Section One

Introductory

This first section contains two introductory chapters. Environmental economics builds on the
foundations of microeconomic analysis, but introduces a number of key features that make it an
important field of study in its own right. The first chapter provides an overview of environmental
economics and illustrates key concepts by looking at both the global level – greenhouse gas
emissions and climate change, and the local level – vehicle emissions. The second chapter explores
a basic environment-economy framework and asks how can we sustain both, then defines a
number of environmental terms used throughout the book, and provides a picture of the state of
Canada's environment.

Chapter 1
What Is Environmental Economics?
Environmental economics is the study of environmental problems with the perspective and analytical ideas of
economics. Economics is the study of how and why people—whether they are consumers, firms, non-profit
organizations, or government agencies—make decisions about the use of valuable resources. Economics is about
making choices. It is divided into microeconomics, the study of the behaviour of individuals or small groups, and
macroeconomics, the study of the economic performance of economies as a whole. Environmental economics
draws from both sides, but primarily from microeconomics. The study of environmental economics, like all
economics courses, is concerned with the fundamental issue of allocating scarce resources among competing uses.
The concepts of scarcity, opportunity costs, trade-offs, marginal benefits, marginal costs, efficiency and equity
are key ingredients to understanding environmental problems and what can be done about them.
Environmental economics makes use of many familiar concepts in economics. What is different about
environmental economics compared to other economic subjects is the focus on how economic activities affect our
natural environment—the atmosphere, water, land, and an enormous variety of living species. Economic decisions
made by people, firms, and governments can have many deleterious effects on the natural environment. For
example, the dumping of waste products into the natural environment creates pollution that harms humans and
other living things, production, and degrades ecosystems – the planet’s air, water, and land. It leads to wasteful use
of resources and threatens the sustainability of both our environment and economy. We ask:
 Why don’t people take into account the effects of their economic activity on the natural environment?
 What inhibits economic systems from using its resources wisely and efficiently to protect the sustainability
of our planet and people’s livelihoods over time?
Environmental economics examines these questions by focusing on ways society can reduce its degradation of the
natural environment. Equally as important, environmental economics investigates and assesses different methods
of reaching an efficient and equitable use of all resources (including environmental ones) from the viewpoint of
society, not just individual decision makers as is the typical focus in economic analysis.
To accomplish these tasks, a simple but powerful analytical model is developed that builds on, but modifies
and extends standard economic principles, in particular, the marginal valuations that involve trade-offs between
marginal costs and marginal benefits. While economic efficiency remains the central criterion for evaluating
outcomes and policies, environmental economists also examine other criteria for choosing among alternative
policies that attempt to improve the environment—for example, equity or fairness. If economic efficiency cannot be
obtained, and environmental targets are established using other criteria, an economic approach can still greatly

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assist decision makers in reaching whatever target is set. This book focuses on how individual actions give rise to
environmental degradation and what can be done about these actions. Another branch of economics – natural
resource economics – examines ways to achieve efficient use of our natural environment over time – energy,
forests, land, and harvested species such as fish stocks. We look more closely at the distinction between
environmental and natural resource economics in Chapter 2.
The objective of this chapter is to acquaint you with some of the basic ideas and analytical tools of
microeconomics that are used in environmental economics. We will illustrate how environmental economics helps
answer important questions about our environment and economy real-world examples. We first consider briefly
what we mean by the “economic approach,” then turn to two pressing environmental problems; starting first with a
local and regional concern —motor vehicle pollution, then turning to a global threat – greenhouse gas emissions.
In Chapter 2 we will take a look at the broad linkages existing between economy and environment and define a
number of important pollution terms. After that we will be ready to study the economic principles we will need.

CATCH NEW UNNUMBERED BOX (Included Below)

ECONOMIC EFFICIENCY: Economic efficiency is all about using resources wisely. An outcome is said to be
economically efficient if all resources are put to their highest value use, or equivalently, the economy reaches a
desired outcome using the fewest resources. Chapter 4 provides develops efficiency concepts fully, but for now,
consider this illustration.
Value of
Natural environment use for ‘A’
(air, water, land) used = $100
as an input to produce Value of
a good or service A, B, use for B =
or C (but not all). $50
Value of
use for C =
$10
Should we pick A, B, or C? An economically efficient choice would be to pick ‘A’. Good or service A maximizes
the value of the end use for which resources are being put. In using economic efficiency as an objective, economists
are making a value judgment as well as empirical observation. The value judgment (known as a ‘normative’
approach – see Chapter 5) is that something has value if someone wants it. That ‘something’ can be a computer or
the ability to always take a walk in a forest – it need not be a good that is produced and sold in the marketplace.
Both the computer and the walk in the forest use inputs from the natural environment – minerals for the computer
components, the ecosystem supporting the forest environment for the walk. Environmental economics
emphatically asserts that if individuals value the forest for taking walks more than the computer, than it is the
highest value use, even if there is no explicit market for walks in the forest. The empirical observation behind
efficiency is hundreds of years of observing people make decisions that indicate they are looking for maximum
value such as profit maximization by the owners of firms, or utility maximization by individuals. Environmental
economists may have a broader definition of what constitutes utility – walks in the forest count, not just buying
goods, but the notion of maximizing or making the best use of what resources are available is still fundamental to
how outcomes are assessed.

CATCH NEW UNNUMBERED BOX (Included Below)

EQUITY. Equity is about how the economic ‘pie’ is divided up. Who gets how much income or wealth? Dictionary
definitions of equity talk about ideals of being “just, impartial, and fair”, but who decides what is fair or just? We
are in normative/subjective territory again. Think about the following: suppose our government decided that every
adult should earn exactly the same income; it will take the total earnings of everyone in the economy and divide
them by the total number of workers. Is this equitable? In one sense it is. Everyone is treated equally regardless of
circumstances. But what if a person’s circumstances differ and as a society we want to take that into account. We
may want to divide up the country’s total income according to age, number of children people have, whether they
are able to work or not due to factors beyond their control such as illness or accidents. The dilemma is that there

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are many possible ways to divide things up and people may have very different notions of what is or is not
equitable. Economists, philosophers, and many other disciplines wrestle with the notions of fairness going back
hundreds of years to the early writings in moral philosophy and economics. Environmental economics uses a
number of different definitions of equity to help evaluate economic outcomes (efficient or not). These include:

 Horizontal equity treats similarly situated people the same way. For example, an environmental program that
has the same impact on an urban dweller with $20,000 of income as on a rural dweller with the same income
is horizontally equitable.

 Vertical equity refers to how a policy impinges on people who are in different circumstances, in particular on
people who have different income levels.

 Intergenerational equity looks at whether future generations have the same opportunities as current ones.
How does society trade off using its resources today when their loss may affect the ability of future generations
to enjoy the same quality of life?

Subsequent chapters return to equity as one of the vital criteria in assessing how well the economy is doing.

The Economic Approach

Why do people behave in ways that cause environmental destruction? There are several types of answers to this
question. One goes like this: Environmental degradation comes about from human behaviour that is unethical or
immoral. Thus, for example, the reason people pollute is because they lack the moral and ethical strength to refrain
from the type of behaviour that causes environmental degradation. If this is true, then the way to get people to stop
polluting is somehow to increase the general level of environmental morality in the society. In fact, the
environmental movement has led a great many people to focus on questions of environmental ethics, exploring the
moral dimensions of human impacts on the natural environment. These moral questions are obviously of
fundamental concern to any civilized society. Certainly one of the main reasons environmental issues have been put
on the front burner of social concern is the sense of moral responsibility that has led people to take their concerns
into the political arena.
But there are problems with relying on moral reawakening as our main approach to combating pollution.
People don’t necessarily have readily available moral buttons to push, and environmental problems are too
important to wait for a long process of moral rebuilding. Nor does a sense of moral outrage by itself help us make
decisions about all the other social issues that also have ethical dimensions: poverty, housing, health care,
education, crime, and so on. In a world of competing objectives we have to worry about very practical questions:
are we targeting the right environmental objectives; can we really enforce certain policies; are we getting the most
impact for our money; and so on. But the biggest problem with basing our approach to pollution control strictly on
the moral argument is the basic assumption that people pollute because they are somehow morally underdeveloped.
It is not moral underdevelopment that leads to environmental destruction; rather, it is the way we have arranged
the economic system within which people go about the job of making their livings.
So, a second way of approaching the question of why people pollute is to look at the way the economy and its
institutions are set up, and how they lead people to make decisions that result in environmental destruction.
Economists argue that

people pollute because it is the cheapest way they have of solving a certain very
practical problem: how to dispose of the waste products remaining after
production and consumption of a good.
People make these decisions on production, consumption, and disposal within a certain set of economic and
social institutions; 1 these institutions structure the incentives that lead people to make decisions in one direction
and not in another. An incentive is something that attracts or repels people and leads them to modify their
behaviour in some way. An “economic incentive” is something in the economic world that leads people to channel
their efforts at production and consumption in certain directions. Economic incentives are often viewed as

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consisting of payoffs in terms of material wealth; people have an incentive to behave in ways that provide them
with increased wealth. But there are also many non-material incentives that lead people to modify their economic
behaviour; for example, self-esteem, the desire to preserve a beautiful visual environment, or the desire to set a
good example for others. Happiness is not a function solely of material wealth. What we will study is
 how incentive processes work, and
 how to restructure them so that people will be led to make decisions and develop lifestyles that have more
benign environmental implications.
One simplistic incentive-type statement that you often hear is that pollution is a result of the profit motive.
According to this view, in private-enterprise economies of industrialized nations people are rewarded for
maximizing profits, the difference between the value of what is produced and the value of what is used up in the
production process. Furthermore, the thinking goes, the profits that entrepreneurs try to maximize are strictly
monetary profits. In this headlong pursuit of monetary profits, entrepreneurs give no thought to the environmental
impacts of their actions because it “doesn’t pay.” Thus, in this uncontrolled striving for monetary profits, the only
way to reduce environmental pollution is to weaken the strength of the profit motive.
But this proposition doesn’t stand up to analysis. It is not only “profit-motivated” corporations that cause
pollution and threaten the environment with their activities; individual consumers are also guilty when they do
things like pour paint thinner down the drain, use anti-bacterial soap, or let leave all the chargers for their
electronic gadgets plugged in. Since individuals don’t keep profit-and-loss statements, it can’t be profits per se that
lead people to environmentally damaging activities. The same can be said of government agencies, which have
sometimes been serious polluters even though they are not profit-motivated. But the most persuasive argument
against the view that the search for profits causes pollution comes from political events in Eastern Europe and the
former USSR. With the collapse of these formerly Communist regimes, we have become aware of the enormous
environmental destruction that has occurred in some of these regions—heavily polluted air and water resources in
many areas, with major impacts on human health and ecological systems. Many of these problems exceed some of
the worst cases of environmental pollution experienced in market-driven countries. But they have happened in an
economic system where the profit motive has been entirely lacking. Which means, quite simply, that the profit
motive in itself is not the main cause of environmental destruction.
1.
By “institutions,” we mean the fundamental set of public and private organizations, customs, laws, and practices
that a society uses to structure its economic activity. Markets are an economic institution, for example, as are
corporations, a body of commercial law, public agencies, and so on.
In the sections and chapters that follow, incentives will play a major role in the analysis of how economic
systems operate. Any system will produce destructive environmental impacts if the incentives within the system are
not structured to avoid them. We have to look more deeply into any economic system to understand how its
incentive systems work and how they may be changed so that we can have a reasonably progressive economy
without disastrous environmental side effects. Two concepts that are important to an understanding of the
incentives that exist regarding the environment are external effects (also called externalities) and property rights.
These concepts illustrated in the following two examples and explained in detail in later chapters. Essentially, they
involve the question of a lack of ownership of environmental resources. A fundamental point is that

lack of ownership rights to environmental resources means that there are few
incentives to take the environmental consequences of our actions into account.

Externalities and Property Rights

In Section 4, we will examine the role of property rights in reaching a socially efficient level of pollution. Property
rights—or the lack thereof—are crucial in understanding why we have today’s environmental problems. The basic
point is that environmental resources generally do not have well-defined property rights. No one owns the
atmosphere, our oceans, or large underground aquifers. Two examples illustrate how externalities are connected to
property rights.

Auto emissions. When an SUV releases carbon monoxide and carbon dioxide into the
atmosphere, you cannot jump out in front of the vehicle and shout “Stop! You are polluting

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 my air and releasing greenhouse gases that contribute to global climate change!” We all
breathe the same air in our communities and GHGs travel to our global atmosphere. For
externalities that involve many different sources of pollution, perhaps spread over large areas,
there is no effective way to reach any sort of private agreement to limit the emissions.
Designing environmental policy is more challenging the more pervasive the externality is
across regions or countries and for different sources.
Dog waste. You detect your neighbour’s dog leaving its waste products on your lawn. This too
is an externality. The dog and its owner do not take into account the impact dog waste is
having on your lawn when they go about their activities. Contrary to the case of automobile
air contaminants and GHG emissions, you and your neighbour would find it relatively easy to
negotiate a mutually agreeable resolution to this problem. The neighbour might agree to keep
the dog on a leash or to pick up its waste. You may build a fence, or get the neighbour to pay
for it. The dog externality is internalized through discussion and negotiation. A solution that is
mutually agreeable to both parties can be worked out; the only difference in possible outcomes
is who pays for them. That is a function of our bargaining strengths and other factors.
Why is the dog case different from the auto emissions case? You own your property and the dog is essentially
trespassing. Laws say you can keep others off your property. There is also just one other person to bargain with—
the dog owner. This case could be more like urban smog if you don’t know whose dog is dumping on your lawn.
Then you must incur search costs, set up dog surveillance, and so on to detect the perpetrator.
Our most serious environmental problems are closer to the vehicle smog case than the case of the wandering
dog. They involve lots of possible polluters, with perhaps very little knowledge about even the source of emissions
or the link between emissions and environmental impact. Society members may not recognize that an activity they
have been doing for years has a deleterious impact on the environment. For example, manufacturers of leather
products in eastern Canada used to use mercury in the tanning process. They would simply dump their wastes in
streams or on the ground. Over the years, the mercury percolated into groundwater and contaminated people’s
drinking water. But people didn’t know at the time how toxic mercury is. The tanners themselves suffered from
mercury poisoning. This is where the term “mad as a hatter” emerged—mercury poisoning affects brain function.
The leather manufacturers are now gone, but mercury still remains a dangerous pollutant in our ecosystem. How
can today’s population engage in any sort of negotiation with the leather producers of 100 years ago to reach a
mutually agreeable level of waste disposal and compensation for disease, shorter lifespans, and contaminated water
and soils? This example illustrates the difficulties inherent in depending on individuals who act in their own self-
interest to reach a socially efficient outcome. Information about potential problems may be imperfect or non-
existent. People today cannot be counted on to make decisions that maximize the well-being of generations who
follow. When these conditions exist, some form of government intervention is necessary.

Practical Illustration #1: Smog and Motor Vehicles

Each year in Canada, automobiles and light duty trucks discharge approximately 11.5 percent of Canada’s total
carbon dioxide emissions, 21 percent of nitrogen oxides, 50 percent of volatile organic compounds, 47 percent of
carbon monoxide, and 4% of fine particulate matter (PM-2.5). 2 These compounds, known as air contaminants
contribute to urban smog, acid precipitation, and global climate change. In turn, these environmental conditions
adversely affect the health of people and our ecosystem, the survival of many species, the cost of producing goods
and services, and our overall enjoyment of our surroundings. Environment Canada 3 estimates that 6,000 Canadians
die prematurely each year due to air pollution, while tens of thousands more suffer from bronchitis exacerbated by
pollution. Exposure to urban smog may increase the likelihood of cancers in children by up to 25 percent and raise
the chance of getting childhood asthma by 400 percent. Acid precipitation changes aquatic and land-based
ecosystems, killing fish, amphibians, and other aquatic species and affecting forest growth. Global warming, while
a controversial topic, could lead to massive ecosystem changes with worldwide impact. Motor vehicle use
contributes to congestion on our roads. Congestion increases driving times, promotes accidents, and generally
makes people very crabby, contributing to “road rage.”
2.
See Government of Canada, Environment Canada (2010 National Inventory Report, 2010. 1990-2008
Greenhouse Gas Sources and Sinks in Canada for data on greenhouse gases and www.ec.gc.ca/air for information
on air contaminants.

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 See Environment Canada’s Web site (www.ec.gc.ca), then go to the Air Quality page for information about the
3.

impact of air pollution on health.

Environment Canada: www.ec.gc.ca

Driving one’s car or truck thus affects all sorts of other people (whether they too drive a motor vehicle or not)
and our environment. This is an external effect. When you drive to school or work or to the beach, you get the
direct benefit of transportation services. Others—bystanders—receive the negative impacts of your driving: air
pollution, congestion, and associated impacts. The bystanders don’t control your driving. And the price you pay for
driving your car, your direct costs in the form of gasoline, maintenance, and monthly car payments, do not reflect
the negative impacts you impose on others—hence the words externality or external effects to describe this
situation. An externality occurs when the actions of one or more individuals affects the wellbeing of other
individuals without any compensation taking place. While externalities can be positive as well as negative (think
enjoying viewing your neighbour’s flower garden), pollutants such as air contaminants are negative externalities.
We will examine in detail in Section 4 what sorts of initiatives, both individual and with the help of government,
can be used to address externalities. For now, let’s think a bit more about motor vehicle externalities and what can
be done about them. To do so, we look at the concept of incentives.

Incentives: Households and Vehicle Use

When you drive your car, sport-utility vehicle (SUV), or truck, the price you pay per kilometre travelled reflects
your private costs—gasoline, oil, insurance, and so on. These prices do not take into account the damage the
emissions from your car impose on others and the environment; rather, they reflect costs of producing gasoline,
retailer markups, and so on. You will respond to changes in these private costs, for example, by driving more when
gasoline prices fall and less when they rise. What sort of positive incentive could we contemplate that would induce
drivers to reduce the number of emissions they release? A simple relationship may help us see where incentives
could enter.

Total quantity of emissions = Number of vehicles  Average kilometres travelled

 Emissions per kilometre
Incentives can target the number of vehicles on the road, the average number of kilometres travelled, and
emissions per kilometre. In addition, we might want to consider where people drive their vehicles. A car driven in
downtown Toronto, Montreal, or Vancouver will have a larger impact on urban smog than that same vehicle being
driven in Moose Jaw, Saskatchewan. The release of carbon dioxide will, however, contribute to global warming
regardless of where the vehicle is driven.

AirCare: www.aircare.ca

What are some possible incentives to alter people’s behaviour? In greater Vancouver, all older model cars,
SUVs, and light trucks must pass an AirCare test once every two years. This test checks to see that motor vehicle
exhaust is not emitting more pollutants than consistent with government standards. The policy goal is to create an
incentive for vehicle owners to regularly service and maintain their vehicles and thereby reduce emissions per
kilometre.
How would we influence the number of kilometres travelled? The economic answer is to increase the cost of
driving per kilometre. This provides an incentive for people every time they drive their vehicle to minimize the
number of trips, thereby reducing their direct costs. An example of a direct incentive to increase costs of driving is
to tax people on the number of kilometres travelled. This could be done using a tax that is payable annually as

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people renew their vehicle licence. An indirect incentive is to tax gasoline, thereby increasing the costs of driving.
How would we influence the number of vehicles on the road? This could be done with an annual tax on vehicle
ownership or a buyback program that pays people to retire their older vehicles. Old vehicles contribute far more per
kilometre travelled to air emissions than do newer, more fuel-efficient and less pollution-intensive vehicles. We
might also want to think about other incentives that might change behaviour. These could include advertising and
education programs that inform people about how their driving decisions affect air quality and, hence, their well-
being. Are there others?

Incentives for Businesses

Incentives can also apply to businesses. Think about the producers of motor vehicles and vehicle parts. All
industrial firms work within a given set of incentives: to increase profits if they are firms in market economies.
Firms have an incentive to take advantage of whatever factors are available to better their performance in terms of
these criteria. One way they have been able to do this historically is to use the services of the environment for waste
disposal. The motivation for this practice is that these services have essentially been free, and by using free inputs
as much as possible a firm obviously can increase its profits. The challenge is to find incentives to alter firms’
behaviour so they treat environmental services as a costly activity rather than a free good.
One policy approach is to introduce and then try to enforce laws or regulations that direct the amount of
pollution a firm can emit. Canada has company average fuel consumption (CAFC) guidelines for all new cars and
light trucks produced in Canada. Vehicle manufacturers have agreed to design their cars and light trucks to meet a
voluntary target level of gasoline consumption averaged over their entire fleet of vehicles produced each year.
Guidelines were introduced for cars in 1978 at 13.1 litres per 100 kilometres, then were tightened to 8.6 litres per
100 kilometres in 1986, where they remain today. Guidelines for light trucks were not introduced until 1990 (at
11.8 litres per 100 kilometres) and were gradually tightened to 10.0 litres per 100 kilometres in 2010. In January
2008, the federal government announced that Canada will adopt the same fuel efficiency standards as the United
States as its target for 2020. The US standards require a combined corporate average (for all makes and models of
vehicles sold each year) of 35 miles per gallon (6.72 litres per 100 kilometers).Fuel efficiency of all cars on the
road has increased from approximately 15 litres per 100 kilometres in 1965 to 6.7 L/100 km in 2010. 4 Light duty
trucks were estimated to average 8.6 litres per 100 kilometres in 2010.
4.
For the history of the development of CAFC guidelines see http://www.tc.gc.ca/eng/programs/environment-fcp-
history-630.htm, accessed September 26, 2010. Information on fuel efficiency of vehicles can be found at
http://www.tc.gc.ca/eng/programs/environment-fcp-cafctargets-385.htm, accessed September 26, 2010.

Natural Resources Canada Office of Energy Efficiency Initiative: http://oee.nrcan.gc.ca/english/index.cfm?

attr=0

The CAFC guidelines are voluntary, not compulsory. Vehicle manufacturers meet the standards because the
United States has the same type of policy and it is compulsory in that country. The North American automobile
industry is completely integrated—cars and light trucks produced in Canada are exported to the United States and
vice versa. Canadian cars that do not meet the U.S. fuel efficiency standards cannot be sold there. There is a clear
profit incentive for Canadian manufacturers to comply with the voluntary standard. Note that CAFC standards
require the auto manufacturer to meet the standard on average across all its cars or trucks produced each year. If
automakers produce a lot of low-polluting cars, they will more readily meet the target than if they produce high-
polluting vehicles such as SUVs. The regulations thus provide an incentive for manufacturers to alter the mix of
vehicles produced to reduce the emissions that will ultimately come when drivers purchase and use the vehicles.
Canadian governments also regulate the sulphur content of gasoline. The regulations specify that oil refiners must
produce gasoline containing on average no more than 30 mg/kg of sulphur (and never to exceed 80 mg/kg) as of
January 2005. New Footnote #1 Sulphur in gasoline, when combusted, produces sulphur dioxide, a contributor to smog
and acid precipitation. The incentive effect here is this: abide by the regulation or you will be fined by the
government.
New Footnote #1: See Chapter 6 for a detailed discussion of the sulphur in gasoline regulations.

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 A more effective policy might be to design a system that takes advantage of firms’ normal monetary incentives
in such a way as to lead them to pollute less. For example, oil refiners could be taxed on the basis of the sulphur
content of their gasoline produced. This may induce them to switch their production to lower-sulphur fuels so as to
avoid the tax. They might increase the proportion of methanol derived from grains in their fuels. Methanol does
not contain any sulphur. Gasoline prices are likely to rise, then providing an additional incentive to drivers to
reduce their consumption of gasoline. The Canadian government decided not to tax sulphur, but to subsidize the
production of ethanol at the farm level. This lowered the price of ethanol relative to petroleum, but had a number
of negative consequences such as raising the cost of corn products worldwide and diverting corn from feeding
people to producing vehicle fuels. Corn production is also very fertilizer and pesticide intensive, and can lead to
undesirable environmental impacts. Section Five looks at different ways government can design policies that are
effective in meeting environmental and equity goals while minimizing adverse impacts to the economy. The
essence of the economic incentives approach is to restructure the incentives facing firms and consumers in such a
way that it mobilizes their own energy and ingenuity to find ways of reducing their impacts on the environment.

Incentives in the Pollution-Control Industry

The pollution-control industry develops waste recycling techniques, pollution-control equipment, and pollution-
monitoring technology. It sometimes handles and treats waste products, and is often involved in managing waste-
disposal sites. It also includes firms that develop new environmentally friendly products like low-sulphur gasoline,
low-phosphate detergents, and recyclable paper products. A lively and progressive pollution-control industry is
obviously needed if we are to come to grips effectively with all of our present and prospective environmental
problems. Thus, one of the major things environmental economists must study is the incentives facing this industry
—what causes it to grow or decline, how quickly or slowly it responds to new needs, and so on. In our example of
air pollution from motor vehicles, the pollution-control industry could include manufacturers of zero-emission
vehicles. These vehicles might run on fuel cells, on electricity, or use other technologies. Are policies needed to
encourage these industries? One might argue that the existence of policies that provide incentives to reduce air
emissions will be enough to stimulate the development of alternative fuels or engines. However, various
governments have also subsidized the research and development costs for these manufacturers either through tax
incentives or outright grants of funds. The rationale is that the development of the new technologies will have
broad-reaching social benefits.

Practical Illustration #2: Greenhouse Gas Emissions and Climate

Change
The carbon dioxide (CO ) content of the earth’s atmosphere has increased by over 38 percent since 1750. 6 Figure 1-
2

1 shows the rising time trend of world CO emissions since 1965. The key question is what effect these emissions
2

have on the earth’s climate now and into the future. The science of climate change is complex, with many
uncertainties due to the difficulty of measurement as well as interpretation of the data and attempts to determine
cause and effect.7 It is estimated that the average surface temperature of earth has risen approximately 0.6C over
the 20th century (with a confidence interval of ± 0.2C).8 Climate change models forecast a rise in the earth’s
temperature over the 21st century by anywhere from 1.5 to 6C. Some models also predict an increase in climate
variability and extreme weather events in the future due to the increase in emissions of greenhouse gases (GHGs) –
carbon dioxide (CO ) and other gases in the atmosphere. However, human and natural factors can affect models’
2

results. Natural processes such as volcanic activity send bursts of gases and particulate matter into the atmosphere,
causing changes in rainfall patterns and temporary cooling. Pollution, in the form of accumulated SO in the lower
2

atmosphere, reflects sunlight and works against the greenhouse phenomenon. Carbon dioxide is also absorbed by
carbon sinks in the form of trees, wetlands, and oceans. Just exactly how much the sinks can absorb and under what
conditions is an important area of study.

See the Fourth Assessment Report of the Intergovernmental Panel on Climate Change, Climate Change 2007:
6.

Synthesis Report, for recent data on climate change and a discussion of the state of climate-change science and
policy. Unless otherwise noted, all the numerical estimates presented in this paragraph are from this document.
The report is available at http://www.ipcc.ch/pdf/assessment-report/ar4/syr/ar4_syr.pdf.
7.
Many hundreds of books and articles have been written on the science and economics of global climate change.
This section will just scratch the surface and hopefully stimulate more reading. New information is continually
released that may help to resolve the uncertainties in climate-change predictions. See Chapter 20 for more detail on
Canadian policy and the references at the end of the text.

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8.
See Goddard Institute of Space Studies (NASA) at http://data.giss.nasa.gov/gistemp/graphs/ for data on world
temperatures.

Intergovernmental Panelon ClimateChange:www.ipcc.ch

Figure 1-1: World Greenhouse Gas Emissions [NOTE TO COPY EDITOR: WILL NEED TO
REDRAW, SO NOT AN EXACT REPRESENTATION AND THEN DON’T NEED
PERMISSION TO REPRODUCE]

The time trend of CO2 emissions for the past 100 years is positively sloped and has gotten steeper, with emissions
increasing by five-fold since 1950.
Note: CO2 emissions are from fossil fuel combustion plus cement processing and gas flaring.

Source: Data from World Resources Institute, World Resources, Climate Analysis Indicators Tool,
http://cait.wri.org/, accessed September 27, 2010.

Climate change, global warming or the greenhouse effect are the common names used to describe the potentially
major changes in the world’s climate. The principle of a greenhouse is that the enclosing glass allows the passage
of incoming sunlight but traps a portion of the reflected infrared radiation, which warms the interior of the
greenhouse above the outside temperature. Greenhouse gases in the earth’s atmosphere play a similar role; they
serve to raise the temperature of the earth’s surface and make it habitable. With no greenhouse gases at all, the
surface of the earth would be about 30C cooler than it is today, making human life impossible. The main
greenhouse gases (GHGs), their approximate proportionate contribution to global warming, and their major
sources are shown in Figure 1-2..

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U.S. EPA Climate Change Site: http://www.epa.gov/climatechange/

Natural Resources Canada’s Climate Adaptation Site:

http://adaptation.nrcan.gc.ca/

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 Figure 1-2: Global Anthropogenic Sources of GHG Emissions

Anthropogenic sources are those created by human activity. The graph measures sources in gigatonnes (Gt) of
the greenhouse gases in a common unit that takes into account their impact in the atmosphere (CO 2e for CO2
equivalent). CO2 is carbon dioxide, CH4 is methane, NO2 is nitrogen dioxide, and F-gases are fluorinated gases.
Source: Fourth Assessment Report of the Intergovernmental Panel on Climate Change, Climate Change 2007:
Synthesis Report, Figure 2.1, page 36.

If global climate changes result in global warming, the earth may become very different from its current state.
The rate of heating is estimated to be at least 0.2C per decade based on current levels of GHGs in the atmosphere. 9
This may not sound like a very rapid change, but historical studies have shown that in past episodes of warming
and cooling, during which agricultural societies of the time suffered major dislocations, climate change occurred at
a rate of only about 0.05C per decade. The forecast rate of change for the 21st century is six times faster than the
rates faced by humans in the past. If countries do nothing to offset the increase in greenhouse gas emissions,
adaptation to climate change by future generations may be very costly, especially for some parts of the world.
Adaptation refers to actions taken to offset or reduce the adverse impacts of climate change. For cooler countries in
higher latitudes, with relatively little critical shoreline, adaptation costs may be fairly “modest.” Countries in the
opposite situation will have very high costs of adapting to higher temperatures and rising sea levels. Rising sea
levels may inundate entire nations, such as some islands in the Caribbean and South Pacific, and require relocation
of large populations that now live in low-lying coastal regions (e.g., those living along river deltas in Southeast
Asia and the Nile). The Arctic polar ice caps are melting at a very high rate, threatening that fragile ecosystem and
its inhabitants. Countries differ also in terms of agricultural adaptability—the ability to shift crops, varieties,
cultivation methods, and so on—to maintain production in the face of climate changes and are likely to have very
different perceptions about how they will be affected by global warming.

Fourth Assessment Report of the Intergovernmental Panel on Climate Change, Climate Change 2007: Synthesis
9.

Report.

Responses to Climate Change: Scientific Uncertainties, the Precautionary

Principle and Mitigation Strategies

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Given the uncertainties in climate and natural science, there is an argument that until we “know for sure” that
climate change is happening and is due to human activity no policies for reduction or mitigation of greenhouse-gas
emissions should be introduced. There are several problems with this viewpoint. What if society does nothing today
to mitigate GHG emissions, but there is a small chance that global warming could lead to extremely high
adaptation costs in the future? Then, some years from now, the costs of adjusting to climate change could comprise
a much larger share of GDP than would be realized if society initiates mitigation policies today. People today would
be imposing huge costs on future generations – violating our notions of intergenerational equity. The
precautionary principle says that society should weigh the trade-off between the cost of measures taken today
versus benefits in terms of reduced future risk. Expected net benefits are calculated as the benefits minus the costs
of each scenario weighted by the probability of the event occurring, taking into account that these benefits and
costs will occur into the future. Chapters 6, 7, and 8 illustrate how these benefits and costs are measured and net
benefits computed over time. If the probability that global warming raises average temperatures by 3C in 50 years
is low (e.g., .0005 or .005), society minimizes its costs by doing nothing today because net benefits are higher (a
smaller negative number) with no current policies adopted. But if society estimates the probability at a 5- or 10-
percent chance, action now to reduce GHG emissions becomes the preferred choice.
GHG mitigation policies could include taxes carbon emissions, introducing standards to improve energy
efficiency of vehicles, appliances, and buildings, and a host of other actions. By waiting to see what happens,
society may incur much higher costs than if actions were taken today to put it on a more sustainable path that
reduces carbon emissions. As well, if society does nothing and turns out to be wrong, climate change impacts could
be devastating for countries that cannot easily adapt. The cost to the global economy would be enormous and
inequitably felt across countries and regions. Another uncertainty that is difficult to quantify is the role of
technological change in helping to mitigate global warming. It may be in society’s interest to delay introducing
specific mitigation policies in the present in the hope that technological improvements will allow it to reach a GHG
target at much lower costs in the future. However, this does not necessarily suggest that no GHG policies should be
introduced in the present. For example, a GHG tax at a very low rate could be introduced now with the rate rising
over time. This tax will signal that it will be increasingly costly over time to release GHGs into the atmosphere.
Putting a price on GHG emissions will help incent technological activity.
Recall how total emissions of vehicle pollutants were identified. A similar identity exists for GHGs and
illustrates how they can be reduced.

Total GHGs = Population  GDP/population  Energy/GDP  GHGs/energy

The focus in the equation above is on energy because as Figure 1-2 illustrates, combustion of fossil fuels
contributes the majority of GHGs to the atmosphere. One can read in for “energy” any other primary source of
GHGs. The first term in the word equation is population. Other things remaining equal, larger populations will use
more energy and therefore emit larger amounts of GHGs. The second term is GDP per capita, a measure of the
domestic output of goods and services per capita. Increases in GDP are normally associated with economic growth.
Neither of these first two factors can be considered likely candidates for reducing GHG emissions in the short run.
Deliberate population control measures are a complex policy area that many countries do not want to pursue.
Countries will be reluctant to reduce their rates of economic growth. In the long run, however, the interaction of
these two factors will be important, as history seems to show that increases in income per capita are associated with
lower population growth rates over time. This means that significant near-term GHG reductions will have to come
from the last two terms in the expression. The third is what can be called energy efficiency , the amount of energy
used per dollar (or per franc or rupee or peso) of output. The key here is to move toward technologies of
production, distribution, and consumption that require relatively smaller quantities of energy. The last term is
GHGs produced per unit of energy used. Since different energy forms have markedly different GHG outputs per
unit, reductions in GHG can be achieved by switching to less GHG-intensive fuells.

Table 1-1 lists the major types of changes that could be made in different economic sectors to reduce GHG
emissions. There is no single source that society could call on to get drastic reductions in CO 2 production. Instead,
significant changes could be made in hundreds of different places—transportation, industry, households, and
agriculture. These changes are both technical (as, for example, the switch to more energy-efficient equipment and
low-CO2 fuels) and behavioural (for example, changing driving habits and adopting less energy-intensive

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lifestyles). In Section 4, we develop economic models that show how regulation, taxes, markets, and other policies
can be developed to mitigate GHGs and pollutants of air, water, and lands. Section 5 looks at what is being done in
Canada to reduce emissions and improve environmental quality.

Table 1-1: Means of Reducing Greenhouse Gases

Sustainability of Our Environment and Economy

Basic Issues
The previous examples of smog and motor vehicle pollution and climate change resulting from GHG emissions
illustrate the enormous impact human activity has on the natural environment. Environmental economists argue
that it is vital to link closely the economy with the natural environment. While the natural environment has always
been treated as an essential input into production, few models looked explicitly at the interaction between
ecological systems and the economy. The field of ecological economics examines these interactions more fully. An
important objective of this field is to search for sustainable paths of economic development—actions that do not
destroy ecological systems, but allow for increases in the well being of people. New Footnote #2 The essential idea is
that a sustainable economy is one that has the ability to allow people’s well-being to either rise over time or at least
remain constant (i.e., not fall). To accomplish this, a number of economists argue that current generations cannot
“use up” so much of the existing stocks of natural and environmental resources that future generations will be
impoverished or non-existent. We must examine our economic activities with regard to the carrying capacity of our
ecosystem.

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New Footnote #2: See, for example, Peter Victor (2008), Herman Daly and Joshua Farley (2010), and Robert Costanza
et al. (2011) in the selected references to this chapter.

All economies use natural and environmental resources to sustain life. Rising world population puts increasing
pressure on our natural endowments all the time. Many fear that our current path of production and population
growth is not sustainable. What can be done? One possible approach is to argue that each generation in a
sustainable economy has the obligation to replace what it uses with investment in social capital. This is a very
broad definition of “capital.” It includes everything the economy can invest in—physical capital to produce goods
and services, education, infrastructure, renewable and non-renewable natural resources, and, of course, the
environment itself as a stock of capital. When we use up some of our existing capital, the only way the economy
can be sustainable over time is to reinvest to keep the social capital stock at least constant. Pollution control and
treatment is a means of keeping the environmental capital stock constant. So is recycling to some degree. Whether
sustainability is achievable depends on the actions of people, industries, and governments. Some questions to
contemplate: Will private markets keep the stock of social capital constant? Is government intervention necessary?
If so, in what form?
Sustainability also depends on the degree of substitutability among natural capital (the environment and
natural resources), produced capital, and labour. Technology and technological change is another vital element in
the search for sustainable paths. Technology will influence the degree of substitution among factor inputs and affect
the amount of inputs needed to produce a unit of output. Some technologies may promote sustainability, others not.
Economists play important roles in helping to find answers to all these questions, by building models that explicitly
incorporate the role of the natural environment and by examining these issues empirically. To recap,

a sustainable economy is one in which investment in social capital allows the economy to grow
so that people are at least as well off in the future as they are in the present, while sustaining
the health of ecological systems.

Trade-offs and Sustainability

Economists illustrate the trade-offs between output of goods and services and environmental quality by using a
production possibility frontier (PPF). A PPF is a way of diagrammatically depicting the choice faced by a group of
people between two desirable outcomes—output of goods and services and environmental quality. The basic
relationship is shown in Figure 1-3. Suppose we are exploring the trade-offs that arise from our use of fossil fuels:
the goods and services they produce in our current ‘fossil fuel intensive economy versus the degradation to our
ecosystem and economy from climate change. The vertical axis has an index of the aggregate economic output of
our high-carbon economy, the total market value of conventional economic goods sold in the economy in a year.
The horizontal axis has an index of environmental quality, derived from data on different dimensions of the
ambient environment; for example, what the economy would look like if, for example, we had fewer GHG
emissions and airborne pollutants. The curved relationship shows the different combinations of these two outcomes
—a carbon-intensive economy or one with higher levels of environmental quality and fewer GHG and air
contaminant emissions—that are available to a country given its endowment of resources with which to work. The
PPF is shown with a dashed line from an environmental quality below e. Below e, the economy cannot produce any
additional goods and services because there are too few environmental resources to sustain production. EMAX shows
the maximum amount of environmental quality if there is no goods production at all (presumably meaning no
human population).
The production possibility frontier is determined by the technical capacities in the economy together with the
ecological facts—meteorology, hydrology, and so on—of the natural system in which the country is situated. It
says, for example, that if the current level of economic output is c1, we can obtain an increase to c2 only at the cost
of a decrease in environmental quality from e1 to e2. But while the PPF itself is a technical constraint, where a
society chooses to locate itself on its PPF is a matter of social choice. And this depends on the relative values that
people in that society place on conventional economic output and environmental quality. Economists illustrate
social choices with a relationship called a social or community indifference curve (CIC). Community indifference
curves are shown for country A on Figure 1-3. Each point on a CIC shows combinations of environmental quality
and goods perceived by society to provide a given level of well being. CICs that lie farther from the origin yield
higher levels of well-being than those closer to the origin. Societies will seek the highest level of well-being that
they can attain. This will be where the CIC is tangent to the PPF. For country A, this is CIC 2, tangent at point A,
with e2 environmental quality and c2 goods. Another country might have a different set of social preferences that
lead to choosing different bundles of environmental quality and goods; for example, at point B, with c1 and e1
being chosen. The choices made by society will affect the sustainability of the economy and environment.

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Figure 1-3: A Production Possibility Frontier (PPF) between a High-Carbon Economy and
Environmental Quality

The PPF illustrates possible trade-offs between goods produced in a high-carbon economy and environmental
quality. As society consumes more carbon-intensive goods, it gives up environmental quality. Below e, no goods
can be produced because environmental quality is too low to sustain production. Community indifference curves
(CICs) indicate a country’s choice of the mix of carbon-intensive goods and environmental quality. Country A
chooses more goods/less environmental quality than country B.

The Environment and Growth: Sustainability over Time

Sustainability isn’t just about choice in a given year, but what happens to the economy and environment over time.
The PPF will not remain in the same place, as conditions such as production technology and environmental
degradation change over time. We illustrate two possibilities. Figure 1-4 shows the possible trade-offs facing
society in 50 years. Panel (a) presents a pessimistic scenario. Suppose we continue on our current path of
consuming large amounts of carbon-intensive fossil fuels to produce energy for our economy and we thereby
deplete our natural capital in the form of a degraded air quality and climate change that reduces agricultural
output, displaces human settlement, and requires other forms of adaptation to climate change. These outcomes
may be the result of having chosen to be at point A on the PPF in Figure 1-3 in preceding years. As a result, the
PPF for the year 2050 lies inside of the PPF today. Society, no matter where it chooses to locate, now must consume
either fewer goods or have lower environmental quality than is possible today. If we try to keep production of goods
at c2, environmental quality falls to e3. Alternatively, if environmental quality is to stay at e2, it is possible to
produce and consume only c3 goods.
Panel (b) is more optimistic. Suppose we develop and adopt new technologies to produce substantial amounts
of energy from sources that neither release GHGs nor damage other components of our natural environment. Our
PPF for the present now shifts out to reflect the ability of society to produce more goods with a higher level of
environmental quality. Notice that we have skewed the shape of the PPF to show that at c2—the same level of
goods society chose in the base year—we have e4 environmental quality rather than e2, because a non-polluting
energy source was developed. Alternatively, at e2, production at c4 is possible. These cases illustrate that the future
is not independent of the choices we make today.

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Figure 1-4: Possible PPFs in 50 Years: Two Scenarios

The PPF in panel (a) presents a pessimistic scenario, in which the PPF shifts inward due to environmental
degradation. This means that the country can no longer consume at both c2 and e2; one must decline. Panel (b) is
more optimistic. The PPF may shift out due to technological developments. Now consumption of goods and
environmental quality can both rise over time.

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SUMMARY
The purpose of this chapter was to whet your appetite for the subject of environmental economics by indicating
some of the main topics that the field encompasses, showing very briefly the approach that economists take in
studying them. Our focus will be on microeconomic aspects of environmental economics—to see why externalities
exist and persist and how to design and analyze economic policy instruments that can help improve the quality of
our environment.
When we get involved in some of the conceptual and theoretical issues that underlie environmental economics,
it is easy to lose sight of what we are trying to accomplish. We are trying to develop basic principles so that we can
actually use them to address real-world problems such as air and water pollution. Although the principles may
appear abstract and odd at first, remember the objective: to achieve a cleaner, healthier, and more beautiful natural
environment that can be sustained over time.

KEY TERMS
Cost effectiveness, 22
Ecological economics, 10
Economic efficiency, 2
Equity, 3
Externality/external effects, 5
Incentive, 4
Income elastic good, 14
Marginal benefits, 2
Marginal costs, 2
Normal goods, 18
Opportunity costs, 2
Private costs, 6
Production possibility frontier (PPF), 11
Property rights, 5
Scarcity, 2
Social capital, 10
Socially efficient level of pollution, 8
Sustainability, 11
Trade-offs, 2

DISCUSSION QUESTIONS
1. “Annual testing of all motor vehicles on the road is not a cost-effective policy.” Do you agree with this
statement? Explain why or why not.
2. Why would a tax on gasoline provide a larger incentive to reduce air emissions from motor vehicles than an
annual tax on owning a vehicle?
3. The Canadian CAFC standards apply to new vehicles as they come off the assembly line. Provide two reasons
why this might have a perverse effect on total emissions from motor vehicles. Explain your arguments.
4. Does Canada need a voluntary CAFC standard when the United States has a mandatory one? Discuss.
5. What factors influence the trade-offs illustrated in the production possibility frontier? How can environmental
policy affect these trade-offs?

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6. Suppose there is a technological change that allows firms to produce goods and services with less energy and
hence fewer GHG emissions. Show graphically and explain how this will alter the PPF and a society’s
potential choice of where to locate on the PPF.
7. If produced capital is not readily substitutable for environmental capital (natural resources, air and water
quality), how will this affect the trade-offs between economic growth and the environment?

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