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You are here: Home / Signals — well-being and the environment / Signals 2014 / Close up / Basics of economics and the environment

Basics of economics and the environment

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In March 2014, Paris, France, was affected by a particulate matter episode. Private car use was highly restricted for days. On other side of the planet, a Chinese company was launching a new product: smog insurance for domestic travellers whose stay was ruined by poor air quality. So how much is clean air worth? Can economics help us reduce pollution? We take a closer look at basic economic concepts.

 Image © Gülcin Karadeniz

The word ‘economy’ comes from the ancient Greek word ‘oikonomia’, meaning household management. The activities it covers go back even further. Early communities consisted mainly of extended families working together to ensure that the group survived and their basic needs were met. Different members of the community were responsible for diverse activities: providing food, finding or building shelter, etc.

As our societies and the technology available got more sophisticated, members started to specialise in various tasks needed by the community. Specialisation came with an increasing exchange of goods and services, both within the community and with other communities.

Market prices

The use of a common currency facilitated commerce. Whether in the form of beads, silver coins or euros, ‘money’ reflects an implicit agreement that anyone in possession of it can exchange it for goods and services. The actual price — how many units of the common currency to be exchanged for a product — is also an agreement between the buyer and the seller.

There are different models used for explaining how markets determine the selling/buying price. One of the basic assumptions is that the buyer or the consumer is attributing some value to the product and is willing to pay for it. For most products, the higher the price is, the fewer the consumers willing to buy.

Another assumption is that the supplier would not produce the product if the product cannot be sold at a price higher than what it cost to produce a unit of that product. In the real world, to force competitors out of the market or reduce redundant stocks, suppliers might sell their products below production costs, a practice called ‘dumping’.

The key word here is ‘cost’. How do we calculate the cost? Do the prices we pay for goods and services include the cost of using natural resources — in more technical terms ‘natural capital’ — or the cost of the pollution generated during production and consumption?

The short answer is no. Hardly any of the prices on the market reflect the true cost of a product — i.e. one covering both production costs and environmental costs (including health costs linked to environmental degradation). Our current economic system is built on thousands of years’ of practice based on an understanding that the services nature provides to us are free. In most cases, what we pay for materials (oil, iron ore, water, timber, etc.) covers extraction, transportation and business costs. This is one of the main weaknesses of the current economic system and it is not easy to remedy, for two main reasons.

Difficulty in estimating costs

First, it is very difficult to come up with a cost estimate for all the services and benefits that nature provides to us, or for all the damages that our activities inflict. How much individuals or societies are willing to pay for clean air can vary substantially. To a population exposed to extremely high levels of particulate matter pollution, it might be worth a fortune; to those enjoying it on a daily basis, however, it might be something they barely notice.

Environmental economists are developing accounting concepts that try to calculate a ‘price’ for such benefits we get from the environment as well as for damages to the environment caused by our activities.

A part of the environmental accounting work focuses on damage costs, in order to calculate a monetary value for the services. In the case of air quality, for example, they calculate medical costs due to poor air quality, loss of life, loss in life expectancy, loss of working days, etc. Likewise, how much is living in a quiet area worth? The difference in housing prices for houses of similar standing might be used to get an estimate of the market value for a silent environment.

However, all these calculations remain indicative. It is not always clear to what extent poor air quality contributes to specific respiratory problems or noise to lower house prices.

For some resources, environmental accounting also estimates how much of that resource is available in a given area, for example, fresh water in a river basin. It adds up precipitation rates, river flows, surface water and ground water, etc.

Fish for free

(c) Gülcin Karadeniz

Paying for environmental services

Secondly, even if we could come up with a clear price tag, reflecting this ‘extra cost’ in current prices in the short term would have severe social consequences. The drastic increase in food prices in 2008, where the price of some staple foods doubled in six months, affected everyone, but the poorest were affected the most. A quick switch from a system where natural services are free of charge to one with all costs included would be quite socially controversial.

However, there are already some environmental costs included in the prices we pay for some goods and services. Taxes and subsidies are the most common tools governments use to ‘adjust’ market prices. Environmental taxes add an extra cost to product prices, making the selling price higher. This tool could be used to curb consumption of certain unsustainable products. For example, congestion charges applicable in some European cities allow only those private car users who have paid an extra charge to drive in the city centre.

Similarly, subsidies can encourage consumers to choose more environment-friendly products by lowering their buying price. These tools can also be used to address social equity issues by providing assistance to disadvantaged and affected groups.

Environmental economists are also developing the concepts around ‘environmental fiscal reform’ to explore how taxes can be shifted to favour environment‑friendly alternatives and how environmentally harmful subsidies can be reformed.

In some cases, a market actor (supplier or buyer) can be big enough to influence the market. For some green technologies and products, public authorities’ decision to switch to these technologies has enabled them to penetrate the market and compete against established players.

Although the economics field helps us understand some concepts driving our consumption and production patterns, prices and incentives, in our globalised world, many other factors, such as technology and politics, can come into play.

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