Coastal Services Center

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Environmental Economics

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An Economic View of the Environment

Figure 1. Sunrise on the Coast Courtesy NOAA photo library.

Figure 2. Overview of the topics discussed on this Web page.

Introduction

Economists are often charged with the difficult task of placing a value on environmental resources. The air we breathe and the water we drink are environmental resources that are required to sustain life on this planet. The environment also serves as a source of pleasure to humans in viewing the sun on the horizon, admiring the tranquil beauty of a forest-ringed lake, or driving along a scenic ocean road (Figure 1). Many people argue that environmental (e.g., land, air, and water) and natural resources (e.g., coal, trees, and fish) are, in fact, priceless. Thus, they say, it is not appropriate to consider them within the context of economic valuation. However, the world's population has proven unwilling to forgo all future economic activity to eliminate all factors that cause environmental damage. Human societies are willing to give up certain environmental assets to generate other kinds of economic gains. The value placed on environmental assets is illustrated in our choices against other competing economic needs. Figure 2 shows an economic view of the environment and outlines the topics discussed below.

Economic principles suggest that the well-being of a society can be measured as the sum of all the individuals' level of well-being. This well-being, or what economists call "utility," is not derived solely from purchasing and consuming goods and services, but also from things like safety, and our physical, mental, and spiritual well-being.

The fact that all these things have utility is evident in that we are willing to trade our time, effort, money, and other resources to get them. The utility or degree of satisfaction experienced by individuals, and thus society, can be quantified in terms of the "willingness to pay" for goods and services, including environmental resources. In many cases, individuals do not pay for the environmental benefits they receive. However, their willingness to pay for these benefits can be derived from surveys, observed behavior, or through other methods. The willingness-to-pay concept is key in environmental valuation, granting analysts a framework upon which to examine and measure individual preferences. Positive preferences for environmental resources translate into an expressed or observed willingness to pay for them. Conversely, individuals are not willing to pay for environmental resources that they do not value.

Coastal areas contain resource-rich environmental systems that provide a broad spectrum of services to humankind. From recreational opportunities, such as hiking and wildlife observation to the harvesting of fish and other seafood for human consumption, coastal habitats provide many direct benefits. Indirect benefits (e.g., biological support and water and air purification) and non-use benefits (e.g., the satisfaction that we get from knowing that the environment has been preserved for future generations) also affect the decision to exploit or conserve natural resources (Figure 3).

Figure 3. Direct benefits of the coastal environment include (a) whale watching and (b) shrimp harvesting, while an indirect benefit is (c) the habitat provided. Non-use benefits are derived from the satisfaction of knowing an area will be preserved for future generations (d).

Natural resources are also valuable in the production of other goods. The output of any firm is a function of several important inputs, which economists call "factors of production." The factors of production include labor, capital (such as buildings and machinery), and an array of environmental inputs. These environmental inputs include the land upon which production takes place, raw materials extracted from the environment, such as minerals and timber, and often, clean air and water. It is sometimes, but not always, possible to offset declines in the natural resources required in production processes by increasing labor and capital. However, environmental depletion and damage ultimately lead to declining input availability and reductions of output and utility.

The decisions society makes about how to use its natural and other resources involve tradeoffs. All other things being equal, when we decide to increase the flow of one service of coastal resources (e.g., fish nursery), we are also implicitly deciding to decrease the flow of another service (e.g., disposal of wastewater). In other words, our decision to harvest fish is tied to a decision to damage the fisheries output by disposing of polluted wastewater.

The decisions we make regarding resource use are governed by scarcity. To economists, scarcity is a function of supply and demand. If resources are highly valued, it is because they are scarce and the demands placed upon those resources are large relative to their availability. Further, the decision of how to allocate these scarce resources has an impact on all sectors of the economy because of the complex relationship between natural resource inputs and economic output.
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The Circular Flow of the Economy and the Environment

The economy and the environment are inextricably linked. The environment supplies the raw materials and energy that are used to produce the goods that we consume. Waste generated by this production process is either recycled or dumped back into the environment. Figure 4, which represents a small part of the overall picture, partially demonstrates the interconnectivity of the economy and environment (Pearce and Turner 1990).

Figure 4. Resource inputs and positive amenity creates utility.

Later we will demonstrate that the relationship between the economy and environment does not represent an open, linear process, but is rather illustrative of a closed, circular system. Within the environment and economic flow diagram, raw materials (R) are used as inputs into the production process (P) that creates the goods consumed by households (C). The end result of production and consumption is the creation of utility (U) or satisfaction. Thus, the function of the environment, as highlighted within the diagram, is to provide material inputs into the production process and positive amenity to humankind.

In Figure 5, the resource box, R, is expanded to encompass two forms of natural resources: exhaustible and renewable resources (highlighted in red). Exhaustible resources (ER), which are not renewable, include oil, coal, and minerals. Renewable resources (RR), such as water and trees, may be replenished. In the diagram, "h" refers to the harvest of the resource and "y" to the sustainable yield. With respect to exhaustible resources, the harvest always exceeds the sustainable yield because these resources have no regenerative capacity. For renewable resources, the resource stock will decline if the harvest exceeds the yield but may actually grow if the harvest is less than the environment's capacity for regeneration. Thus, to guarantee the continued use of a renewable resource, it must be harvested at a rate slower than the sustainable yield.

Figure 5. Exhaustible and renewable resources.

The diagram is expanded in Figure 6 to include the generation of waste products (W) (new elements are highlighted in green). Waste products arise from processing or mining of resources. Waste products, such as the emissions and solid waste generated by industrial facilities, are also created by the production process. Final consumers also create waste by disposing of product packaging and, ultimately, the product itself.

Figure 6. Interconnectivity of the economy and environment.

The box labeled "r" represents the share of total waste that is recycled and thus put back into the production process. Bottles, paper products, cans and plastics are all products commonly recycled by households. Scrap metal and water used in industrial processing are often recycled. The practice of recycling has expanded significantly in most sectors during the past 20 years, during which time the number of curbside recycling programs expanded from a single program to more than 9,000 programs. Based on U.S. Environmental Protection Agency (EPA) 2001 estimates of recycling rates for consumer goods, newspapers are now recycled at the rate of 60.2 percent, steel cans at 58.1 percent and glass containers at 22.0 percent (EPA 2004). Note, however, new practices in sectors such as farming are running counter to those trends and have implications for coastal management. For example, the expansion of concentrated animal feeding operations or CAFOs (i.e., greater than 1,000 animal units confined at a single location) has decreased recycling in farming by concentrating animal waste in smaller, confined areas. Manure and wastewater from CAFOs can contribute to pollution by depositing excessive amounts of nitrogen, phosphorus, organic matter, sediment, heavy metals, hormones, and antibiotics in streams and rivers adjacent to farms. EPA estimates the number of CAFOs located across the United States at roughly 15,000 (EPA 2003).

What happens to the remainder of the waste that is not recycled? It is dumped back into the environment. From the industrial and municipal sewage that flows into the seas to the carbon dioxide emitted by motor vehicles, the environment serves as the ultimate repository of many waste products. Thus, the second function of the environment is to serve as a waste sink (W).

Natural systems also generate waste, from leaves that drop from the trees every fall to animals that perish every winter due to starvation or exposure. The important difference between natural and economic systems is that waste generated by natural systems is generally recycled. Leaves decompose and serve as organic fertilizer, and carrion serves as an important food source for scavenging hunters. Economic systems have no similar built-in system for recycling waste. Thus the environment has a limited capacity to absorb waste and convert it into biologically benign material. This absorption capacity is known as assimilation (A). Provided that the environment's assimilative capacity exceeds the volume of waste generated through economic activity, the environment remains unharmed. Unfortunately, however, the volume of waste often exceeds the assimilative capacity of the environment, and damage occurs. Environmental damage reduces the future productive capacity of the environment and adversely affects amenity values. Waste resulting in the decline of the environment has an adverse impact on individual and societal utility, which brings us to the third, and final, function of the environment highlighted in the diagram: the positive amenity value it provides to humankind. For example, wetland areas provide amenity values that include hiking and bird watching. Though difficult to quantify, such values matter to individuals. Thus, economists attempt to quantify those values.
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Market Allocation of Natural Resources

The goals of consumers and producers are in conflict. Rational consumers try to achieve the highest level of utility that is possible within the limits of their budget, and rational producers try to maximize their profits. Lower prices enable consumers to purchase more of a good, thus expanding their utility. However, lower prices reduce the revenues, and thus profits, that accrue to producers. In a market economy, these conflicting goals are reconciled at a competitive market equilibrium price that balances the forces of supply and demand.

Demand is a schedule of how much of a good or service individuals will purchase during a specified period, depending on price and other factors. The law of demand states that as prices increase, the quantity demanded will fall, and as the price falls, more will be demanded, all other things being equal. Supply is a schedule of how much of a good or service firms supply during a specified period, depending on price and other factors. The law of supply states that as prices grow, the quantity supplied will increase, and as prices fall, firms supply less to the market.

Figure 7 demonstrates how demand and supply work together to determine the price of a commodity. Other factors being unchanged, the demand curve shows the relationship between price and quantity demanded, whereas the supply curve shows the relationship between price and the quantity supplied. Figure 7 demonstrates these concepts by examining the market for farmed oysters. In Figure 7, the competitive market equilibrium (point b) is reached at a price of $0.62 per pound of oysters, resulting in a supply of 500 thousand pounds. Note, however, that unlike oyster farms, most fisheries are characterized as common property resources with open access, and fisheries often become overfished economically and sometimes biologically as well. For example, the market supply curve for salmon does not represent the marginal cost of supplying salmon because of the common property aspect of the resource combined with open access to the fishers. These two institutional characteristics lead to application of additional capital and labor until economic returns are equal to average (rather than marginal) costs and the economic benefits of fishing are dissipated. When a fishery is being overfished from a biological standpoint, production will not be sustainable. Thus, any benefits associated with habitat restoration could be negated by overfishing. There are techniques, however, to resolve the problem of overfishing, including limited entry programs and individual transferable quotas (ITQs). These institutional solutions must also be considered when conducting habitat restoration.

Figure 7. Supply and demand for farmed oysters.

The supply curve for farmed oysters mirrors the marginal cost to the oyster farming industry of harvesting oysters (e.g., purchasing juvenile oysters, purchasing algae for feeding, growth monitoring, extraction, and transportation). Provided that the full costs to society associated with harvesting oysters (including environmental) are captured, the equilibrium point "b" highlighted in Figure 4 will result in an efficient resource allocation and a maximum level of economic benefit to society. At any quantity below 500 thousand pounds of oysters, the benefits associated with increasing the yield would exceed the costs of harvesting the oysters. Alternatively, any quantity that exceeds the market equilibrium would result in costs to industries that exceed the benefits supplied to the consumer.

The supply and demand for farmed oysters, however, are not static and can shift over time. A number of variables can lead to a shift in the entire demand curve for a product. These variables include tastes and preferences, the number of buyers, income, prices of substitute goods, prices of complement goods, and expectations. Figure 8 demonstrates how a change in one of these shift variables can lead to an increase in demand. Imagine that a medical report hailed the health benefits of oyster consumption. The demand for oysters would increase and a new equilibrium price ($0.76) and quantity (680 thousand pounds) would be reached. A number of variables can cause a shift in supply as well, including resource prices, the number of sellers, technology changes, prices of alternative outputs, expectations, taxes, and subsidies.

Economists measure the net economic benefit in a market as the difference between what it costs to produce a good or service, on the one hand, and what consumers are willing to pay for it, on the other. In an efficiently functioning competitive market, the net economic benefit is divided between consumers and producers. The net economic benefit is, therefore, divided between what is known as consumer and producer surplus. Consumer surplus is the difference between what each customer is willing to pay at each point in time and the price of the good or service and is represented by the area falling above the price line and below the demand curve. Consumer surplus in Figure 7 is represented by area abc and is represented by area gef in Figure 8. Producer surplus is the difference between what a supplier is paid for a good or service and what it costs to supply, and is represented by area bcd in Figure 7 and area deg in Figure 8. The total economic benefit of a sale is the sum of the consumer and producer surplus. Consumer and producer surplus is a function of both supply and demand. Figure 8 demonstrates that as demand increases as represented in the outward shift in the demand curve, consumer and producer surplus is increased.
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Figure 8. Shifting demand for farmed oysters.

Market Failure

The market represents a decentralized exchange mechanism that enables society to allocate resources efficiently. Markets, however, efficiently can fail to allocate environmental assets through the price mechanism if they are unable to accurately capture the full social costs of exploiting the natural resource. Thus, there are a number of factors (e.g., imperfect information, uncompensated environmental damage) that constrain the capacity of the market to achieve an accurate competitive market equilibrium. For example, the previous analysis would not measure net economic benefit if the oyster industry damaged the environment while harvesting. These are additional societal costs that are not necessarily reflected in the industry supply curve and market clearing price. When there are factors that prevent the market from achieving an efficient allocation of resources, market failure is evident. Externalities and nonprivate goods are two of the most recognized forms of market failure.

Many economic activities may provide secondary benefits or impose spillover costs to individuals and to society. These secondary effects, which are not recognized in the market transaction, are referred to as externalities. A negative externality occurs when the byproduct of an economic activity imposes a cost on society not captured in the market. For instance, motor vehicle emissions (e.g., carbon dioxide, nitrogen oxide) contribute to the warming of the troposphere through the greenhouse effect. In turn, atmospheric warming contributes to rising sea levels. Rising seas, in turn, lead to increased flooding and corresponding loss of coastal wetlands. These costs are not captured through registration fees or the price of a gallon of gasoline.

Returning to our example, the full social cost of harvesting oysters is captured by the social supply curve in Figure 9, reflecting the marginal cost to society of consuming oysters. Because the firm does not pay the full economic or opportunity cost of providing the good, the private supply curve is too low and the good will be oversupplied (500 thousand pounds of oysters rather than 380 thousand pounds) and offered at a price below the social optimum ($0.62 rather than $0.75). Thus, the benefits of consuming oysters are exceeded by the full social costs of harvesting the resource. The loss of benefits due to overharvesting is illustrated in area abc.

Figure 9. Market failure.

Nonprivate goods represent another form of market failure. Most goods in our economy are classified according to two criteria: excludability and rivalness. Excludability is present when ownership is clearly identified and benefits accrue only to the owner. Rivalness is present when the owner's capacity to derive utility by consuming the good or service diminishes the capacity of others to enjoy the same benefit. Table 1 presents a typology of goods. The four types of goods highlighted are a) private goods, b) common resources, c) club goods, and d) public goods.

How do public goods vary from private goods? Private goods are exchanged in a market with buyers and sellers agreeing on a price and exchanging ownership rights. Private goods are, therefore, excludable, meaning that owners are clearly identified and the stream of benefits accrue only to the owner. Private goods also demonstrate rivalness.

Table 1. Typology of goods.

 

Public goods on the other hand are nonexcludable and nonrival in competition. Oceans provide a good example. An ocean will not cease to exist, even if large numbers of individuals enjoy its benefits. Further, one consumer generally cannot prevent another from enjoying the recreational and amenity values an ocean provides, nor can they claim ownership of an ocean. Other examples of public goods include clean air and public roadways. In turn, externalities arise from public goods because there are no prices attached to a good that has value. Thus, individuals receive benefits without paying for them.

Public goods are at one end of the spectrum (nonrival, nonexludable), completely private goods (rival, excludable) at the other end, and goods with varying degrees of excludability and rivalness are located in between. Common resources are not excludable but are rival goods because one person's use of the common resource reduces the benefits that accrue to other users. Thus these resources are available to any consumer at no cost, but consumption of the resources diminishes their availability to other consumers. Common resources tend to be overexploited or used excessively. The government can solve the problems associated with common resources by defining property rights and by regulating private behavior (e.g., catch limits, taxes). Club goods are excludable but nonrival. Examples of club goods include toll roads, swimming pools, fire protection, satellite television transmission, and electrical power. Environmental regulators are using the concept of excludability to regulate and protect natural resources. The opportunity to regulate a club good occurs when the government exercises its power as a "gatekeeper" and restricts entry to companies that pay into an externality-remediation fund or adopt practices that limit externalities.

Market failure is evident in the case of many environmental resources, including those associated with coastal habitat. For example, sport fishing and wildlife viewing provide an important source of recreation and amenity to the population. When private firms damage the quality of the habitat and reduce the recreational and amenity value it provides, governments often intervene to reduce the harmful impact of the environmental externality. For example, water quality permits are issued by states to individuals and businesses that discharge pollutants into surface and ground waters. Water quality permits are issued to protect surface and ground waters by regulating sewage and wastewater discharges and stormwater runoff from industrial and construction-related activities. Discharges can occur through a number of sources, including irrigation, on-site sewage systems, dry wells, and seepage ponds. The permit, which generally varies in price based on the type of operation and anticipated discharge levels, is designed to monetize and collect compensation for the impact of an environmental externality (i.e., decline in water quality) resulting from construction and industrial activities.
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Conclusion

The fundamental economic principles detailed in this article provide the framework for the valuation of environmental resources, a topic covered in another portion of this Web site. Valuation of environmental resources enables planners and policymakers to weigh environmental policies and strategies and select the course of action that yields the most benefits to society.

This introductory article focuses on the following main points:

• Economists measure the well-being of a society as the sum of all the individuals' well-being, or what economists call "utility."
  
  
• The level of utility or degree of satisfaction experienced by individuals, and thus society, can be quantified in terms of the "willingness to pay" for goods and services, including environmental resources. The willingness-to-pay concept is key in environmental valuation, granting analysts a framework upon which to examine and measure individual preferences.
  
  
• Coastal areas provide a broad range of values to humankind. Environmental values are categorized as direct use (e.g., hiking, wildlife observation, inputs into the production process), indirect (e.g., biological support, water and air purification), and nonuse (bequest and existence values). Each of these values affects the decision to exploit or conserve natural resources.
  
  
• The environment and economy are inextricably linked. The environment supplies the raw materials and energy that are used to produce the goods that we consume. Waste generated by the production process is either recycled or dumped back into the environment. Thus, the relationship between the environment and the economy does not represent an open, linear process, but is rather illustrative of a closed, circular system.
  
  
• The demand for products and the supply or availability of natural resources determine the market allocation of natural resources. A number of factors (e.g., scarcity, tastes and preferences, the number of buyers, income, prices of substitute goods, prices of complement goods, expectations, resource prices, number of sellers, technology change, prices of alternative outputs, and taxes and subsidies) collectively determine the supply and demand for products, thus dictating how best to allocate scarce natural resources efficiently.
  
  
• Markets can fail to allocate natural resources efficiently through the pricing mechanism if they are unable accurately to capture the full social costs of exploiting the natural resource. When there are factors that prevent the market from achieving an efficient allocation of resources, market failure is evident.

Economists agree that markets are generally most well-suited for efficiently allocating society's resources. Markets can fail, however, resulting in the byproduct on an economic activity, generally referred to as an externality, to impose costs on society not captured in the market. To combat environmental externalities and other forms of market failure, government agencies use various strategies (e.g., permits, restrictions to access, regulations, equipment restrictions, taxes) designed to correct these market imperfections and protect the environment. Finding an appropriate balance between the demands of the marketplace and the need to preserve natural resources enables our society both to expand the economy and preserve the environment for future generations.
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References

EPA (Environmental Protection Agency). 2003. National Pollutant Discharge Elimination System Permit Regulation and Effluent Limitation Guidelines and Standards for Concentrated Animal Feeding Operations (CAFOs). Final Rule [68 FRL 74247, February 12, 2003 ]. 

EPA (Environmental Protection Agency). 2004. http://www.epa.gov/epaoswer/non-hw/muncpl/recycle.htm 

Pearce, D.W., and R.K. Turner 1990. Economics of Natural Resources and the Environment. Harvester Wheatsheaf. London, UK.
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Additional Reading

Baumol, W., and W. Oates. 1988. The Theory of Environmental Policy: Second Edition. Cambridge University Press. New York, NY. 

Freeman, A. 1993. The Measurement of Environmental and Resource Values: Theories and Methods. Reasons for the Future. Washington, D.C.

Field, B.C . 1994. Environmental Economics: An Introduction. McGraw-Hill [Publishers]. New York, NY. 

Fullerton, D., and R. Stavins. 1998. How Do Economists Really Think About the Environment? Resources for the Future. Washington, D.C. 

Greeley-Polhemus Group, Inc. 1991. National Economic Development Procedures Manual — Overview Manual for Conducting Economic Development Analysis. U.S. Army Corps of Engineers. Fort Belvoir, VA.

Hanley, N., J. Shogren, and B. White 1997. Environmental Economics: In Theory and Practice. Macmillan. London, UK.  

Hartwick, J., and N. Olewiler. 1998. The Economics of Natural Resource Use: Second Edition. Addison Wesley Longman. New York, NY.

Spurgeon, J. 1999. "The Socio-Economic Costs and Benefits of Coastal Habitat Rehabilitation and Creation." Marine Pollution Bulletin Volume 37, Number 8-12, Pages 373 to 382.
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