Module 3 The economics of climate change 3 The economics of climate change 1 Introduction gives rise to climate change, considered to be the biggest market failure in human history. module Module 1 showed that economic activities can influence the climate because the economy and Since markets have failed, policy interventions are the environment are interdependent. Module needed to mitigate climate change. Even though 2 explained the climate science behind climate it has been known for some time how policy in- change and showed how human activities con- terventions could mitigate climate change, the tribute to change the climate. This module shows international community has been struggling how economic theory explains the occurrence of for decades to solve the issue. Section 4 investi- transboundary environmental problems, such as gates how economic theory explains the inability climate change, and clarifies why it can be so dif- of governments and societies to mitigate climate ficult to implement solutions to these problems change. It shows that climate change mitiga- even though those solutions are well known. tion is a global “public good” that has non-rival and non-excludable benefits (see Section 3.1). As Neoclassical economic theory stipulates that no country can single-handedly take actions to markets allocate resources in an optimal, i.e. ef- eliminate the threat of climate change, interna- ficient, way. At the same time, however, economic tional cooperation is needed. However, such co- behaviour leads to important negative effects operation is extremely difficult to achieve when on the environment such as climate change. If dealing with a global public good. To illustrate markets allocate resources efficiently, how is it this difficulty, the section introduces game the- possible that severe environmental problems ory concepts that are used to analyse strategic like climate change exist? Sections 2 and 3 of this interaction among countries. It shows that the module aim to answer this question. main cause of the failure of collective action is that countries have strong incentives to free-ride Section 2 reviews the basic concepts of economic and not contribute to reducing emissions. This theory on markets and optimal allocations. It in- leads to an outcome that is not socially optimal. troduces the standard theoretical model describ- The section concludes by drawing several lessons ing market economies and the concept of Pareto from game theory models that allow us to iden- efficiency used to evaluate whether resources are tify ways to foster cooperation among countries. allocated efficiently. It shows that, in theory, fully competitive markets allocate resources in a Pareto- At the end of this module, readers should be able to: efficient way and thus optimally from a social point of view. However, this theoretical result only holds • State the implications of the first welfare theorem; up provided that certain assumptions are satis- • Understand the conditions under which the fied; if these assumptions are not met, markets fail first welfare theorem does not hold and define and generate outcomes that are not socially opti- market failures; mal. This is what is called a “market failure.” • Explain why the atmosphere is considered to be an open-access resource; Section 3 shows that climate change is the re- • Explain why greenhouse gas emissions are neg- sult of such a market failure occurring because ative externalities; two assumptions are not met. First, contrary to • Discuss why climate change is considered to be the assumption of all commodities being pri- the biggest market failure in human history; vate goods, the atmosphere is an open-access re- • Use game theory tools to analyse how econo- source (see Section 3.1). As such, there are no legal mists explain the fact that the international constraints on its use, and therefore any country community has been struggling to implement can release any amount of greenhouse gases climate change mitigation policies. into the atmosphere at any time. Open-access re- sources cannot be “efficiently” exploited in mar- To support the learning process, readers will find ket economies because countries tend to overuse several exercises and discussion questions in Sec- them. Second, GHG emissions are negative exter- tion 5 covering the issues introduced in Module 3. nalities (see Section 3.2). Negative because they Additional reading material can be found in Annex 1. detract from social welfare and externalities be- cause they are external to any accounting within the economic system. Economic agents do not 2 The competitive markets model take negative externalities into account when and Pareto efficiency making their decisions, and consequently over- emit greenhouse gases into the atmosphere. Due Neoclassical economic theory stipulates that to the combination of these two factors, markets markets allocate resources efficiently. If this is in- fail to generate a Pareto-optimal situation. This deed the case, then why do markets sometimes 64 The economics of climate change 3 fail to do so, producing highly inefficient out- modelled. Economists have developed a standard comes leading to environmental problems such model of a competitive market economy,41 which 41 Going into the details of module as climate change? To answer this question we we will now briefly introduce and which will the microeconomic foun- first have to understand why economic theory serve as a starting point to understand how eco- dations of the competitive market model is beyond concludes that markets produce efficient out- nomic theory explains the occurrence of climate the scope of this material. comes, in particular, understand (a) how econo- change. Interested readers may refer mists conceptualize market economies, and (b) to standard microeconomic how economists evaluate the efficiency of market In this standard model, the economy is assumed textbooks such as Varian economies. This section clarifies these two points to be composed of economic agents (firms and (2010). Additional readings can also be found in Annex 1. and shows that, given certain conditions, eco- households) acting purely in their own self- nomic theory predicts that markets indeed pro- interest – i.e. trying to optimize their behaviour duce efficient outcomes. Section 3 subsequently to achieve the outcome that is best for them. In shows that in the context of climate change, other words, firms try to maximize their profits some of these conditions are violated, and there- while households try to maximize their utility fore markets fail to achieve efficient outcomes. (i.e. consume a mix of goods and services that makes them as satisfied as they can be on a giv- 2.1 A simple model of market economies en budget). The model assumes that there are many different markets, one for each commodity. Economic processes are inherently complex and Each competitive market connects demand (how difficult to understand. Economists thus rely on much households are willing to pay for the com- theoretical models of the economy to improve modity) and supply (how much firms want to be their understanding of these processes. Eco- paid to produce the commodity), thereby deter- nomic models are theoretical constructs that mining how much of the specific commodity is aim to represent different aspects of economic produced. In such a competitive market, the price processes in a simplified way. They therefore rely of a commodity adjusts until demand equals on assumptions that might not necessarily hold supply. This is called equilibrium. Put differently, a in reality. Nevertheless, the models are very use- market is in equilibrium if the sum of the quanti- ful tools because they shed light on complex eco- ties of commodities that households want to buy nomic mechanisms and their relationships with at current prices equals the quantities of com- the environment. Market economies, currently modities that firms want to produce at current the dominant form of economic organization prices (see Box 12 for a graphical illustration of an (Cohen, 2009), have been extensively studied and equilibrium in a single competitive market). Box 12 Equilibrium in a single competitive market Figure 30 displays a single competitive market for a normal good and shows the demand and supply curve for this particular good. The demand curve relates the quantity demanded by consumers to the market price. It is downward sloping, meaning that the cheaper the good, the more of it consumers are willing to buy. The supply curve relates the quantity supplied to the price and is upward sloping, meaning that the higher the price firms can charge, the more they are willing to supply. The market is in equilibrium at price P* and cor- responding quantity Q*, as this is the only point where demand equals supply. Note that given the supply and demand curves, this is the only equilibrium in this particular market. For any other price, supply does l l not equal demand. To see this, look for instance at price P : at this price, consumers demand Q d, but producers l are only willing to supply Q s. This situation is clearly not an equilibrium, as the quantity demanded is higher than the quantity supplied. Figure 30 Equilibrium in a single competitive market Price Supply P* Pl Demand l l Q s Q* Q d Quantity Source: Author. 65 3 The economics of climate change If all firms maximize their profits, all consumers While the Pareto-efficiency criterion is useful as a maximize their utility given their budget con- benchmark for evaluating whether or not an al- module straints, and all individual commodity markets location is efficient, it has its limits. If two alloca- are in equilibrium, then the resulting allocation of tions are Pareto-efficient, the criterion is unable commodities and the corresponding set of prices to evaluate which of the two allocations is prefer- is called a competitive equilibrium. Put differently, able.