Natural Resources and Environmental Economics

1. Introduction Natural Resources and Environmental Economics

1.1.Basic Concepts

What is economics? is the social science that analyses the production, distribution, and

consumption of goods and services. It also deals with how scarce resources are allocated

among competing uses.

What are Natural resources? They are naturally occurring substances that are considered

valuable in their relatively unmodified or natural form. Natural resources are capital assets

and are not provided by human activity. A commodity is generally considered a natural

resource when the primary activities associated with it are extraction and purification, as

opposed to creation. Thus, mining, petroleum extraction, fishing, hunting, and forestry are

generally considered natural-resource.

What are Environmental resources? Environmental resources are any materials and service

from the environment that is valuable to society. This can refer to anything that people find

useful in their surroundings. Land, air, and water are environmental resources. Heat from the

sun, transportation and recreation in lakes, rivers, and oceans, a beautiful view, or the

discovery of a new species are all environmental resources.

They include biodiversity; scenic, educational or research value of landscapes; protective

value of vegetation in relation to soil and water resources; the functions of the vegetation as a

regulator of climate and of the composition of the atmosphere; water and soil conditions as

regulators of nutrient cycles, as influencing human health and as a long-term buffer against

extreme weather events; occurrence of vectors of human or animal diseases (mosquitoes,

tsetse flies, etc.).

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Figure 1: Classification of Natural Resources

Natural Resources

Flow Resources Fund/Stock Resources

Non storable Resources Renewable Resources Non -renewable Resources

(Environmental Resources)

Recyclable Resources Non-recyclable Resources

Storable Resources

1. Flow Resources (non depletable)

 Examples of flow resource are solar radiation, and the power of the wind of

tides and of flowing water. Today‟s use has no implications for tomorrow‟s

availability (using more solar radiation today does not itself have any

implications for the availability of solar radiation tomorrow)

(a) Non-storable (sometimes called “environmental resources”)

 Often indivisible: Environmental resources are to a large degree "non-

tangible" in strictly economic terms. They are resources provided by

nature that are indivisible. Inexhaustible (in human span of time)

 Time & management relevant only to consumption, not supply

(b) Storable (by nature or by humans with technology)

 May be divisible

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 Time & management relevant to both to consumption & supply

2. Fund Resources (stock or depletable resources)

 In the case of stock resources, the level of use today does have implications for

availability tomorrow. Eg. Plant and animal populations, mineral deposits,

(a) non -Exhaustible & Renewable

 Renewable resources have the capacity to regenerate over time. If growth and use are

in balance, then the stock of a renewable resource is maintained indefinitely, apart

from natural disasters and events. Renewable resources are biotic, plant and animal

populations, and have the capacity to grow in size over time, through biological

reproduction. Regenerative within human use time frame.

(b) Exhaustible & Non renewable

 Non-renewable resources are abiotic, stocks of minerals, and do not have that capacity

to grow over time. They are sometimes referred to as „exhaustible‟, or „depletable‟,

resources. This is because there is no positive constant rate of use and eventually the

resource stock must be exhausted. Relatively fixed stocks/fund within human use time

frame

NB: Renewable resources become non- exhaustible if harvested for too long at a rate

exceeding their regeneration capacities.

Non-renewable resources can be of non-recyclable or recyclable

1. Non-recyclable: (Examples: fossil-fuel energy resources (oil, natural gas, coal, peat,

many “renewable” resources when thresholds violated)

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2. Recyclable: (Examples: some minerals (iron, aluminum, gold, silver)

 In considering the efficiency and optimality of non-renewable resources, we must take

account not only of use at a point in time but also of the pattern of use over time.

Environmental resource stocks have rates of return associated with their deferred use. The

rates of return on environmental assets must be taken into account in trying to identify

efficient and optimal paths of environmental resource use over time.

1.2. Natural Resource Economics Vs. Environmental Economics

What is natural resource economics?

 is the study of how to best govern scarce natural resources, especially, those such

as air ground water, marine fishery that are common rather than private

properties.

 Natural resource economics deals with two broad categories of resources:

nonrenewable resources, such as petroleum and minerals, and renewable

resources, such as forests, fish, freshwater and wildlife.

 Natural Resources Economics deals with the problems of managing common-

pool natural resources, determining optimal rates of extraction, & understanding

resource markets

The sort of questions and problems to be studied in the area of natural resources economics

are:

 Production, markets, management, uses, and abuses of natural resources such as

fisheries, forests, and non-renewable resources extraction

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What is environmental economics? Is the study of the impact of the goods and services

produced by economy, particularly market systems of allocation, on environmental quality

and ecological integrity? The sorts of questions and to be studied under environmental

economics are:

 Economics of pollution, causes, targets and instruments for their control, and

environmental valuation.

Environmental economics has three primary focuses:

 An environmental sector is added to the traditional circular flow model of

conventional economics. In this model the environment seems have no place. And it

has been severely criticized by environmentalists for not sufficiently accounting the

link between the environment and the economy.

 Environmental economics provides a framework for evaluating alternative

technologies and public policies for reducing environmental pollution.

 Environmental economics provides analytical methods for estimating the economic

value of improving environmental quality.

NB: Natural Resource and Environmental Economics is the application of the principles

of economics to the study of how environmental and natural resources are developed and

managed.

Figure 2: Natural resource economics Vs Environmental economics

Nature
ECONOMY
Resources
Residuals

Natural Resource Economics Environmental Economics

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Natural Resources Economics is concerned with the production and use of natural resources

both renewable and exhaustible. While, Environmental economics is concerned with the

impact of the economy on the environment, the significance of the environment to the

economy and the appropriate ways of regulating economic activities so that balance is

achieved among the environment, economics and other social goals.

1.2. A Brief History of Natural Resources and Environmental Economics

The emergence of natural resources and environmental economics as a distinct sub discipline
has been a relatively recent event. However, natural resources use and environmental issues
have been an area of concern for economists since the simultaneous birth of modern
economics and industrial society in the eighteen century.

Classical economists constitute the early economists from the classical economics school of
thought. Another dominant school of thought is the neoclassical economics. A discussion
concerning issues of environment by these schools of thoughts will be presented. The view of
the prominent economists from this school of thought will also be discussed.

A. Classical Economics (Adam Smith, Thomas Malthus, Davis Ricardo and John S.
Mill)
The term classical refers to number of economists writing up in the eighteenth and nineteenth
centuries, a period during which the industrial revolution was taking place ( at least in much
of Europe and North America) and agricultural productivity was growing rapidly. Natural
resources and environmental issues were the major concerns of classical economists.
Particularly, the dependence of economic activities on natural environment was a central
concern of the classical economics.
Adam Smith (1723-1790)
Adam Smith was the first writer to systemize the argument for the importance of market in
allocating resources. His major work “An Enquiry in to the Nature and Causes of Wealth of
Nation (1776) consists of the famous statements of the role of the invisible hands. The belief
in the efficacy of the market mechanism still constitutes a fundamental organizing principle

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of the policy prescriptions of modern economics, including resources and environmental

economics.
Thomas Malthus (1766-1834)
Early classical economists viewed the environment (particularly land) as the constraint of
economic and population growth. They were concerned with long term prospects of living
standards of an economy subject to constraints on the supply of land. Land (sometimes used
to refer to natural resources in general) was viewed as limited in its availability. Assuming
that land was a necessary input of production and that it exhibited diminishing returns.
The early classical economists came to the conclusion that the prospects for the living
standard of the majority of people were dismal. This view was strongly associated with
Thomas Malthus. Malthus was concerned with choking off of population and the well being
of the people by land and food constraint. In his essay, the Principle of Population (1798),
Malthus predicted a long run tendency for a decline in the living standard of the people to a
subsistence level and the ultimate halt in population growth due to land and good constraint.
Eventually, population growth will exceed the growth of food supply resulting in a fall in
output per capita overtime. This will lead to a decline real wages to a subsistence level.
Ultimately, death from disease and famine will reduce population size.
David Ricardo (1772-1823)
In his Principle of Political Economy and Taxation (1817), David Ricardo replaced Malthus‟
assumption of a fixed stock of land by a conception in which land was available in parcel of
varying quality; land differs in quality. According to Ricardo, agricultural output can be
expanded by increasing the intensive margin (exploiting a given parcel of land more
intensively) or by increasing the extensive margin (bringing previously uncultivated land in
to productive use). However, in either case, returns to land input were taken to be
diminishing.
John S. Mill (1806-1873)
Mill‟s work, particularly, his Principle of Political Economy(1857) utilizes the idea of
diminishing returns but recognizes the countervailing influence of the growth of knowledge
and technological progress in production. He replaced less emphasis on diminishing returns,
as innovation was rapidly increasing agricultural productivity. In other words technical
progresses sustain growth. In addition to this Mill adopted a boarder view of the roles played
by natural resources. In addition to agricultural and extractive uses of land, Mill saw it as a

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source of amenity values (such as intrinsic beauty of countryside) that will become of
increasing relative importance as material conditions improve
B. Neoclassical Economics: The Marginal Theory and Value
A serious of major work published in the 1870s known as the “Neoclassical economics”
resulted in a change in the manner in which value was explained. Classical economics view
value as arising from the labour force embodied (directly or indirectly) in output; labor was
considered to be the source of value. Neoclassical economists explained value as being
determined in exchange reflecting preferences and costs of production. Moreover, the
technique of marginal analysis was adopted allowing earlier notions of diminishing returns in
terms of diminishing marginal productivity.

Leon Walras (1834-1910)

He developed Neoclassical General Equilibrium Theory and in doing, he provides a rigorous
foundation for the concept of efficiency and optimality.
Vilfredo Pareto (1897)
He developed the notion of Pareto optimality (also known as economic efficiency or
allocative efficiency). An allocation is Pareto optimal if it is not possible to make any one
better off without making at least one other person worse off. The concept of efficiency and
optimality are extensively used as tools of analysis in environmental economics.
Efficiency: one way of thinking about efficiency is in terms of missed opportunities. If we
use resources wastefully then opportunities are being squandered. Therefore, eliminating such
a waste (or inefficiency) can bring net benefits to some groups of people. Example: energy
inefficiency. It is often argued that much energy is produced or used inefficiently, and that if
different techniques were employed significant resource savings could be gained at no loss in
terms of final output. This kind of argument usually refers to some kind of technical or
physical inefficiency.
But of greater interest to economists are allocative inefficiencies. That is even where
resources are used efficiently in technical sense, net benefits are sometimes squandered.
Example, suppose that electricity can be generated by the burning of either some heavily
polluting fossil fuel or a less polluting alternative fuel. Because of lower prices of the former
fuel, it is chosen by profit-maximizing electricity producers.
However, the pollution results in damages which necessitate expenditure on health care and
clean-up operations. These expenditures may exceed the cost saving that electricity

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producers obtain from using the cheaper fuel. When this happens there is inefficiency that
results from resource allocation choices though where there are no technical inefficiencies.
Society as a whole would obtain positive net benefits if the less polluting fuel were used.

Such inefficiencies will be pervasive in the use of natural and environmental resources in
pure market economies. A substantial part of environmental economics is concerned with
how economies might avoid inefficiencies in the allocation and use of natural and
environmental resources.

Optimality: to understand the idea of optimality we need to have in mind:

(1) A group of people taken to be the relevant „society‟;

(2) Some overall objective that this society has that enables us to measure the extent to which
some resource use decision is desirable from that society‟s point of view.

A choice of a given resource use is socially optimal if it maximizes that objective given any
relevant constraints. The Definition of Efficiency in welfare economics owes much to the
economist-Vilifiredo Pareto. Therefore, an efficient local State is often known as Pareto
Optimality.

Definition of Pareto optimality:

“A situation is efficient or Pareto optimal if it is impossible to make one person better-off

except by making some one else worse-off”.

Stated differently, Pareto efficiency is a situation in which it is impossible for an individual to

gain without another individual incurring a loss. But if an economy is inefficient, it is
possible to make at least one person better off at no cost to any one else. Such a change is
called Pareto Improvement or a Pareto Superior Move.

Efficiency and optimality are related because a resource allocation cannot be optimal unless it
is efficient. That is, efficiency is a necessary condition for optimality. If society squanders
opportunities, then it cannot be maximizing its objective. However, efficiency is not a
sufficient condition for optimality; in other words, even if a resource allocation is efficient, it
may not be socially optimal. This arises because there will almost always be a multiplicity of

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different efficient resource allocations, but only one of those will be „best‟ from a social point
of view.

Alfred Marshal (1842-1924)

He elaborated the partial equilibrium supply and demand analysis of price determination.
Moreover, an important early work in the analysis of the externalities and market failure is
found in Marshall‟s Principles of Economics (1890).

Early neoclassical economic analysis ignored the productive services that natural resources
offer. What is noticeable in the early neoclassical growth models is the absence of land or
natural resources from the production function used in such models. In other words, the
dependence of economic activity on the natural environment was a central concern of
classical economics but not for neoclassical economics. The introduction of natural resources
in to the neoclassical model of economic growth took place in the 1970s, when neoclassical
economists first systematically investigate efficient and optimal depletion of resources. The
models of efficient and optimal exploitation of natural resources and the theory of accounting
for the environment as it relates to the question of sustainability (involves taking care of
posterity) are based on the writing of those authors. This body of work and the developments
that have followed from it led to the development of natural resources economics.

The first systematic analysis of environmental pollution as an externality is found in Pigou

(1920). The development of cost benefit analyses in 1950s and1960s significantly advanced
interest in market and non-market goods leading to the development of the sub-discipline of
Environmental Economics

Environmental economics is concerned with the impact of the economy on the environment,
the significance of the environment to the economy and the appropriate ways of regulating
economic activities so that balance is achieved among the environment, economics and other
social goals. Natural Resources Economics is concerned with the production and use of
natural resources both renewable and exhaustible. The modern sub-disciplines of natural
resource economics and environmental economics have largely distinct roots in the core of
modern mainstream economics. The former emerged mainly out of the neoclassical growth
economics, the latter out of the welfare economics and the study of market failure. Both can
be said to effectively date from the early 1970s, though of courses earlier contributions can be

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identified. The two sub-disciplines are combined to make Natural Resources and
Environmental Economics.

1.3. Fundamental issues in the economic approach to resource and environmental

issues

1.3.1. Property rights, efficiency and government intervention

A central idea in modern economics is that, given the necessary conditions, markets will
bring about efficiency in allocation. Well-defined and enforceable private property rights are
one of the necessary conditions. Because property rights do not exist, or are not clearly
defined, for many environmental resources, markets fail to allocate those resources
efficiently. In such circumstances, price signals fail to reflect true social costs and benefits,
and a prima facie case exists for government policy intervention to seek efficiency gains.
Some environmental problems cross the boundaries of nation states and are properly treated
as global problems. In such cases there is no global government with the authority to act on
the problem in the same way as the government of a nation state might be expected to deal
with a problem within its borders.

1.3.2. The role, and the limits, of valuation in achieving efficiency

As just observed, many environmental resources – or the services yielded by those resources
– do not have well-defined property rights. Clean air is one example of such a resource. Such
resources are used, but without being traded through markets, and so will not have market
prices. A special case of this general situation is external effects, or externalities. An
externality exists where a consumption or production activity has unintended effects on
others for which no compensation is paid. Here, the external effect is an untraded – and
unpriced – product arising because the victim has no property rights that can be exploited to
obtain compensation for the external effect. Sulphur emissions from a coal-burning power
station might be an example of this kind of effect. However, the absence of a price for a
resource or an external effect does not mean that it has no value. Clearly, if well-being is
affected, there is a value that is either positive or negative depending on whether well-being
is increased or decreased. In order to make allocatively efficient decisions, these values need
to be estimated in some way. Returning to the power station example, government might
wish to impose a tax on sulphur emissions so that the polluters pay for their environmental
damage and, hence, reduce the amount of it to the level that goes with allocative efficiency.

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But this cannot be done unless the proper value can be put on the otherwise unpriced
emissions. There are various ways of doing this – collectively called valuation techniques.

1.3.3. The time dimension of economic decisions

Natural resource stocks can be classified in various ways. A useful first cut is to distinguish
between „stock‟ and „flow‟ resources. Whereas stock resources, plant and animal populations
and mineral deposits, have the characteristic that today‟s use has implications for tomorrow‟s
availability, this is not the case with flow resources. Examples of flow resource are solar
radiation, and the power of the wind, of tides and of flowing water. Using more solar
radiation today does not itself have any implications for the availability of solar radiation
tomorrow. In the case of stock resources, the level of use today does have implications for
availability tomorrow.

Within the stock resources category there is an important distinction between „renewable‟ and
„nonrenewable‟ resources. Renewable resources are biotic, plant and animal populations, and
have the capacity to grow in size over time, through biological reproduction. Non-renewable
resources are abiotic, stocks of minerals, and do not have that capacity to grow over time.
What are here called non-renewable resources are sometimes referred to as „exhaustible‟, or
„depletable‟, resources. This is because there is no positive constant rate of use that can be
sustained indefinitely – eventually the resource stock must be exhausted. Renewable
resources are exhaustible if harvested for too long at a rate exceeding their regeneration
capacities. From an economic perspective, stock resources are assets yielding flows of
environmental services over time. In considering the efficiency and optimality of their use,
we must take account not only of use at a point in time but also of the pattern of use over
time. Efficiency and optimality have, that is, an intertemporal, or dynamic, dimension, as
well as an intratemporal, or static, dimension. In thinking about the intertemporal dimension
of the use of environmental resources, attention must be given to the productiveness of the
capital that is accumulated as a result of saving and investment. If, by means of saving and
investment, consumption is deferred to a later period, the increment to future consumption
that follows from such investment will generally exceed the initial consumption quantity
deferred. The size of the pay-off to deferred consumption is reflected in the rate of return to
investment. Environmental resource stocks similarly have rates of return associated with their
deferred use. The relations between rates of return to capital as normally understood in
economics and the rates of return on environmental assets must be taken into account in

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trying to identify efficient and optimal paths of environmental resource use over time. Many
pollution problems also have an intertemporal dimension, and it turns out that the analysis
developed for thinking about the intertemporal problems of resource use can be used to
analyse those problems.

1.3.4. Substitutability and irreversibility

Substitutability and irreversibility are important, and related, issues in thinking about policy
in relation to the natural environment. If the depletion of a resource stock is irreversible, and
there is no close substitute for the services that it provides, then clearly the rate at which the
resource is depleted has major implications for sustainability. To the extent that depletion is
not irreversible and close substitutes exist, there is less cause for concern about the rate at
which the resource is used. There are two main dimensions to substitutability issues. First,
there is the question of the extent to which one natural resource can be replaced by another.
Can, for example, solar power substitute for the fossil fuels on a large scale? This is, an
especially important question given that the combustion of fossil fuels not only involves the
depletion of non-renewable resources, but also is a source of some major environmental
pollution problems, such as the so-called greenhouse effect which entails the prospect of
global climate change. Second, there is the question of the degree to which an environmental
resource can be replaced by other inputs, especially the human-made capital resulting from
saving and investment. This question is of particular significance when we address questions
concerning long-run economy–environment interactions, and the problem of sustainability.
Human-made capital is sometimes referred to as reproducible capital, identifying an
important difference between stocks of it and stocks of non- renewable resources. The latter
are not reproducible, and their exploitation is irreversible in a way that the use of human-
made capital is not. With renewable resource stocks, depletion is reversible to the extent that
harvesting is at rates that allow regeneration. Some pollution problems may involve
irreversible effects, and the extinction of a species of plant or animal is certainly irreversible.
Some assemblages of environmental resources are of interest for the amenity services,
recreation and aesthetic enjoyment that they provide, as well as for their potential use as
inputs to production. A wilderness area, for example, could be conserved as a national park or
developed for mining. Some would also argue that there are no close substitutes for the
services of wilderness. A decision to develop such an area would be effectively irreversible,
whereas a decision to conserve would be reversible.

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1.4. Why Study Natural Resource and Environmental Economics?

The Economics of the Environment has a number of special features that are not typical of

many economic problems:

1. Optimal allocation of environmental resources has implications for future

choice

The decision to consume a good today typically does not affect the ability to consume it

tomorrow. However, the decision to use natural resources today does affect what will be

available tomorrow.

2. Many decisions regarding environmental resources are irreversible.

3. Market failure is an important characteristic of many environmental issues.

 When market failures exist, government intervention may be

appropriate.

4. Optimal allocation requires understanding the whole ecological system and

how it responds to changes in both ecological and economic systems.

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