Economic Analysis in Brief
Much of what constitutes "economic analysis" is not really very controversial. It is simply a way of thinking about choices and about the costs, benefits, and trade-offs that underlie those choices. A basic notion in economics is that we make trade-offs "at the margin." We do this on a daily basis, for example, when we allocate our time between work and play, or when we allocate money between spending and saving. Groups of individuals—such as households, organizations, towns, or countries—face similar kinds of collective choices, and economics has a systematic way of thinking about these trade-offs as well and of applying these ideas to a wide range of situations. Economics also tries to understand how individuals behave and how they respond to incentives of various kinds. This makes it possible to evaluate how a given change in incentives—such as a change in government policy—is likely to alter individuals' actions.
Economic analysis is essential for the environment because environmental issues are fundamentally economic ones: people cause environmental problems because of their choices, and people distinguish small environmental problems from large ones based on their values. It follows that finding solutions to environmental problems requires understanding those values and those choices. That is what economics tries to do. It tries to understand people's individual incentives and choices, as well as the collective opportunities and constraints faced by society as a whole.
To help us get started, let's take a look at some key economic concepts and ideas and then apply them to the example of water. Water provides a good example because it is both a resource and a commodity, and it's also an essential ingredient in ecosystems and habitats. The availability of water depends on many things, including the choices made by individuals and households, towns and cities, and countries. So, as we introduce these key economic ideas, we'll consider how they relate to the allocation of water and how a small community might apply these economic ideas and tools to water allocation issues.
One note of caution: What follows is a compact overview of some big issues and ideas, which may make the delivery in this first chapter seem more like a fire hose than a drinking fountain to some readers. Don't despair. The intention here is to introduce some key ideas and to entice. A more detailed, step-by-step approach follows in the remaining chapters. Also, a number of key concepts used throughout the book are shown here in bold, followed by brief definitions or explanations. More detailed discussions of each can be found in later chapters.
Marginal versus Total Value
One of the most fundamental concepts in economics is the idea of marginal value , such as the value of one additional gallon of water, one more hour spent studying, or the value of one more dollar spent on junk food. When we make choices that involve the allocation of a resource to a particular use, or when we give something up that is valuable to us, almost always we are doing this "at the margin." This means we are making only an incremental change in the amount of the resource being allocated to a particular use as compared with other uses, for example, when a household allocates water for drinking, bathing, or gardening.
When we do this, it makes sense to consider the incremental or marginal benefit of this particular change. Even though the value of the first unit of a particular good or service may be very high to us, it is likely that with additional quantities the marginal value will decline. Economists call this diminishing marginal utility. It is extremely important to recognize the difference between marginal value and total value because while a particular good may have an extremely high total value (for the whole amount used), this does not necessarily mean that the marginal value of one additional unit of that good is also extremely high. For example, because we cannot live without water, the total value of water can be thought of as being infinite. But the value of an additional gallon of water may be close to zero if we are at the point where all our current needs for water have been satisfied.
Economists illustrate this graphically as in figure 1.1, where the marginal or incremental value of one additional unit of a good (like water) or a service (like a haircut) may be very high when the quantity used (in a given period of time) is low, but will generally decline at higher levels of consumption or use. At a very high level of use, the marginal value of water will eventually fall to zero (somewhere off the right end of the horizontal axis in figure 1.1). But at a very low level, water will have an exceedingly high marginal value—for example, when thirst becomes a life or death situation.
Since the total value is just the adding up of all the incremental or marginal values from the first gallon to the last gallon, even in a situation where the marginal value is very low, the total value may be very high for an example like water. The marginal value at low levels isn't even shown in figure 1.1 because it goes off the top of the graph. If the marginal value is infinite at very low quantities, then the total value will be infinite as well, even though the value of the last gallon consumed is very low. Individually and collectively, we face many choices, but these usually involve incremental changes in resource allocation. That is why we should often focus on the incremental changes in value for a given use rather than the total value.
A second key concept in economics is opportunity cost. Nearly all choices involve trade-offs. That means that a choice to allocate a resource to one use necessarily implies not putting it to some other use. By not putting a resource to that other use, you give up the benefits from that other use, and this is the opportunity cost. Using water to water the garden means giving up its value for drinking or bathing. Cutting down a tree to build a house means giving up its value as part of a forest. Spending time exercising implies giving up the value of that time for working.
In general, the more of a thing we take away from one use and put to another, the higher the opportunity cost. The relationship can be appreciated by looking again at drinking water in figure 1.1. If we begin with a large quantity of drinking water, but then take away water for irrigating a garden, we move from right to left in figure 1.1. The marginal value of a unit of water that could be used for drinking will rise as we take away additional units for gardening. This implies that the opportunity cost of water used to garden will rise with the amount used, as shown in figure 1.2.
Economists recognize that as units of a resource are taken away from one use and put to a second use, the opportunity cost rises and the value of the resource in the second use declines. Because of this, we expect there to be a point where the marginal values of the resource for the two competing uses will be equal. This is the point where shifting units of the resource one way or the other will not increase the combined total value for the two uses. In the case of water, if a household uses water for gardening up to the point where the marginal value from that use is just equal to the marginal value from using water for drinking or bathing, then the sum of the total value from each use will be maximized, and the household will have gotten the most total value, or benefit, out of its water use. We call this efficiency.
For a water-using community, these same ideas about opportunity cost and making trade-offs at the margin will apply. The competing demands of different individuals for water will require compromise and trade-offs among different individuals' priorities. If the community's water delivery system is inadequate for a growing population, a system of larger pipes could be installed—at a cost. This means the funds used for replacing pipes would not be available for other uses. The reliability of the community's water supply might be greatly improved by damming a nearby river, but with a cost, the adverse effects on recreation and fishing.
The stark reality that we must make trade-offs—that more of one thing implies less of something else—seems often to be missed by individuals whose own interests are narrowly focused, especially when the opportunity costs are at the community or societal level. Some individuals in the community may oppose any damming of rivers, no matter how many other rivers there may be. To look at a different example, librarians may insist that all books have enormous value and are worth saving, or that our nation's libraries are inadequate and that we should do everything possible to bring them all up to a very high standard. While this may be a priority for a librarian, in a society where different people have different interests, preferences, and goals, the librarian's view neglects these two key notions of opportunity cost (money spent on books can't be spent on public safety or museums) and diminishing marginal value (doubling the size or numbers of libraries is unlikely to double their value to society). The point is not that librarians or river advocates are wrong to have these views, but rather that in a world with many people with diverse interests and priorities, compromises and trade-offs are unavoidable.
A related concept to opportunity cost in economics is substitution. Whether a particular good or service has a high or low value at the margin will depend on how important it is to individuals. If there are no substitutes for a particular good, and the good is essential, then it will likely have a very high value. But if the good is not essential or if there are close substitutes—goods that can serve the same or similar purpose—then the marginal value of the good will be low. Water is essential for survival, and since there are no substitutes for it, it will have a very high value over some range of quantities. The community may value a river very highly as a source of water for drinking, but a particular river may not have a high value if there are several other streams nearby that could be used instead.
By contrast, if the substitute good is costly or inconvenient, or if it is an imperfect substitute, then there will be lost benefits when the substitution is made. Water that is located one hundred miles away may be a poor substitute for water that is immediately available.
In general, economists are quick to sing the praises of competitive markets—the "invisible hand" that has the potential to allocate resources efficiently. But economists also recognize that there are many situations in which markets cannot be relied upon to achieve an efficient, or desirable, allocation of resources. The example most relevant to environmental concerns is the notion of a public good. A public good cannot be divided up and sold individually to consumers according to their preferences. The benefits or services from a public good are nonrival, which means that the good can be consumed or used by one person without reducing the amount available to others. Drinking water is a rival good: if I drink it, it is no longer available for others to drink. A radio broadcast, by contrast, is nonrival: I can listen to it without reducing the amount available for others. I can also enjoy clean air or a scenic, free-flowing river without reducing the amount available for others to enjoy.
Public goods may sound like a great thing, but they also create a problem. Everyone has incentives to use them; no one has a strong incentive to provide or protect them. Clean air, migratory seabirds, wilderness areas, and national security are just a few of the public goods that will not be produced or maintained at the desired levels simply by "letting the market work." Individuals have an incentive to be free riders, meaning they can let others produce or protect these public goods and then enjoy them without contributing toward their cost. This free rider problem is a fundamental source of conflict between social goals and individual incentives, providing a clear rationale for collective (e.g., government) intervention to make decisions about the level or quantity of these goods to provide, how to provide them, and who should pay.
In our hypothetical community, the infrastructure for delivering water to households from an upstream source is a type of public good. The risk of flooding may be a collective risk for the community, one that might be reduced with a flood control dam, another kind of public good. But individual households are unlikely to build flood control dams on their own. If some members of the community joined forces to build a dam for this purpose, free riders, who didn't share in the cost of the dam, would still be protected from flood risk. Should all community members be required to pay for the dam? Should everybody pay the same amount? What about the poor, or those who live in locations with little risk of flooding?
The potential value of a resource to society must be measured in terms of the incremental or net benefits associated with an increase in the availability of that resource. To measure net benefits, we need to subtract the incremental costs involved in making the additional goods or resource available. For example, if our community taps a source of irrigation water that produces $1 million worth of crops, this does not mean that the value of the water to society is $1 million. If equipment was used to build the infrastructure for dams and canals, then these are one- time or fixed costs that must be subtracted from the value of the end result. Moreover, if the crops grown in the irrigation project are grown using seeds, fertilizers, tractors, and labor, then the costs of these inputs must also be subtracted from the value of the output, if we are interested in measuring the net benefit to the community. This difference between gross value and net value, or value-added, is often overlooked in discussions of projects or policies.
As another example, assume we know that there is $1 billion worth of oil somewhere in the ground in country X, but we do not know exactly where it is. Does that mean that the value to society of exploiting it is $1 billion? No, certainly not. If it would cost $0.5 billion just to figure out where it is, and another $0.1 billion to drill and pump it out, and another $50 million to ship it to where people would consume it, then the value to society of the oil is much less than the total value at the selling point.
Individuals make personal choices based on their own preferences, market information, and what they perceive to be the opportunity costs and net benefits. For society as a whole, there is no equivalent internal mental process to rely on. Since society's "preferences" are not as easily known as an individual's, these kinds of collective choices are even more difficult. For example, if our hypothetical, water-using community is considering replacing the pipes that deliver water, or switching to a system of wells and pumps, or building a dam to control flooding or improve water supply, there are many costs and benefits to consider and take account of, and the values and preferences of individuals in the community will differ.
One approach to this kind of complex problem is benefit-cost analysis, an important tool used by economists to evaluate policy options or projects that involve collective trade-offs. It identifies the impacts of a policy or project and estimates the value of those impacts as benefits and costs. The value that people place on the goods and services affected is the basis for estimating the project's benefits and costs. For goods and services that are sold in markets, the market price provides a measure of the marginal value of the good. For goods and services that are not sold in markets, we cannot observe what people actually pay, so we try to estimate what people would be "willing to pay," which is a difficult practical matter.