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ECON 4925 Resource EconomicsAutumn 2006

Lecturer:Finn R. Førsund

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Perman et al. Chapter 1.An introduction to natural resource and environmental economics

Three themes: efficiency, optimality, sustainabilityEfficiency

eliminating wastetechnical inefficiency (physical) allocative inefficiency

Concern: how economics might avoid inefficiencies in the allocation and use of natural resources.

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Perman et al. Chapter 1.1 Optimality

A group called societySome overall objective that this society has; can then measure desirability of resource use decisionsOptimality: maximising the objective under relevant constraints.Resource allocation: cannot be optimal without being efficient. Necessary, but not sufficient.

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Perman et al. Chapter 1.1 Sustainability

Taking care of posterity.Given optimality, is sustainability redundant? Pursuit of optimality will not necessarily take care of posterityTaking care of posterity as a moral obligation: then sustainability constraints have to be included in the optimality problem

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Perman et al. Chapter 1.2.1

Classical economists: 1700-1800 centuryEconomic growth: importance of natural resources (land)Living standards in the long run subject to constraints (land)Diminishing returns , inevitability of a stationary state

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Perman et al. Chapter 1.2.1

Adam Smith: markets and allocation of resources, invisible handMalthus: population growth geometric and food output growth arithmeticRicardo: subsistence wage level in steady state, land in varying qualityJohn Stuart Mill: diminishing returns, but also growth of knowledge and technical progress. Amenity values, first environmental economist?

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Perman et al. Chapter 1.2.2

Neoclassical economics: marginal theory and value in exchange1870+, Jevons, Menger, Marshall (consumer surplus), Walras (general equilibrium)Production- and utility functionsKeynes: short-run use of resourcesNeoclassical growth theory: absence of natural resources, introduced from 1970+

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Perman et al. Chapter 1.2.3 Welfare economics

Rankings of allocation must be based on ethical criterionsUtilitarian moral philosophy, Hume, Bentham, Mill. Weighted average of the total utility levels enjoyed by all individuals in the societyPareto optimality (1897)

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Perman et al. Chapter 1.2.4 Ecological economics

Economic system part of the larger system, interdependence of economic and natural systems, sustainability at the forefront.Boulding: spaceship earth

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Perman et al. Chapter 1.3 Economic approaches to resource issues:

Property rights, efficiency and government interventionRole of markets and property rights as the basis for markets

Exhaustability, sustainability and irreversibilityStock and flow resources Renewable and non-renewable resources

Time dimension of economic decisionsResources as stocks, must study pattern of use over time, optimality an intertemporal problem

Substitutability between resources, between man-made capital and resourcesIrreversibility: asymmetry implies stronger preferences for non-development

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Perman et al. Chapter 2

Can the global economic system continue to grow without undermining the natural systems, which are its ultimate foundation?Can poverty be alleviated in such ways that do not affect the natural environment in such a way that future economic prospects suffer

Interrelationship between poverty, economic development and the state of the natural environmentWorld Commission on Environment and Development 1987 Our Common Future

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Perman et al. Chapter 2

A general production function

l=labour, K=capital, M=waste, A=ambient concentration

Waste creation has a resource base, M’ > 0Limits to growth

Resources, environment, population, food

( , , , ( ), ( ))y f l K R M R A M= ∑

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Perman et al. Chapter 2.1. BiodiversityBiodiversity: variety and variability of all living organisms in terrestrial, marine and other aquatic ecosystems and the ecological complexes of which they are parts.Diverse gene pools, evolutionary potential, insurance against ecological collapseSource of medicine, resources. Measures of biodiversity

Population and genetic diversityNumber of species within an areaEcosystem-diversitySurrogate measure: magnitude of undisturbed ecosystems

Biodiversity a multidimensional concept, cannot be reduced to a single measure

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Perman et al. Chapter 3. Ethical foundations for economics

Naturalist moral philosophiesHumanist and naturalist moral philosophiesLibertarian: (John Locke)Fundamental inviolability of individual rightsUtilitarian school: (David Hume, Bentham)

Well being comparable over persons and timeIndividuals and generations, intertemporal welfare function

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Perman et al. Chapter 3. Utilitarism

Discounting ethical indefensible?

Positive time preference and consumersovereigntyIndividual preferences and social preferencesRole of population growth

0 0

(1 ) ( )tT

t tt t

t t

W U U e dtρρ=∞

− −

= =

= + =∑ ∫

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Perman et al. Chapter 3. UtilitarismUtility discount rate and consumption discount rate, r.

Discounting discriminating against future generations?Rising consumption over time may be consistent with positive discounting

0

( )T

tt

t

W U C e dtρ−=

= ∫

''( ),'( )t

t

U C CCrC U C

ρ η η= + = −&

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Perman et al. Chapter 3 (11).Derivation

( ) '( )t tt tt

d U C e U C edC

ρ ρ− −⎡ ⎤ =⎣ ⎦

'( ) ''( ) '( ) ''( )'( ) '( ) '( )

t t tt t t

tt t

t t t

d dCU C e U C e U C e U C Cdt dtU C e U C e U C

ρ ρ ρ

ρ ρ

ρρ

− − −

− −

⎡ ⎤ −⎣ ⎦= = −

&

rt rtt

t

d C e edC

− −⎡ ⎤ =⎣ ⎦

rtrt

rt rt

d e redt re e

−−

− −

⎡ ⎤⎣ ⎦ −= = −

''( )'( )t

t

U C C Cr rU C C

ρ ρ η− = − ⇒ = +& &

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Two reasons for discounting futureconsumption

Care less about consumption tomorrow than today, ρ > 0, pure rate of time preference, defective telescopic faculty (Pigou)One believes tomorrow’s consumer will be better off than today’s , / 0C C >&

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Perman et al. Chapter 3. RawlsTheory of justice

Rawlsian social welfare indifference curves

{ }min ,A BW U U=

U1

U2

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Perman et al. Chapter 4. SustainabilityIf a man takes no thought about what is distant, he will find sorrow near at hand

Confucius

Sustainability in the past:Historic and archaeological evidence of non-sustainable developments

Easter Islands: non-sustainable culture; building of large stone monuments, had to be transported on timber rollers, lead to deforestation and climate change destroying the culture, could not escape on rafts because the trees had gone

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Setting the new agenda for sustainability issues

World Commission on Environment and Development (WCED): Our Common Future (1987)

A sustainable development is a development which meets the needs of the present without compromising the ability of the future generations to meet their needs.

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Sustainable income

Person living off wealth: sustainable consumption is how much that can be consumed without reducing the wealth (John Hicks, Erik Lindahl, Irving Fisher)Calculate the present value of predicted future incomes, find a constant amount per year that has the same present value.This is sustainable consumption

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“Think globally, act locally”World Commission on Environment and Development

Sustainability from the macro level to the micro level: can all micro levels be sustainable? Sustainable transport, sustainable agriculture, sustainable tourism, sustainable cities?Must make a decision on level of aggregation and geographical dimension

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Sustainability problemsHow to compare the present and really distant futureHow to find sustainable developmentsHow to know when we have sustainable developmentHow to deal with scientific uncertainties about eco-system responses

reduce the use of environment as an insurance

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Sustainability definitions

Ends-based definitions:Non-declining per capita consumptionNon-declining per capita welfareSurvivable development, C*>CSURV

Means-based definitions:non-declining stock of aggregate capital; man-made physical capital, knowledge/ cultural capital, resource/environmental capital

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Natural capital stock approaches

Non-declining natural capital approach: keystone processes, photosynthesis, nutrient cyclesSafe minimum standards approach: biodiversity, critical loads, assimilative capacityResearch challenges: define natural capital, safe minimum standards, measure critical loads

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Substitution between man-made and natural capital

Man-made and natural capital: substitutes or complements? Can natural resources be substituted?

Weak and Strong sustainabilityIs it meaningful?

Substitution natural birdsong experienced outdoors and a CD with birdsong played indoors? Swimming pools and lakes?

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Sustainability definitionsThe basic issue: whether future generations will be at least as well off as the present generationLong tradition in economics considering unfavourable treatment of future generations as ethically unacceptableSustainability implies that environmental and natural resources have to be shared with future generationsSustainability: future generations can obtain a utility level at least as high as ours

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Sustainability, equity and efficiencySustainability requirement

Genuinely ethical as it is based on a desire to be fair toward future generations

EquityEvery generation should be treated equally in intergenerational social preferences, which is the same as saying discrimination towards future generations is excluded.

Efficiency The strong Pareto axiom of efficiency

Only sustainable paths are ethically acceptable when efficiency and equity are used as ethical axioms

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Defining sustainability

A generation tInherits capital kt , chooses a utility level ut and feasible capital stocks kt+1 bequeathed to the next generation t+1

SustainabilityFuture generations can obtain a utility level at least as high as ours; constant utility path is feasible from t+1 given kt+1

1( , )t t t tu u F k k +≤ ≤

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Defining sustainability, cont.

It may be the case that it is not desirable to follow any sustainable pathBut any “good” path may be sustainable:

If we have a non-decreasing utility path that is feasible given k1, then this path is sustainable

Justification of sustainabilityWhenever equity and efficiency are fulfilled utility paths are non-decreasing

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Technology assumptionsImmediate productivity of the technology:

Consumption can costlessly be postponed to later periods by transforming consumption sacrifices into stocks of man-made capital or by not depleting natural capital.

But efficient sustainable paths need not existEventual productivity of the technology:

For any t and kt there exists a feasible and efficient path with constant utility. This utility level is the maximal sustainable utility if capital kt is inherited

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Discounted utilitarismEquity rules out social preferences based on discounted utilitarism But paths that are maximal under discounted utilitarism are not necessarily ruled outOptimal paths that impoverish generations in the distant future, although sustainable paths are feasible, do not seem ethicalSustainability may be justified as a side constraint

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Sustainability and the Hartwick ruleConstant population, each generation lives for one instance

Any intertemporal issue is of an intergenerational nature

Multiple capital goodsHuman economic activity leads to depletion of natural capitalIs our accumulation of man-made capital sufficient to make up for the decreased availability of natural capital?

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The setting , cont.

Assumption: existence of intertemporal competitive equilibrium that leads to efficiency and that provides market prices for all capital goodsDynamic efficiency is equivalent to Pareto efficiency when each generation is only living an instant

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Can sustainability be measured?

Extension of national accounts: Concern has been expressed for the long-term effects of natural resource depletion and environmental deterioration

National accounts constructed to measure current economic activity:

Providing information on unemployment, savings, growth, balance of payments, etc. necessary for conducting economic policy

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Green national accounting

Can national accounting be “greened” by taking into account the changes in the stocks of natural and environmental resources ?Would Green NNP be able to indicate whether the actual development is sustainable?

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Rules within resource economics

Two intertemporal allocation rules have attracted particular attention: the Hotelling rule and the Hartwick ruleThe Hotelling rule:

No-arbitrage possibility condition that every efficient resource utilisation path has to meet. The net price of an exhaustible resource must grow at a rate that equal the interest rate

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The Hartwick rule:prescription or description?

The Hartwick investment ruleInvest proceeds from resource extraction such that total capital is constant

The Hartwick resultThe investment rule rule is necessary but not sufficient for constant sustainable consumption

The relevance of the Hartwick rule for sustainability is related to the question of whether a constant utility path exists

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Using the Hartwick rule

The Hartwick investment rule cannot serve as a prescription for sustainabilityNeither necessary nor sufficient for sustainabilityIf the Hartwick rule is followed it describes how the path would look like, egalitarian constant utility path, descriptive result characterising an efficient and egalitarian utility path

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Problems with the Hartwick ruleCompetitiveness conditions require all externalities internalised.

How can we now know that competitiveness conditions will be followed in the future?

Constant present value of net investmentsNot sufficient to have current price information, must have information for all future points in time

Feasibility: constant positive consumption sustained indefinitely

How can we know that now?No exogenous technical progress

How do we know that future technical progress can be attributed to accumulated stock of knowledge?

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