Markets and the

environMentsecond edition

Foundations of Contemporary Environmental Studies

Ecology and Ecosystem Conservationoswald J. schmitz

Global Environmental GovernanceJames Gustave speth and Peter M. haas

Coastal Governancerichard Burroughs

Water Resourcesshimon C. anisfeld

Ecology and ReligionJohn Grim and Mary evelyn tucker

Markets and the

environMent second edition

nathaniel o. keohane

sheila M. olmstead

Washington | Covelo | London

Copyright © 2016 nathaniel o. keohane and sheila M. olmsteadFirst island Press edition, 2007

all rights reserved under international and Pan-american Copyright Conventions. no part of this book may be reproduced in any form or by any means without permission in writing from the publisher: island Press, 2000 M street, nW, suite 650, Washington, dC 20036.

isLand Press is a trademark of the Center for resource economics.

Library of Congress Control number: 2015939771

Printed on recycled, acid-free paper

Manufactured in the United states of america

10 9 8 7 6 5 4 3 2 1

keywords: environmental economics, environmental policy, cost-benefit analysis, externalities, capital assets, natural resources, green accounting, water pricing, carbon market, limits to growth

For Frances and Eleanor, and for Gau.—n.o.k.

For Kevin, Finn, and Laurel.—s.M.o.

Contents

Preface xv

Chapter 1: Introduction 1

economics and the environment 1

Global Climate Change 2

organization and Content of this Book 6

What We hope readers Will take away from this Book 9

Chapter 2: Economic Efficiency and Environmental Protection 11

economic efficiency 12

efficiency and environmental Policy 20

equating Benefits and Costs on the Margin 22

dynamic efficiency and environmental Policy 31

Conclusion 34

Chapter 3: The Benefits and Costs of Environmental Protection 35

Measuring Costs 35

evaluating the Benefits 44

Benefit–Cost analysis 55

Conclusion 68

Chapter 4: The Efficiency of Markets 69

Competitive Market equilibrium 70

the efficiency of Competitive Markets 74

Conclusion 78

Chapter 5: Market Failures in the Environmental Realm 80

externalities 81

Public Goods 85

the tragedy of the Commons 91

Conclusion 97

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Chapter 6: Managing Stocks: Natural Resources as Capital Assets 99

economic scarcity 100

efficient extraction in two Periods 103

a Closer Look at the efficient extraction Path 105

What about Market Power? 110

the Critical role of Property rights 111

Conclusion 113

Chapter 7: Stocks That Grow: The Economics of Renewable Resource

Management 114

economics of Forest resources 114

Fisheries 128

Conclusion 137

Chapter 8: Principles of Market-Based Environmental Policy 139

the Coase theorem 140

the array of Policy instruments 143

how Market-Based Policies Can overcome Market Failure 147

raising revenues 160

setting Prices versus setting Quantities 162

Conclusion 167

Chapter 9: The Case for Market-Based Instruments in the Real

World 168

reducing Costs 169

Promoting technological Change 179

Market-Based instruments for Managing natural resources 184

other Considerations 189

Conclusion 198

Chapter 10: Market-Based Instruments in Practice 199

the U.s. sulfur dioxide Market 200

individual tradable Quotas for Fishing in new Zealand 207

Municipal Water Pricing 214

the european Union’s emissions trading system 217

Water Quality trading 221

Waste Management: “Pay as You throw” 223

habitat and Land Management 224

Conclusion 230

Chapter 11: Sustainability and Economic Growth 231

Limits to Growth? 232

sustainability, in economic terms 238

keeping track: Green accounting 245

contents xiii

are economic Growth and sustainability Compatible? 252

Conclusion 253

Chapter 12: Conclusion 254

What does economics imply for environmental Policy? 254

the roles of Firms, Consumers, and Governments 256

some Final thoughts 257

Discussion Questions 259

References 267

Further Reading 291

Index 297

Preface

this book provides a concise introduction to the economic theory of environmental policy and natural resource management. if you have used this book before, you may be asking yourself what is new in the second edition. in the 8 years since the publication of the first edition, although little has changed in economic theory with respect to environmental quality and environmental policy, readers urged us to revise the book for several reasons. First, faculty members using the book to teach undergrad-uate environmental and resource economics encouraged us to strengthen the links between the material in the book and that covered in a typical introductory microeconomics course, mostly via changes in the language we used in discussing economic concepts. We’ve done this throughout the book. also at the recommendation of users, the descriptions of cost and benefit estimation in Chapter 2 have been revised and expanded, and the discussion of environmental taxation in Chapter 8 has been restructured.

research in the field of environmental economics moves quickly, and we’ve incorporated a good deal of important new knowledge created since the first edition. throughout the book, we have updated old ex-amples and added many new examples of market-based environmental policy in action, primarily in the boxes that accompany the text but also in the text itself. in this vein, major updates were made to the cover-age of deforestation in Chapter 7, the discussion of market-based instru-ments and nonuniformly mixed pollutants in Chapter 9, and all sections in Chapter 10.

Finally, we were shocked at how quickly some of the popular culture references in the first edition (those to compact discs and napster, for example) became dated, so we’ve done our best to sound current, al-though we admit that our children are now better sources for this kind

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of information than we are. despite these many changes, this edition pre-serves the basic structure of the original, with some small exceptions; for example, we have dropped the mathematical appendix on the economics of fishing from Chapter 7.

as in the first edition, our goal is to illuminate the role economic the-ory—and more broadly economic thinking—can play in informing and improving environmental policy. to our minds, noneconomists tend to perceive economics rather narrowly, as being concerned only with money or with national indicators such as exchange rates and trade balances. in fact, economics has a much wider reach. it sheds light on individuals’ con-sumption choices in the face of scarce resources, the interaction between firms and consumers in a market, the extent to which individuals are likely to contribute toward the common good or ignore it in the pursuit of their own self-interest, and the ways government policies and other institutions shape incentives for action (or lack thereof ). as we explain in the first chapter of the book, economics is central to understanding why environmental problems arise and how and why to address them. as concerned citizens as well as economists, we think it is vital for anyone interested in environmental policy to be conversant in the language of economics.

the approach we have taken here draws on our own experience teach-ing environmental and natural resource economics to master’s students and undergraduates. it also draws on our experiences in the real world of environmental policy, in the public and nonprofit sectors. the emphasis is on intuition rather than algebra; we seek to convey the underlying concepts through words and graphs, presenting mathematical results only when necessary. We have also included a wealth of real-world examples, from the conservation of the California condor, to mitigation of global climate change, to using markets to manage fisheries in new Zealand and elsewhere.

the book was written with university students in mind, but its infor-mal style and the importance of the subject make it suitable for a wide range of professionals or other concerned readers seeking an introduction to environmental economics. We have tried to make the language acces-sible to someone without any prior knowledge of economics. at the same time, the treatment is comprehensive enough that even an economics major with little experience in environmental policy could learn a great deal from the book. the lack of mathematical notation does not reduce the rigor of the underlying analysis.

preface xvii

in our teaching, we have noticed a gap between short articles on how economists think about the environment and textbooks filled with alge-bra and detailed information on the history of U.s. federal environmental legislation. in addition, most textbooks on the subject of markets and the environment treat either the economics of pollution control or the eco-nomics of natural resource management. at an introductory level there is little integration of these two “halves” of the discipline of environ-mental and resource economics. this book aims to fill these gaps. it can be used as a primer for a core course in environmental studies, at either the undergraduate or master’s level. in that context, this book would be the sole economics text, used alongside several other books representing different perspectives on environmental studies from the social, natural, and physical sciences. the book is also well suited to a semester-long course in environmental or natural resource economics, either as a main text (supplemented with more mathematical lecture notes and problem sets) or as a complement to another, more detailed (but perhaps less in-tuitive) textbook. Finally, the book could be used (as we ourselves have used the notes from which it grew) as an introduction to environmental economics in a course with a different focus. For example, a course on business strategy can use this book to explain the basic logic and prac-tice of market-based policies to regulate pollution. similarly, a principles of microeconomics course could use this book to show how economic theory can be applied to real-world problems and illuminate the market failures aspect of the course.

at the end of the volume, readers will find a list of references, includ-ing works cited in the text and other recommended readings of possible interest. We have also provided a set of study questions for each chapter, designed to be thought provoking and open-ended rather than simply reiterating the material.

We thank karen Fisher-vanden for providing thoughtful comments on the first edition and robert stavins, elizabeth Walker, and Louise Marshall for their extensive input on what to fix in the second. We are also grateful to the book’s many other users who have e-mailed us comments, suggestions, and corrections over the years. Please keep that information coming. our editors at island Press for both editions, todd Baldwin and emily davis, patiently moved us through the process of writing and revis-ing the book. We thank our spouses, todd olmstead and Georgia Leven-son keohane, for their support and encouragement. Finally, we both owe a great deal to robert stavins, whose passion for teaching environmental

xviii preface

economics and communicating its principles to policymakers—and un-rivaled ability to do so—continues to inspire us.

nathaniel o. keohane sheila M. olmsteadnew York, new York austin, texas