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Economics of Climate Change

Introduction

This short unit explains how decisions are taken about allocating scarce resources in a market economy, and why such decisions may have potentially disastrous effects on the environment, including the climate.

Unit authored by Alistair Young

Learning outcomes

By the end of this unit you should be able to:

  • develop an understanding of the contribution of economic institutions to the problem of climate change;

  • encourage familiarity with the relevant conceptual tools used by economists to analyse the problem.

1 The market

1.1 How the market works …

In a free market economy, consumer wishes are linked to producer supply through the medium of prices. We express the strength of our desire for particular goods and services by the price which we are willing to pay for them. Thus, prices give firms information about what to produce, and they also provide incentives to get on with producing it. This is because firms are motivated by profits: the revenues they make from selling us goods, minus the costs of producing and marketing them. The revenues are simply the prices they get for the goods, multiplied by the quantities they are able to sell at these prices. The costs are given by the quantity of resources they use up in production, multiplied by the prices firms have to pay to attract these resources away from their next best uses.

The system is a very flexible one. If consumers change their minds about what they want, this will be signalled through a rise in the prices they are willing to pay for their new preferences and a corresponding fall in the prices of the old ones. Spurred by the desire to make greater profits and avoid losses, firms will switch their resource use accordingly.

The free price system can be researched on Wikipedia.

Activity 1

Before going on, consider the following question: if the free market and the profit motive are so efficient at delivering the goods people want, why are they so often criticised?

1.2 … and why it sometimes doesn't work so well

For the market to work well, a range of conditions have to be fulfilled. But for our present purposes, one of these is especially important: the property rights in resources used in production have to be clearly assigned and be capable of enforcement at low cost.

A simple example may make this clear. Imagine you live in a society with no taxes on fuel or energy use, where all electricity comes from privately financed coal-fired power stations. When you switch on your kettle, what resources are you using and what does it cost you? You have to pay a price for generating the electricity; part of this cost will be to pay off the costs of building and maintaining the power station, another part for the operation of the power station and part for the mining and transportation of coal to the power station.

In all these cases, you are compensating the owners of property rights for the use of their ‘property’, broadly interpreted to include labour services as well as plant and raw materials. You are destroying coal by having it burned up to supply your electricity, but you have to pay for this because somebody else owns clearly defined property rights in the coal and can easily enforce them.

But you are destroying something else as well, which you will not be asked to pay for: an unpolluted atmosphere. The burning of the fossil fuel releases carbon dioxide into the atmosphere, and, in consequence, causes climate instability. When our actions destroy a scarce resource which we are not required to pay for, we have what economists call an ‘externality’ problem.

The market works well when providing goods for which the full cost to society has to be borne; this obliges consumers to ‘economise’ in their use of the scarce resources used to produce the goods. But because we cannot create, transfer or enforce private property rights in the atmosphere, we have been able to treat it as a free and unlimited resource, when in fact it is scarce and may be irretrievably damaged by the misuse to which the economic incentive system encourages us to subject it.

The concept of externalities is of wide relevance in economics. It is further explained, with particular reference to environmental problems, in an article in The Encyclopedia of Earth.

2 Competing goods?

2.1 Public goods and private goods

So markets fail when there is a difference between private costs and social costs arising from an activity, caused by those costs that are ‘external’ to the decision-maker who chooses to undertake the activity.

An alternative way of looking at the problem is to suggest that markets function well when providing ‘private’ goods, but not ‘public’ goods. Public goods are not to be confused with goods provided by the government; there is overlap, but many government-supplied goods are not public, and some public goods are not supplied by governments (and hence often not supplied at all).

The technical definition of a public good requires that it should satisfy two criteria:

  • non-rivalness – an additional person may enjoy the good without reducing the enjoyment of anyone else (unlike a private good – if I have a slice of cake there will be less cake for you)

  • non-excludability – once the good has been provided for one person, it cannot be denied to any others who might want it.

Climate stability is a good that exemplifies the non-rivalness condition; if we manage to create a stable climate for even one person then any other person may benefit from it too, at no extra cost. It is also nonexcludable, since once the global climate has been stabilised, everyone in the world will automatically get the benefits from this, whether or not they have been prepared to bear the costs of bringing this stability about.

This last point creates a problem for the provision of public goods. If you will benefit from the good whether or not you have helped to pay for it, there will be a strong incentive to avoid bearing the costs of provision. This may be clearly seen using a model from game theory known as the prisoners' dilemma.

2.2 Game theory: prisoners' dilemma

Suppose you have become convinced that long-distance flights are having a significant impact on global warming, but that you get a lot of pleasure from holidays in the Far East. If you could be sure that global warming would be substantially reduced if you personally stopped flying, you would willingly pay that price. But in fact you also know that your own contribution to global warming is a very small part of the total; if you alone stop flying, then there will be no observable impact on global warming, while if everyone else stops taking long-distance holidays global warming will be reduced even if you carry on. We may show this situation in the form of a matrix, as follows:

Stop flying Carry on flying
Everyone else's strategies Second best Third best
Your strategy Worst Best

The words in italics show the rank order of your personal ‘payoffs’ from different strategies, given the reactions of other people. You will see that your optimum strategy is to carry on flying, regardless of what others decide. For, if they stop, you will gain from a reduction in global warming even if you carry on, and in the latter case you will still be able to enjoy your holiday: ‘best’ is better than ‘second best’. Similarly, if they don't stop flying either, then you will suffer from the effects of global warming, but at least you too will have been able to get away on holiday; ‘third best’ is better than ‘worst’. In the language of game theory, the strategy ‘carry on’ dominates the strategy ‘stop’. It seems logical to assume that everyone else will have made the same calculation, and thus everyone else will adopt the ‘carry on’ strategy.

This allows us to predict that everyone will end up in their own third-best boxes, even if we were all agreed that it would be better for us personally if we were all in the second-best box. The structure of the payoffs implies that a purely voluntary system of paying for a public good such as climate stability will not achieve that end; in general, where public goods are concerned, a free market system cannot work and some form of collective compulsion is required.

This is a very simplified introduction to prisoners' dilemma. For more details, including some discussion of the evidence of its practical relevance, you can consult Wikipedia.

Activity 2

You may wish to consider these questions:

  • Economists are often accused of overemphasising the role of self-interest in human affairs. If we assumed that people were prepared to act altruistically, how much difference, if any, might it make to the public goods argument?

  • If we apply the prisoners' dilemma argument to treaties between nations rather than the decisions of private individuals, does it make the problem of global warming easier or harder to resolve?

  • The implication of seeing climate stability as a ‘public good’ problem is that coercive government action may have to replace voluntaristic market mechanisms in order to solve it. What limits on effective government action are likely to be encountered?

  • Can you think of ways in which governments might try to use market incentives in trying to solve the problem of climate change?

Acknowledgements

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Text

Unit authored by Alistair Young

Unit image

Getty photodisc

Links

All links accessed 27 November 2009.