, J. (2011) Natural Resource and Environmental Economics. 4th edition. Pearson Education. pp. 16–21. This reading is the first part of Chapter 2 in the textbook by Perman et al. Read up to the end of Section 2.1.2. It relates specifically to Section 2 on the economy–environment interdependence.

1.0 INTRODUCTION

Section Overview

This section introduces you to the subject of natural resource economics. It looks at what natural resources are, looks briefly at the concept of sustainability, and considers what distinguishes natural resource economics from environmental economics.

Section Learning Outcomes

By the end of this section, students should be able to: • explain the difference between different types of natural resources, giving examples • explain the difference between natural resource economics, environmental economics, and ecological economics.

1.1 Classifying natural resources

Natural resource economics is, as the name suggests, about natural resources. But what exactly are natural resources? Think about this for a moment before reading the following definition.

Natural resources are all the original resources of the earth that are utilised by people and the range of natural services provided by these resources that support life and economic activity. Thus natural resources include industrial raw materials and renewable resources such as timber and fisheries, but also other environmental common property resources such as clean freshwater that are used in or support economic activity. Source: unit author

The definition above stresses that the natural environment is inherently multi- functional. It provides numerous economic functions or services in addition to raw materials such as timber, fossil fuels, minerals, and those relating to food. Thus, physical natural resources are just part of a wider system – the environment. In this module our primary focus is upon the allocation of the physical natural resources that are used as inputs in various economic activities. This is what distinguishes natural resource economics from the broader discipline of environmental economics. We shall say more about this distinction shortly. Underpinning the definition of physical natural resources are a number of important distinctions between natural resource types which we will now examine in a little more detail.

Renewable and non-renewables

Some resources, such as minerals or oil, exist as finite stocks, which are non-renewable within an economic time frame. Others, such as timber or solar energy are renewable and, potentially, the flow of services from these resources can be harvested indefinitely. However, the distinction is not absolute and the key lies in the word ‘potentially’. The only resources that are always ‘renewed’ are solar radiation, the winds and tides. Many renewable resources such as fish, timber, and even water can be mismanaged, degraded and eventually exhausted. A more useful distinction may therefore be between stock and flow resources. Stock resources These are compounds which have taken millions of years to form and so, from an economic perspective, may be considered as ‘fixed’ in supply. There is, therefore, a limit to the quantity of these which can ultimately be used. However, in many cases we do not know where this limit lies. This, in turn, can cause difficulties in designing policies to ensure optimal allocation. The stock resource class is not a homogeneous one. An important distinction arises between those resources which are consumed by use and those which can potentially be recycled. With existing technologies many metals can be reused with little loss of quality. In principle, their total stock could remain constant over time, taking account both of the metal remaining in the earth’s crust and that temporarily stored in products. Thus, we may make a further classification into theoretically recoverable stocks and recyclable stocks. Flow resources Flow resources are defined as those which can be naturally renewed within a sufficiently short time-span to be of relevance to decision-makers. It is useful, however, to make a further distinction between those flows which do not appear to be dependent on human activity and those which are indefinitely renewable if use remains at or below their capacity to reproduce or regenerate. The latter, the so-called ‘critical zone resources’ can, however, be exploited to exhaustion. If the rate of use exceeds the rate of natural replenishment, such resources can effectively be mined like a mineral stock. Non-critical zone resources remain renewable irrespective of human activity. Reserves A further, crucially important, distinction is made between currently exploitable resources and theoretically exploitable resources. Current resource appraisals often identify currently exploitable resources as reserves. These are the supplies of materials or energy which are exploitable in political, economic and technical terms under current conditions. Other sources may not be currently exploitable, but may become so if extraction technology improves or if demand for the resource is high enough to justify exploitation of these more difficult and costly sources. In other words, they may become part of the reserves in future.

1.2 Sustainability

Limits to growth

For centuries, researchers have put forward widely divergent views regarding the relationship between economic growth and the increasing use of natural resources. A central theme in the debate about the seriousness of the problem has been that there is some limit to growth, where the earth has a finite amount of resources and therefore a limited capacity to supply resources for human needs and activities. As the natural world provides our resource base, it is proposed that this finiteness could be, or could become, a problem and must therefore be incorporated into economic decision-making processes. Today, these concerns are often couched in terms of ‘sustainability’ and ‘sustainable development’. These concepts are very broad and their use extends far beyond the narrow confines of economic growth to include a much broader view on the developments needed to enhance human welfare.

Sustainable development

The basic premise of sustainable development is that activities to promote it need to take into account the needs of both current and future generations. Importantly, the activities of the current generation should not compromise the ability of future generations to meet their own needs. The concept of ‘inter-generational equity’ is central to most definitions of sustainable development. Additionally, for an activity or policy to be sustainable it needs to be economically, environmentally and socially sustainable. Clearly, though, it can be difficult to define with any precision the criteria for sustainability in each of these three dimensions, let alone specify the trade-offs and synergies that exist between economic, social and environmental goals. Identifying the needs of current generations is fraught with difficulty, doing the same for future generations faces even bigger obstacles. Sustainable development can therefore be defined in many different ways and defining it for practical purposes is ultimately the outcome of political processes.

Income and growth

At the macro level, natural resource economics typically approaches the sustainable development debate with a somewhat narrower focus, namely that of income and economic growth. It assumes that economic growth is a desired goal because by enhancing people’s income and consumption it raises their welfare. It then looks at how different patterns of natural resource use affect that goal, not only in terms of present income, but also in terms of the income of future generations. Bear in mind, though, that whilst natural resource economics is implicitly concerned with macroeconomic growth, its practical application typically takes place at the micro level – eg identifying efficient and sustainable harvesting rates for renewable resources, or analysing the economic effects of different rates of non-renewable resource extraction.

Steady-state equilibrium

In the context of renewable natural resources in particular, one definition of sustainability relates to the concept of a ‘steady-state equilibrium’. Steady-state refers to a stock size and a flow of services that is sustained over an indefinite period of time. In other words, a steady-state is a kind of equilibrium, which, in the absence of any outside forces, can be sustained forever. However, it has been argued that a steady-state is a rather extreme and unrealistic target at which to aim in relation to ‘real world’ natural resource management. Indeed, in very few cases has the history of natural resource use remotely resembled anything even approaching the hypothetical steady-state. Therefore, some have suggested that perhaps a more realistic sustainability ‘target’ might be to prevent renewable resource flows from declining. However, even this, rather laxer, sustainability target runs into a host of problems when applied in the real world. So, in practice, a host of complex trade-offs and conflicting objectives will usually need to be assessed on a case-by-case basis, in relation to ‘real world’ natural resource management.

Substitutability and irreversibility

An important factor in assessing the ‘sustainability’ of natural resource flows relates to the issues of ‘substitutability’ and ‘irreversibility’. Substitutability refers to the extent to which the function performed by the flow of one natural resource could be performed by an alternative resource, natural or man-made. Irreversibility draws attention to the risks of exploiting resources in ways that lead to irreversible changes (typically declines) in the stocks or flows of valuable natural resources. These dangers are obviously greatest if there are unlikely to be any close substitutes for the damaged resource.

 Can you think of any examples where one natural resource might be substituted by another natural resource or by a man-made resource? Answer

There are many examples one could give. An important one is the substitution of oil and gas for coal and charcoal or wood as a fuel. A less obvious one is the substitution of human capital and know-how for oil and gas. Although the former can never on its own completely substitute for the latter, investments in human capital can lead to major efficiency gains that will allow far less fuel to achieve a particular energy output or service. Ultimately, however (and hopefully, in terms of reducing harmful climate change), human capital combined with energy from renewables and perhaps nuclear power (such as fusion-based technologies) may substitute completely for fossil fuels.

 Can you think of examples of where ‘irreversibility’ might be of particular concern? Answer Again, there are many examples one could give here. The most obvious one relates to irreversible changes in the environment and its ability to support human and other life resulting from major climate change. Reductions in the stocks of non-renewable resources (oil and minerals) are, for practical purposes, irreversible, although how dangerous this is will depend upon the ‘substitutability’ question. Certain types, and levels, of damage to biological resources — natural eco-systems particular species and genetic biodiversity generally — are irreversible (and depending on the ‘service’ provided by the resource) may not be ameliorated by ‘substitution’.

Scarcity

In economics the concept of scarcity is defined in terms of the relationship between supply and demand. Without demand there can be no scarcity, but as demand rises in relation to supply, or supply declines in relation to demand, scarcity rises. This is clearly happening in relation to natural resources as a whole, and in relation to some natural resources in particular, although the processes involved are often quite complex.

1.3 Origins and related disciplines

We have already begun to describe what natural resource economics is and you will obviously learn more about the subject as you progress through this module. However, before we conclude this section, it is worth saying a little bit more about its history and how it fits in with related fields of study.

Classical economics

Natural resources have always been part of the study of economics ever since economics emerged as a distinct discipline during the time of Adam Smith (1723– 1790). Indeed, during the so-called ‘classical’ period of economics natural resource scarcity was a focal concern, particularly in relation to the effects of population growth on the demand for food and the strain this placed on agricultural land. A famously pessimistic view is associated with Thomas Malthus (1766–1834) who predicted that, whilst living standards were being driven up by the industrial revolution, they would inevitably fall back to subsistence levels as attempts to raise food production ran into the problem of the diminishing marginal productivity of land. Even amongst the less pessimistic classical economists, such as David Ricardo (1772–1823) and John Stuart Mill (1806–1873), the limits to economic growth caused by diminishing marginal returns were widely recognised. Towards the end of the classical period of economics, pessimism about food production and growth more generally waned due, in part, to the opening up of new agricultural land in the Americas and other less densely populated colonies and also due to improvements in technology that raised the marginal productivity of existing agricultural land. In more recent times, however, a ‘neo-Malthusian’ pessimism has

© SOAS CeDEP 8 Natural Resource Economics Unit 1 occasionally resurfaced – notably, following the oil shocks of the 1970s and again in the late 2000s in response to the so-called ‘triple-f’ crisis (food, fuel, and finance) during which fuel and food prices spiked simultaneously, a 30-year long decline in food prices appeared to be at an end, and global finance fell into turmoil.

Neoclassical economics

Back in the latter half of the 19th century increasing optimism about the ability of agricultural production to keep pace with the rising demand for food coincided with the arrival of ‘neoclassical’ economics which, in its early days, focused mainly on the way in which markets and prices signal preferences and allocate resources within an economy. In contrast to many classical economists, they were less concerned about the size of the economy as a whole or constraints to growth, focusing instead on the way consumers and firms make decisions and interact with each other in competitive markets. The work of neoclassical economists, such as Leon Walras (1834–1910), William Jevons (1835–1882), Alfred Marshall (1842–1924), and others led to a body of theory that continues to provide the underlying framework for most economic analysis today. Indeed, although the neoclassical school has evolved in response to challenges from both outside and within the school, mainstream economics (especially microeconomics) is often treated as synonymous with neoclassical economics. Although many modern economists, especially in applied fields, would reject this label, preferring to call themselves institutional economists, political economists, welfare economists, environmental economists etc, most recognise a debt to neoclassical economics and continue to use many of its models and analytical tools.

Welfare economics

One branch of neoclassical economics that has been influential in natural resource economics is welfare economics. Welfare economics seeks to understand how different allocations of resources affect the welfare of society as a whole or, indeed, specific interest groups within society. It combines neoclassical theories of the consumer and the firm with utilitarian theories of ethics to produce decision-making criteria that can be used by policy-makers to rank alternative ways of allocating scarce resources. Drawing on ‘utilitarianism’ these rankings are set according to the level of benefit each allocation conveys to society as a whole. Estimates of social benefit or social value are based upon the underlying assumption that individuals are the best judge of what is in their interests, and that if competitive markets existed for all scarce resources, these interests or preferences would be implicitly revealed, in aggregate, by the way markets respond to each individual’s participation in the market place. Under these assumptions the equilibrium prices resulting from the interaction of supply and demand in competitive markets (for both inputs and outputs) are said to reflect the value that society places on goods, services and factors production (land, labour and capital). These prices form the basis of the calculated values that welfare economics uses to compare one resource allocation against another.

Of course, competitive markets often do not exist. Hence, much effort in welfare economics is devoted to finding ways to: • make markets more competitive • correct the price signals that emanate from non-competitive markets (eg through taxes and subsidies) so that the resulting resource allocations move closer to the competitive ideal • create competitive markets for scarce resources that are not currently allocated through market mechanisms • identify what preferences would be revealed if there were competitive markets (eg through experiments and surveys), so that where market allocation is not possible resources can be allocated as though it were. Bear in mind that the preferences revealed in competitive markets, and hence the resulting market prices, are governed in part by each individual’s purchasing power. Since this is a function of their wealth, it is possible that significant alterations in the distribution of wealth within society would reveal a different set of preferences and lead to an alternative set of market prices for use as the metric in social valuations. However, welfare comparisons between alternative resources allocations need to be based upon the same metric – ie they need to be based upon the same set of prices. Hence, when welfare economics compares different resource allocations, it assumes that the underlying distribution of wealth associated with each option is broadly the same.

Natural resource economics

Natural resource economics, and indeed environmental economics, draw heavily on the neoclassical approach to economics, including the models and techniques of neoclassical welfare analysis. The distinctions between natural resource economics and environmental economics are increasingly blurred in that the two are often studied together as a single discipline. Nevertheless, there are historical differences in the evolution of these subjects, which mean that they are often studied separately. That is the case with this module which does not deal with many of the issues covered in environmental economics courses. Historically, the study of natural resource economics has tended to focus on raw materials, treating them as inputs in a production function, and exploring related input and output markets and the efficiency and welfare implications of different patterns of resource exploitation. The approach is often exemplified by the following, or related, models: • the fisheries model • the forestry/timber extraction model • the non-renewable resource model (eg oil).

One of the most seminal works in natural resource economics dates back to 1931 and the publication of Hotelling’s model of exhaustible resources (Hotelling, 1931). However, although Hotelling and others were developing economic models of natural resource extraction at that time, the discipline of natural resource economics did not have much of a profile before the 1970s, a period of raised anxiety about the environment and the limits to growth posed by the finite supply of oil and other critical resources.

Environmental economics

Environmental economics also emerged in the 1970s. It was driven by many of the same concerns as natural resource economics (eg the sustainable harvesting of natural resources) but also included a special focus on the problem of pollution and the value of the environment as a place to live in and value for its own sake. A seminal work in environmental economics also dates back to the early 20th century when Arthur Pigou’s ‘The Economics of Welfare’ (Pigou, 1920) introduced and explained the concept of an ‘environmental externality’. Much of modern environmental economics is focused on ways of addressing environmental externalities, such as pollution. It is important to bear in mind that environmental economics and natural resource economics are complementary rather than competing fields of study. Both offer useful sets of tools for studying particular types of environmental problem.

Ecological economics

Ecological economics has rather different roots from those of either natural resource or environmental economics. Whilst the latter bring the environment into economics – applying conventional economic tools and analysis to environmental and natural resource problems – ecological economics brings the economy into the environment – expanding the study of ecological systems to include the economic systems that operate within and across ecological system and sub-system boundaries. Whilst environmental and natural resource economists use similar sets of tools to examine a slightly different set of problems, ecological economics challenges excessive reliance on this set of tools. Indeed, it was established (in the late 1980s) by its originators as a competitor to mainstream natural resource and environmental economics, as an entirely new discipline with its own set of tools. Its tools seek to integrate insights from a much broader range of disciplines in both the natural and social sciences. Although the subject matter of this module is not generally viewed through the lens of ecological economics, ecological economics clearly does provide valuable insights, and it is hard to argue against the need for inter-disciplinary perspectives in the study of environmental problems. The big question is whether this should be met through greater inter-disciplinary co-operation in tackling environmental problems or by the replacement of existing disciplines with something new (ie ecological economics). There isn’t scope to explore that debate in this module (which covers an existing and relatively well established discipline), but it is something you may reach your own conclusions about as you learn about the strengths and weaknesses of natural resource economics.

Section 1 Self-Assessment Questions

1 Match the correct definitions in the table below. (a) Stock resources (i) Consumed by use, theoretically recoverable, recyclable (b) Flow resources (ii) Critical zone resources, non-critical zone resources (c) Consumed by use (iii) Fish, forests, soil, water in aquifers, water in rivers (d) Recyclable (iv) Fossil fuels such as oil, coal and gas (e) Theoretically recoverable (v) Metallic and non-metallic minerals (f) Critical zone resources (vi) Metals which can be used many times over with little loss of quality (g) Non-critical zone (vii) Solar energy, tide, waves, wind, air resources

2 In relation to the following table, which option is likely to be the most conducive to sustainable development? 1, 2, 3 or 4?

Irreversibility of environmental damage Substitutability of scarce natural High Low resources High 1 2

Low 3 4

3 Which of the following are valid statements? (a) Natural resource economics is more focused on pollution than environmental economics. (b) Ecological economics draws heavily on the tools of neoclassical economics and welfare economics. (c) The neo-Malthusian perspective on the environment is optimistic about the environment’s ability to cope with the pressure placed upon it by human activity. (d) Although, in principle, the total stock of potentially recyclable resources could remain constant over time, taking account of both the metal remaining in the earth’s crust and that temporarily stored in products, the idea of a complete recycling remains a theoretical one due to losses in the process of recycling. (e) A central concept in ‘sustainable development’ is that of ‘inter-generational equity’.

2.0 ECONOMY AND ENVIRONMENT

Section Overview

This section takes an introductory look at ways in which the interaction between the economy and environment can be conceptualised. It looks at the services that the environment provides to the economy and contrasts the way traditional economic analysis has treated the environment with more ecologically rooted perspectives.

Section Learning Outcomes

By the end of this section, students should be able to: • discuss different conceptualisations of the economy–environment relationship and how they have evolved over time • outline the main services that the environment provides to the economy and how they are interrelated.

2.1 Interdependence

The ‘cowboy economy’

Prior to the advent of natural resource and environmental economics, economists paid relatively little attention to the relationship between the economy and the environment, partly because, in the early days of neoclassical economics, the economy did not appear to face major environmental constraints and also because environmental issues were considered less important than economic growth. The economic system received inputs from the environment and delivered waste back to the environment (as depicted in 2.1.1) but little attention was given to how the extraction of inputs might affect the environment or the environment’s ability to deliver those inputs to the economy in the future. Nor was much thought given to the impact of putting waste back into the environment – in particular, how that waste might affect the environment’s future ability to absorb waste or its ability to perform other functions for the economy, including life-support functions and the provision of amenity services (agreeable living spaces, recreation etc).

2.1.1 The ‘cowboy economy’

ECONOMY

raw materials waste (input) (output)

Source: unit author

Kenneth Boulding, one of the early inspirations for ecological economics, called this view of the economy–environment relationship the ‘cowboy economy’ (Boulding, 1966), in an analogy that is suggestive of the 19th century American ‘wild west’ where seemingly limitless natural resources were up for grabs to anyone venturing away from the more developed and densely populated eastern seaboard.

Economic analysis of the environment

The advent of natural resource economics and environmental economics represented a move away from the ‘cowboy economy’ model to one in which economic analysis took account of the impact of the economy on the environment and how this impact fed back into the economy. This is depicted in 2.1.2 which is a very simplified representation of the economy–environment relationship.

2.1.2 Natural resource and environmental economics

Source: unit author

Raw materials from the environment provide economic benefits, but their current extraction, in turn, affects the prospects of future extraction (hence, the two-way arrow). This is the particular concern of natural resource economics. The figure also shows waste from production and consumption which cause pollution and feeds back to the economy via the latter’s negative impact on human health and amenity values. These relationships can be analysed using the tools of environmental economics. The approach of both natural resource economics and environmental economics is to treat the environment as a source of services or inputs into the economy. These and any negative externalities arising from waste or over-extraction are given economic values, thereby bringing the environment into the accounting framework of the economy.

Boulding’s ‘spaceship earth’

Another way of conceptualising the economy–environment relationship is depicted in 2.1.3. Here the economy is located physically within a larger system – the environment – which (apart from solar energy and energy radiated back into space) is a closed system with no material exchange across its borders. Boulding (1966) likens this to a ‘spaceship’ with strictly limited life-support capabilities that depend upon achieving a delicate balance between consumption, material recycling, and energy harnessed from outside. The larger the economy is in relation to the environment, the harder it is to maintain this balance. Indeed, many people think that, in material terms, the economy is already too big. However, whilst some believe the solution lies in reigning back

© SOAS CeDEP 14 Natural Resource Economics Unit 1 consumption and halting economic growth, others see the balance being restored through technological innovation (eg cleaner energy) and institutional change (eg giving environmental services an economic value and ensuring that environmental damage is not treated as if it were cost-free).

2.1.3 ‘Spaceship earth’

ENVIRONMENT

ECONOMY

waste inputs

recycling

Source: unit author

Clearly there are many institutional changes needed to place the economy– environment relationship on a more sustainable footing. Natural resource and environmental economics provide useful insights for policy-makers seeking to set priorities for institutional reform. However, the relationship between the environment and the economy is extremely complex and deeply intertwined with the political and social forces behind resource allocation and institutional change. Understanding these forces is very important, but largely beyond the scope of mainstream natural resource and environmental economics. For a deeper understanding of these issues it is necessary to look to other disciplines, such as political economy and social psychology.

2.2 Services

In the previous section we noted that the environment provides human beings with a range of services. Indeed, this is how mainstream economic analysis of the environment tends to view the economy–environment relationship.

 We now look in a little more detail at those services, but before we do think for a moment about what those services might be and how they impact upon your own life and the lives of people around you.

Answer For the purposes of this unit we shall divide environmental services into the following categories — Life support — Resources for production — Waste sink — Amenity services

Life support

The most important service is that of ‘life support’. One can debate the minimum requirements for life support, but few would question the need for breathable air, a temperature range capable of sustaining human life, sufficient amounts of food and water, and protection from harmful levels of solar radiation. The environment performs numerous functions in its life-support capacity, many of which also relate to the maintenance of sufficient environmental stability for human survival – eg limiting the incidence of catastrophic flooding and extreme weather. The ability of the environment to provide life-support services will depend, in part, on the size of the population, on the state of food production technology, and the demand for other environmental services. Whilst the earth probably still has some way to go in terms of the maximum population it could potentially support, in practice, its carrying capacity depends on the extent to which resources are diverted from food production to other productive activities, and how much of the natural environment is left intact to sustain non-human life. The diversion of resources away from basic life-support functions is clearly problematic for some of the world’s poorest people given the existing distribution of income and assets. However, at a global level, maximising the earth’s human life-support capabilities (in terms of population) is not something that is ever likely to be achieved, or, indeed, desired.

Resources for production

The environment’s function as a supplier of raw materials is clearly a pivotal part of the economy–environment relationship and is the focus of natural resource economics. We have already discussed some of the characteristics of this service in our classification of resources in Section 1 of this unit. Resources can be renewable or non-renewable and take the form of stocks and flows. Some resources can be easily substituted with other resources, but many cannot. For some resources, extraction rates can be slowed through recycling (metals and timber, for example), but recycling is not always possible (eg in the case of oil and coal).

 The rate at which resources are extracted can affect the sustainability of both the resource provision service itself as well as the other services provided by the environment. Before reading on take a minute to think about how this might be.

Answer An obvious example is in the impact of resource exploitation on food availability. Overfishing can lead to the collapse of fish stocks and over- exploitation of soils in crop production can lead to a loss of soil fertility for future food production. Food production is also affected by the manner in which water resources are exploited. For non-renewables extraction now will diminish the services these resources can provide for future generations. The use of resources in production and consumption produces waste products, which can, once they have reached critical levels, affect life support, resource, waste sink, and amenity services (see below for more on the latter two).

Waste sink

The environment acts as a sink for the waste products of economic activity. It is a place to dispose of the unwanted by-products of production and consumption – above all in a manner and place which ensures that the waste (whether in solid, liquid or gaseous form) does not cause harm or inconvenience to human beings. The environment has the physical capacity to assimilate certain quantities of waste in ways that meet these requirements. The ecological systems that constitute the environment operate through the perpetual recycling of outputs from natural processes to produce each new generation of living organisms and each consecutive stage in the cyclical transformation of inorganic matter, such as in the nitrogen cycle or the hydrological cycle. Waste products from the human economy can be absorbed by these processes, toxic wastes can be filtered or diluted to render them harmless to human health, wastes that are slow to decay or decompose can be buried in places where they will cause little harm. How well the environment fulfils this waste sink function depends upon the quantity and quality of waste that is produced and the methods of disposal. The environment’s assimilative capacity is not limitless. Too much waste of the wrong sort and in the wrong place can reduce the environment’s assimilative capacity, damaging not only natural ecosystems but also the protection they afford to humans against the pollution caused by their own waste.

 Excessive exploitation of the environment as a waste sink harms other environmental services too. Think why this is the case before reading on. Answer The biggest threat posed by waste is to the life-support system itself. Whilst, the interactions between waste and the ecosystems that support life are complex and varied, the current consensus is that the production of greenhouse gases, for example, are altering the climate in ways that may, if left unchecked, radically modify the life-supporting functions of global ecosystems. The supply of renewable resources will almost certainly be affected. The impact of waste on amenity services is examined in the next section.

Amenity services

Environmental and natural resource economics, with their roots in neoclassical welfare economics follows a utilitarian ethic. This means that the value of things is measured by the utility or satisfaction they bestow upon people, whatever the source of that utility may be. Amenity services relate to the pleasure and satisfaction that people derive from the environment for any reason other than its life-support, resource reservoir, and waste sink functions.

 Before reading on, make a list of the different amenity services provided by the environment. Answer Here is a list of some important ones that it provides: — An agreeable place to live in above and beyond basic life support. This is reflected, for example, in the high prices attached to homes in beautiful locations. — A place for recreation — walking, hiking, swimming, wildlife-watching, or simply relaxing. — A place for filming — much of the pleasure people get from nature is via television or cinema. — Existence value — many get pleasure from merely knowing that the environment is in ‘healthy’ condition and, conversely, suffer disutility from the destruction of natural habitats and the loss of biodiversity, even though they themselves are not directly affected.

The analysis of amenity value is the preserve of environmental economics, rather than natural resource economics. Nevertheless, in studying natural resource economics one obviously needs to be aware that the exploitation of natural resources as raw materials for production and consumption can damage the environment’s amenity services, either directly through the extraction process or indirectly via the pollution created by production and consumption. Any economic analysis of natural resource exploitation that does not account for significant damage of this sort will be incomplete. That is why natural resource economics and environmental economics are complementary rather than competing disciplines.

Section 2 Self-Assessment Questions

4 Which of the following are valid statements? (a) Traditional economic analysis prior to natural resource and environmental economics treated the environment like a ‘spaceship’. (b) Natural resource economics and environmental economics give economic values to the services provided by the environment. (c) In the spaceship model of the economy–environment relationship the relative size of the economy in relation to the environment is of critical importance. (d) The size of the economy that the environment can support has little to do with the state of technology. (e) Recycling and pollution control increases the size of the economy that the environment can sustainably support.

5 Find the best match for the following environmental services and processes (noting that there is a potential overlap).

Service Process (a) Life support (i) Climate regulation and UV protection

(b) Resource reservoir (ii) Decomposition

(d) Amenity (iv) Rock formation and photosynthesis

6 True or false? The services provided by the environment are interconnected – they depend upon a common set of processes and damaging one of these services risks damaging the others.

UNIT SUMMARY

This unit provided an introduction to the subject of natural resource economics. Its aim was to give you a broad understanding of what the subject is about, including the problems and questions that are important for the discipline and the way they are tackled.

Section 1

This introductory section began by looking at the way natural resources can be classified and included discussion of renewable versus non-renewable resources, stock versus flow resources, and reserves. We looked briefly at the concept of sustainability and sustainable development and highlighted the importance of substitutability and irreversibility in defining degrees of sustainability. We concluded the section by looking at where natural resource economics fits in with other related disciplines. We noted that it is closely allied to environmental economics, in that it draws inspiration from the models and tools of neoclassical economics and neoclassical welfare economics (in contrast to ecological economics which is more rooted in the discipline of ecology). Natural resource economics distinguishes itself from environmental economics by being more focused on natural resources as raw materials for production rather than on the broader set of services that they provide.

Section 2

This section gave an overview of the interdependencies between the economy and the environment, contrasting three different ways in which this interdependence can be perceived. The first is the ‘cowboy economy’ view in which the natural environment is treated as a source of inputs for the economy and a sink for its wastes, with no limits on the extent to which it can be exploited. The second view is associated with the arrival of natural resource and environmental economics that recognised the limits and sought to bring environmental values into an economic accounting framework. The third is the ‘spaceship earth’ view in which an increasingly large economy is located within an increasingly strained ecological system. Although environmental accounting perspectives are compatible with this view, many within the ‘spaceship earth’ view place greater emphasis on the need to restrict economic growth than environmental and natural resource economists do. We concluded Section 2 by looking at the various services that the environment provides to the economy. These include services relating to life support, resources for production, acting as a waste sink, and amenity.

UNIT SELF-ASSESSMENT QUESTIONS

1 Fill in the missing words. Since many resources that are classed as ______can ______themselves given sufficient time (millions of years), and since many ______resources do not do so due to ______these resources are sometimes referred to, respectively, as ______and ______.

2 Match the correct definitions.

(a) Critical zone resources (i) Flows that are indefinitely renewable if use remains at or below their capacity to reproduce or regenerate, but can effectively be mined like a mineral stock if the rate of use exceeds the rate of natural replenishment (b) Non-critical zone (ii) Flows that remain renewable irrespective of resources human activity

3 Match the correct definitions.

(a) Natural resource (iii) Concerned with identifying resource economics allocations that maximise the aggregated benefits to society as a whole (b) Environmental economics (iv) Focused on a broader range of services than natural resource economics (c) Ecological economics (v) Its analytical methods build on the model of a perfectly competitive market (d) Classical economics (vi) More concerned with natural resource limits than early neoclassical economics (e) Neoclassical economics (vii) Related to environmental economics and using the tools of neoclassical welfare economics (f) Welfare economics (viii) Rooted more in ecological science than in economics

4 Label the diagrams below using the following: the cowboy economy, spaceship earth, economy, raw materials, waste, recycling, inputs, outputs.

Source: unit author

5 Label the diagrams below using the following: economy, environment, consumption, waste, pollution, health & amenity, raw materials, stocks and flows, production

ECONOMY waste pollution production

Source: unit author

KEY TERMS AND CONCEPTS ecological economics Inspired by ecology rather than traditional economics. environmental economics Broader than natural resource economics, but rooted in traditional economics. flow resources Can be naturally renewed within a sufficiently short time-span to be of relevance to decision-makers. irreversibility Central to assessing the risks of environmental damage. neoclassical economics Foundations for modern economics. non-renewable resources Resources, such as minerals or oil which are non-renewable within an economic time frame. renewable resources Resources such as timber or solar energy which are renewable — the flow of services from these resources can potentially be harvested indefinitely. reserves The supplies of materials or energy which are exploitable in political, economic and technical terms under current conditions. Total stocks are usually greater than reserves. steady-state equilibrium This exists when a stock size and flow of services is sustained over an indefinite period of time. stock resources Have taken millions of years to form and so, from an economic perspective, may be considered as ‘fixed’ in supply. substitutability The extent to which man-made capital can substitute for natural capital. welfare economics A branch of neoclassical economics concerned with public policy decisions.

FURTHER STUDY MATERIALS

Bromley, D.W. (Ed.) (1995) The Handbook of Environmental Economics. Oxford, Blackwell Publishers.

REFERENCES

Boulding, K. (1966) The economics of the coming spaceship earth. In: Jarrett, H. (Ed.) Environmental Quality in a Growing Economy. , Baltimore, Resources for the Future/Johns Hopkins University Press. pp. 3–14. Hotelling, H. (1931) The economics of exhaustible resources. Journal of Political Economy, 39 (2), 137–175. Meadows, D.H., Meadows, D.L., Randers, J. & Behrens, W.W. (1972) The Limits to Growth: a Report for the Club of Rome’s Project on the Predicament of Mankind. New York, Universe Books. Pigou, A. (1920) The Economics of Welfare. London, Macmillan.