Chapter 1 Introduction

Kolstad (2010, Chapters 1, 3); Keohane and Olmstead (2016, Chapter 1)

Environmental Economics studies the role that the environment plays on the economy, the impact that the economy has on the environment, and the appropriate ways of regulating economic activity so that balance is achieved among environmental, economic, and other social goals.

Environment impacts the economy, and indeed our lives, in many ways. For example, the negative impact of warming climate on crop yields in the tropical region, and on winter resorts in the mountains of the temperate region; or the increased incidence of health problems due to air pollution, which causes morbidity and mortality, and also results in more sick days and reduced productivity.

Economy also impacts the environment in a number of ways, an example of which is the inverted U-shaped relationship between per capita real income (or GDP) and environmental issues (e.g. pollution), better known as the Environmental Kuznets Curve or EKC. This relationship is an adaptation of Kuznets’ study of the inverted U-shaped relationship between poverty and income inequality. The general premise behind the EKC is that pollution levels first–increase–then–decrease with the progress from cleaner agrarian economy to polluting industrial economy to cleaner service economy.

1.1 Externalities and Regulation

The issue with environmental goods (or bads)—unlike most other goods and services—is that markets typically do not offer the socially desirable amount of output or damage (e.g., the optimal amount of pollution). Indeed, environmental bads—which consumers do not desire—typically are the by-product of providing market goods; the demand for market goods is, in itself, an incentive for generating pollution. The goal (of an environmental economist) then is to assess the benefits and costs of a regulation (e.g., a pollution control mechanism) that ensures the society is better off with the regulation.

Two major questions arise with respect to pollution:

  • What is the socially desirable amount of pollution?
  • How can we get polluters to maintain their emissions at the socially desirable level?

Determining the right amount of pollution involves assessing damages from pollution. Air pollution may affect population through multiple channels: physical irritation, reduced/degraded visibility, worry about adverse health effects, increased susceptibility to illness, and illness itself. Many of the adverse impacts of pollution cannot be easily measured, which further complicates the issue.

Faced with the prospect of having to reduce pollution levels, the firm has an array options: end-of-pipe treatment, modifying the production process, modifying the product characteristics, relocating the production activities, buying permits to emit pollution. These options are costly, however. And a profit-maximizing firm (which also happens to be a polluter) will not voluntarily applying any of these options. How to motivate firms to pollute less? Even the most effective ways of doing this still involve some administrative/control costs.

1.2 Environmental Decision Making

The process of environmental decision making consists of two major steps. First, we must determine who the key stakeholder(s) are in the decision making. Usually, this is all or a subset of the people affected by the decision. For example, in the case of a publicly–owned forest, the potential stakeholders are: hunters, hikers, birdwatchers, people with a view of the forest, people who value the forest for wildlife habitat, timber producing companies, etc. Second, we must determine what the objective is in the decision making. This can be profits or benefits accrued by producers, consumers, or the government.

There is always an implicit or explicit viewpoint from which decisions are judged to be as ‘good’ or not. Often we take the viewpoint of the ‘economic adviser’ or the ‘benevolent dictator’—an imaginary person who doesn’t have preference for any particular groups of people (e.g., firms, consumers, government officials), but who is trying to suggest what’s best for the society as a whole.

1.3 The Value of the Environment

It is useful to understand some philosophical perspectives that summarize and illustrate different ethical views related to environmental protection.

1.3.1 Biocentrism

Biocentrism places the biologic world at the center of its value system. Biocentrism makes a distinction between instrumental value and intrinsic value. The former pertains to the use value, the latter—does not. For example, something can still have intrinsic value, even when it is of no use otherwise. Biocentrism argues that all living things have intrinsic value, regardless of their instrumental value. Advocates of biocentrism often promote the preservation of biodiversity, animal rights, and environmental protection.

1.3.2 Anthropocentrism

Anthropocentrism places the human at the center of its value system. It argues that the biological world and the environment exist to provide material gratification to humans. Strictly speaking, anthropocentrism places only instrumental value on the environment, which is different from utilitarianism, which emphasizes both instrumental and intrinsic values that people may attain from the environment.

1.3.3 Utilitarianism

Utilitarianism is, also, a human–oriented ethical stance. It promotes actions that maximize happiness and well-being for all affected individuals. Utilitarianism (and anthropocentrism too, for that matter) doesn’t ignore the environment or the biological world. But it promotes the environment most preferred by humans, as the only species to have ever contemplated what is or is not a good environment.

1.3.4 Sustainability

Sustainability is a dynamic concept, and it refers to the capacity for the biologic world to coexist with human civilization. It allows the use of natural resources, but precludes their overuse. It is fine to use the environment for human needs, as long as its long-term health is not jeopardized. The debate over sustainability has focused on its two aspects: (i) the degree to which ‘natural capital’ can be viably replaced by ‘human capital,’ and (ii) the obligation the present generation owes to future generations.


Keohane, Mr Nathaniel O, and Sheila M Olmstead. 2016. Markets and the Environment. Island Press.

Kolstad, Charles D. 2010. Environmental Economics. 2nd ed. Oxford University Press.