A Brief Early History of Environmental Economics

This is a different kind of post than the ones that we will usually have during the remainder of the semester. It is longer than usual and much more academic. I decided though that this would be a productive and helpful exercise to introduce you right from the start to a number of ideas that we will be reading and discussing during the next 13 academic weeks. Read the attached and write a thoughtful comment about it. Do not forget to add your name to your comment and make sure that you post what you have to say before the deadline. Anything submitted after the deadline will not earn you any credit.

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The Emergence of Natural Resource Economics It is in fact quite hard to pinpoint the actual beginning of natural resource economics. The frame of reference for the early classical economists in the late eighteenth century was a society that was still primarily based on agriculture, and the productivity of land therefore played a prominent role in the economics of Adam Smith and his predecessors. In Malthus’ theory (Malthus 1798), agricultural productivity played a central role in his predictions of the population’s future standard of living. Some decades later, Jevons (1865) emphasized the scarcity of a nonrenewable resource (coal) as a constraint on the development of the British economy, while Alfred Marshall (1890) identified the possible inefficiencies that could arise through competitive exploitation of a common property resource. The decades that followed saw the development of economic analysis in relation to both renewable and exhaustible resources. I will focus my remarks here on a few landmarks in the history of natural resource economics.12 Fisheries as a Common Property Resource It took some time for other economists to follow up on Marshall’s interest in fisheries as a common property resource. In fact, in the following decades it was biologists rather than economists who expressed concern that the organization of the fishing industry could lead to an outcome that was suboptimal from the point of view of society as a whole. The contribution that brought fisheries to the attention of the broader economics profession was the article by Gordon (1954), which described the structure of the fishing industry, constructed a formal economic model of biological and economic equilibrium, and derived conclusions for the design of economic policy. In Gordon’s model, fishermen have free access to one or more fishing stocks and the marginal cost of fishing effort is assumed to be constant. From society’s point of view, the optimal fishing effort is the level where the value of the marginal productivity equals the unit cost. However, with free access to the common property resource, the equilibrium will be where the value of the average productivity is equal to the unit cost. Because average productivity is greater than marginal productivity, the level of fishing effort will be too high. In Gordon’s words, “... the rent which the intramarginal grounds are capable of yielding is dissipated through misallocation of fishing effort.” Gordon elaborated on this conclusion: “This is why fishermen are not wealthy, despite the fact that the fishery resources of the sea are the richest and most indestructible available to man. By and large, the 12For more detailed accounts of the history of this branch of economic theory, see Robinson (1989) and Barbier (1989). 56 A. Sandmo Downloaded from https://academic.oup.com/reep/article-abstract/9/1/43/1576378/The-Early-History-of-Environmental-Economics by guest on 05 September 2017 only fisherman who becomes rich is one who makes a lucky catch or one who participates in a fishery that is put under a form of social control that turns the open resource into property rights.” (Gordon 1954, 132) Gordon’s article became extremely influential, particularly in fisheries economics but also in the broader field of the economics of common-property resources. From the point of view of the history of economic thought, it is interesting to note that many of Gordon’s results had already been presented by the Danish economist Jens Warming (1911). However, Warming’s article was published in Danish and thus failed to reach an audience beyond the Nordic countries, and his other efforts to present his theory to a wider international audience were also unsuccessful.13 The Economics of Exhaustible Resources We have seen that Jevons (1865) was concerned about the consequences of the exhaustion of Britain’s coal resources. Today, we might wonder why he did not take up the challenge of analyzing the optimal time pattern of exhaustion. One obvious explanation is that the theoretical tools required had not yet been developed, although only 6 years after publication of The Coal Question Jevons himself sketched the principles of utility maximization over time. Some early efforts to analyze this problem by the use of economic theory did occur during the next few decades, as for example in Gray (1914), which analyzed the problem of exhaustion on the basis of Ricardo’s (1817) theory of rent. However, the great leap forward in this area was in 1931 with the publication of Harold Hotelling’s “The economics of exhaustible resources” (Hotelling 1931). Hotelling notes that the world’s diminishing reserves of minerals, forests (sic) and other exhaustible resources have led to demands for the regulation of their exploitation—as John Stuart Mill (1848) had indeed called for almost a century earlier. As background to his theoretical analysis, Hotelling points out that “[the] feeling that these products are now too cheap for the good of future generations, that they are being selfishly exploited at too rapid a rate, and that in consequence of their excessive cheapness they are being produced and consumed wastefully has given rise to the conservation movement.” (Hotelling 1931, 137) On the other hand, he argues, it is well known that some of the supply of these resources is controlled by monopolies and generally accepted that monopolies restrict output below the social optimum. This view would appear to contradict the feelings prevalent in the conservation movement that resources are being exhausted too rapidly from society’s point of view. To clarify this issue, there is a need for a more rigorous theoretical approach that moves beyond the framework of the static theory of optimal resource allocation. Hotelling argued that the analysis 13Warming’s article was translated into English by Andersen (1983). Warming’s work on fisheries economics is described in an interesting article by Topp (2008), which also contains a biographical sketch. An important feature of Warming’s work was that he analyzed the use of a competitive market for quotas as a means of bringing about optimal resource use in the fisheries. Early History of Environmental Economics 57 Downloaded from https://academic.oup.com/reep/article-abstract/9/1/43/1576378/The-Early-History-of-Environmental-Economics by guest on 05 September 2017 of optimal resource extraction must employ the most advanced mathematical tools of dynamic optimization theory. Indeed “[problems] of exhaustible assets cannot avoid the calculus of variations, including even the most recent researches in this branch of mathematics.” (Hotelling 1931, 140) Hotelling’s Rule The most famous result to come out of Hotelling’s applications of the calculus of variation is his “rule” that under perfect competition the net price of a natural resource must grow at the rate of interest. He compared this equilibrium condition to the result derived from social welfare maximization (assuming that the welfare function took the form of time-additive discounted utility) and showed that the competitive equilibrium satisfied the optimality condition. Hotelling went on to examine a number of extensions of the model that would arguably move it closer to real-world conditions (such as monopoly resource ownership), and he studied the implications of the model for economic policy. Altogether, Hotelling’s “The economics of exhaustible resources” represents a major step forward in natural resource economics. Given its advanced mathematics, it may have been too far ahead of its time to have had a significant impact on economic policy when it was first published. Moreover, in the 1930s, other priorities were at the forefront of policy debates; Keynesian macroeconomics drew more attention from the profession than the economics of natural resources. However, with increased concern about resource scarcity in the 1970s, Hotelling’s contribution received renewed attention from an economics profession that was now better prepared to consider policy analysis that was couched in the complex language of the calculus of variations. Paretian Welfare Economics and Externalities Pareto’s work became more widely known in the mid-twentieth century and began to be explored and extended by some of the most prominent theorists of the time, notably Samuelson (1947), Lange (1942), Little (1950), and Graaf (1957). However, reading these contributions from the perspective of modern environmental economics one is struck by the fact that externalities occupy a very insignificant place in them; externalities as a source of market failure was evidently not considered to be a central element of welfare theory. On a related point, the typical exposition of welfare economics at the time had much to say about the marginal conditions required for an optimum (e.g., the equality of the marginal rates of substitution and transformation) but little to say about the marginal conditions that emerge from utility and profit maximization in a competitive equilibrium.14 It is clear, however, that it is in the comparison of these two sets of marginal conditions and in the analysis of the cases when “prices are wrong” that we find the starting point for the analysis of market failure. Another notable feature of the welfare economics of the mid-twentieth century is that in cases 14In fact, Samuelson’s justly famous chapter on welfare economics in his Foundations (Samuelson 1947) makes no mention of market prices and individual optimization. 58 A. Sandmo Downloaded from https://academic.oup.com/reep/article-abstract/9/1/43/1576378/The-Early-History-of-Environmental-Economics by guest on 05 September 2017 where externalities and prices are actually being treated explicitly, the examples that are chosen to illustrate market failure (e.g., the two agent case of the apple grower and honey-producer in Meade [1952]), suggest that these are not important issues of concern for a modern industrial society. A contribution that is significantly different in these respects is the article by Bator (1958), which explicitly links externalities to the failure of the competitive price system to capture all the costs and benefits that are relevant for a socially optimal allocation of resources. In addition, Bator introduces a separate category of externalities that had not been identified by previous writers, that is, the public goods type of externalities that could be related to the work of Samuelson (1954). Writing just a few years before the birth of modern environmental economics, Bator did not explicitly link this category to environmental externalities; he also failed to explore the distinction between private goods with externalities on the one hand and pure public goods on the other. The Theory of Public Goods The theory of public goods as first presented in the framework of welfare economics in Samuelson (1954) is of obvious relevance for environmental economics. The examples of unspoiled natural beauty and unwholesome factory smoke, as discussed by Mill (1848, 1972) and Pigou (1920), respectively, fit directly into this framework, as do our present-day concerns about biological diversity and global warming. Environmental benefit-cost analysis is the practical application of the fundamental ideas in the theory of public goods. Moreover, the optimality formula for the efficient provision of public goods—which requires that the sum of their marginal benefits equal their marginal cost—is reflected in the applied methodology of environmental project analysis. However, Samuelson’s analysis was limited to the case of pure public goods, and Bator’s discussion was along the same lines. In this case, there is no conceptual distinction between individual and total consumption, and the individual agent has no—or at least extremely weak—incentives to provide a good whose benefits accrue to a large number of individuals but whose costs are borne solely by the individual agent. In the case of private goods with externalities, there is a positive private incentive to consume or produce the good in question. However, the individual has no incentive to take account of the additional costs and benefits, be they positive or negative, that arise for all other individuals in the community. Hence, there is the tendency for goods with negative externalities to be produced in an amount that exceeds the social optimum, while goods with positive external effects will be underprovided. This type of case received a lot more attention during the 1960s and after as the separate field of environmental economics developed. By modeling market failure in regard to the environment as a case where private goods production or consumption generates public goods type externalities, it can be shown that the Samuelson sum of the marginal rates of substitution measures not only the benefits from public goods provision, but also the benefits generated by appropriately leveled Pigouvian taxes that reduce harmful externalities.15 Thus, when environmental economics first emerged as a separate subdiscipline, a consistent framework for the analysis of market failure and corrective policies already existed. The further 15This point is made explicitly in Sandmo (1975). Early History of Environmental Economics 59 Downloaded from https://academic.oup.com/reep/article-abstract/9/1/43/1576378/The-Early-History-of-Environmental-Economics by guest on 05 September 2017 development of welfare economics was marked by the emergence of second-best tax analysis, which, among other things, led to the literature on the double dividend. This issue is a concern of present-day environmental economics and thus moves us rather far from our field’s early history. Nevertheless, it is important to emphasize that the theory of public goods and externalities has shown itself to be remarkably robust in its applications to environmental problems, gradually ascending from the local level of apples and bees to the global problem of climate change, “the greatest market failure the world has ever seen” (Stern 2007). Environmental Economics and Public Finance At this point, a comment may be in order regarding the relationship between environmental economics and public finance or public economics. Environmental taxation was discussed by Pigou in the 1920s and explicitly linked to public economics issues in his Study in Public Finance (Pigou 1928). But the relationship between environmental economics and public finance received relatively little attention in the academic literature in the following decades. One striking example of this neglect is Musgrave’s famous treatise The Theory of Public Finance (1959), which summed up the status of the field at the end of the 1950s. Musgrave devotes little more than a paragraph to Pigouvian taxation, which does not even mention the environmental perspective (Musgrave 1959, 115). Even more puzzling, the paragraph appears in a chapter entitled “The ability-to-pay approach.” This is in sharp contrast to the situation today, where environmental taxation and benefit-cost analysis are common and, in fact, central themes for both public finance and environmental economics. The study of optimal environmental taxation and benefit-cost analysis applies welfare economics to public policy issues. The Paretian approach to welfare economics derives conditions for social efficiency and welfare from individual preference orderings or utilities. However, this approach may become problematic when it comes to examining the effects of consumption or production decisions on individuals when the consequences are hidden from most people, acting in their capacity as individual consumers and producers without specialized scientific information about the consequences of their private choices. The philosopher and economist Henry Sidgwick noted early on that such cases may call for deviations from the principle of consumer sovereignty. In his Principles of Political Economy (1887), Sidgwick pointed out that governments did in fact try to protect their citizens from making unwise choices concerning, for example, unhealthy or diseased food, unqualified physicians, and hazardous industrial work processes. In Sidgwick’s view, consumer sovereignty, which he describes as “the fundamental assumption on which the economic rule of laisser faire partly rests,” should only be accepted as “a handy though rough rule of practical statesmanship” from which exceptions should be allowed in special cases. This view has been reflected in many subsequent discussions of environmental problems, most notably, perhaps, in the current debate about global warming.16 Concluding Remarks This has been a very selective survey of the early history of environmental economics, and it is fair to ask whether we can conclude that environmental economics even has an interesting past 16Banzhaf (2011) provides an interesting historical discussion of this issue. 60 A. Sandmo Downloaded from https://academic.oup.com/reep/article-abstract/9/1/43/1576378/The-Early-History-of-Environmental-Economics by guest on 05 September 2017 prior to the 1960s. My own conclusion—which should come as no surprise—is that it does. Clearly, our discipline has much to learn from the early writings on environmental issues in a more specific sense, and also from the dependence of the growth of environmental economics on the more general development of economic theory and methods. What explains the evolution of environmental economics from its early history of scattered contributions on a diversity of topics to a fully developed field of specialization in the postWorld War II period? This is a big and complex question that cannot be fully answered here. On the one hand, one could cite the growth of environmental problems arising from increasing industrialization, energy use, and the pressure of population. On the other hand, one could also argue that increasing standards of living, particularly in the industrialized world, have led to an increased demand for environmental quality; that is, the appreciation of environmental goods is income elastic. The interactions between these two sets of factors might go a long way toward explaining the increased attention to environmental issues in economics. However, this type of explanation is unlikely to be wholly satisfactory. It took a long time for economists to start paying attention to environmental issues, even though environmental problems like those relating to sanitation and public health must have already been pressing at the early stages of the industrial revolution. One of the reasons for this lack of attention among economists at the time is likely the widely held view that environmental quality was not a core issue of economics as a discipline. Another reason for the delay in focusing on environmental problems must certainly be that it took a long time for economists to develop the theoretical concepts required to analyze problems of market failure related to the environment. Thus, the transition to the modern field of environmental economics in the 1960s may have started with the realization in the economics profession that its tools of analysis had finally reached the stage where they were adequate to the challenges posed by environmental deterioration. If this view is accepted, then the transition is an interesting example of what Tjalling Koopmans (1957) described as the “interaction of tools and problems in economics.” As he put it, “The solution of important problems may be delayed because the requisite tools are not perceived. Or the availability of certain tools may lead to an awareness of problems, important or not, that can be solved with their help” (Koopmans 1957, 170). This perspective offers a promising approach to further examination of the history of environmental economics.