This paper discusses a grab-bag of issues in microeconomics theory and practice that generate confusion or controversy inside and/or outside economics. The aim is to clarify the matters of confusion and identify the essential issues in the controversies. The issues covered are: who should pay for environmental works; public goods, public and private benefits; discounting (short term and long term); double counting in BCA; producer surplus as an estimate of profit; estimating the cost of resource degradation; the hard-hearted nature of economics; the use of economics to predict behaviour; non-market valuation; and the link between externalities and market failure. The paper doesn’t deal with the details of mathematical models for economics – only with economic concepts and ideas. These discussions are edited selections from my weekly “Pannell Discussions”, which are available at <http://www.general.uwa.edu.au/u/dpannell>.

Key words: economics, policy, education, theory

Who should pay?

Public works can be expensive, so there is plenty of attention to the question of who should pay for them. This section considers the question in the context of environmental works.

Given the vested interests of each group to ensure that they are not the ones bearing the costs, it would be nice if we could side-step politics and apply some objective rule for resolving the question of who should pay. Three rules often discussed are:

·        Beneficiary pays,

·        Polluter pays, and

·        Sharing costs according to the share of benefits.

The "beneficiary-pays principle", closely related to the "user-pays principle", says that the beneficiary of a good or service should bear the costs of its provision. Perhaps it is fair enough that if a group wants something, they should be prepared to pay for it. After all, that’s the rule that applies to most goods and services.

The "polluter-pays principle" moves the financial burden onto those who are creating the environmental problem. This was recommended as the default position in a well-known report prepared by the OECD. Perhaps it is fair that someone who is causing problems for someone else should be required to make amends. After all, that’s the rule that often applies in law. The guilty must pay!

Proponents of the "cost-sharing principle" recognise that there can be multiple winners from some environmental works, potentially including some benefits to the polluters. Perhaps it is fair that the costs are shared out according to those benefits. There is another obvious example where we bear a share of the costs in order to get a share of the benefits: buying shares in a company.

All of these "principles" are discussed by economists and appear in economics text books, so people are often surprised to learn that they actually have no status at all in economic theory. None of them is really a principle in the sense of a scientific or mathematical principle: a truth that can be proved based on some other truths. Indeed, polluter pays and beneficiary pays are usually in direct contradiction, so they can’t both have the status of truths. In reality they are nothing more than rules of thumb that might or might not be considered fair.

The question of who should pay for environmental works is a good example of something that economists cannot do: provide definitive advice about the most desirable distribution of benefits and costs. Economic theory focuses on how to maximise the size of a cake (which we call "efficiency"), but not on how to share it out. Of course there are plenty of economists interested in the share question, and lots of good thinking has been done about it, but there is no clear-cut answer. In my view, there never will be; it will always be a matter requiring subjective judgement, so the intrusion of politics is inescapable.

Despite this, economists can still make a number of useful contributions to questions about the distribution of benefits and costs from government policies, including the following.

·        Quantifying the distributional effects of alternative policies. Who wins, who loses and how much?

·        Testing the policies against the various rules of thumb that might be considered fair (polluter-pays, etc.).

·        Pointing out what the rules of thumb imply about property rights.

·        Pointing out some practical limitations of trying to apply any particular rule of thumb about who should pay.

The last point is important because there are problems in trying to rigorously implement any of the rules. One of the problems is lack of information. For diffuse environmental problems, we often don’t know in any detail who is the source of the problem. Often the cause-and-effect relationships between any environmental works and environmental outcomes are unknown or highly uncertain. For environmental issues that have non-market benefits and costs (e.g. existence values) we don’t know who the beneficiaries are. Lack of information means that if a government sets out to implement any of the above three rules as being the most fair, it could easily end up with a distribution of benefits and costs that deviates a long way from the chosen rule.

The market will also have an influence on the distribution of benefits and costs, irrespective of government wishes. For example, if farmers’ production costs go up due to legal requirements to protect biodiversity, the farmers may or may not be able to pass on the increase to consumers of their products, a group which may include many of the beneficiaries of the new law. Whether costs can be passed on depends in part on how responsive consumers are to price changes. If consumers of their products are too responsive and dramatically cut consumption as prices rise, farmers lose more than they gain by attempting to pass on the extra costs. In an unregulated market, the distribution of costs between farmers and consumers is completely outside government control as it depends on the responsiveness of supply and demand to price changes, and these depend on producers’ cost structures and consumers’ preferences, not on government policy. The capacity to pass on costs also depends on the market structure in intervening steps of the supply chain. Costs could potentially be absorbed within the chain such that neither polluters nor beneficiaries pay.

In my observation, an approach that is commonly judged to be politically feasible is to give precedence to the status quo. This means that polluter pays would be applied to prevent a change to a more polluting activity, while beneficiary pays (or an approximation of it in the form of government funding) would be used to encourage a change to a more environmentally beneficial outcome. A group with particularly high political power can override this system, but apart from that it often seems to work out this way. Economists couldn’t say they have anything against this system from a distributional perspective. Depending on the issue and how it is addressed, they may have concerns about efficiency. For example, the proposed solution may create high transaction costs or perverse incentives, or do-nothing might be a better option.

Who should pay? There is no easy answer, so we need to be careful that so-called "principles" like polluter pays and beneficiary pays don’t acquire a God-given-truth status that they don’t deserve. In truth they have no real status other than as rules of thumb that can be applied or ignored as circumstances suit.

Public goods, public and private benefits

“Public good” has specific technical meanings in economics that sometimes don’t coincide with what people tend to think of when they speak of governments doing things “for the public good”. The concept of public benefits is completely different from and theoretically unconnected with public goods. And when economists use terms like “benefits” and “costs”, they encompass more issues than are sometimes considered by non-economists.

Public goods

Public goods are potential causes of “market failure”, which economists usually see as being necessary for government action to be justified, at least if the aim is to maximise the overall benefits rather than to redistribute them. Without appropriate government action, some public goods will be under-supplied, over-exploited and/or over-priced.

There are two different types of public goods: non-price-excludable goods and non-rival goods.

(i) A non-price excludable good is one that consumers cannot be prevented from consuming, leading to problems of free-riders, under-provision or over-exploitation. Consumers have open access to the good and the provider or owner of the good is unable to charge a fee for access (or there is no owner). In the case of a good that must be produced by human efforts (e.g. information from research), the result is under-provision or non-provision of the good in a private market. In the case of a good which exists even without human activity (e.g. a natural resource such as a fishery), the result of non-price excludability is over-exploitation of the good. Possible government responses include public provision of the good, or regulation of the exploitation of a natural resource, such as quotas on fishing.

(ii) For a non-rival good, consumption by one person does not reduce the availability of that good to others. An example is knowledge of the successful conservation of a threatened species. The fact that one person benefits from ("consumes") the knowledge does not reduce the benefits available to others. There is no cost of providing the non-rival good to an additional consumer. Economic theory says that if providing a good to an extra consumer costs nothing, then the price charged to consumers should be zero, and that is the problem. If we enforce a zero price, profit-oriented private firms will not be interested in supplying the good. Possible government responses include: providing the good as a free public service, or allowing the private sector to charge a non-zero price and tolerating the resulting losses of welfare.

Technical details aside, a key point about these two categories of public goods is that they don't necessarily relate to "the public" as any identifiable group. They are simply goods that have particular characteristics that mean it is often worthwhile for government to manage their use in some way.

Public benefits

The context I’m interested in here is public funding to private landholders to undertake environmental works. In that context, “private benefits” refers to benefits that are generated for the private landholder, and “public benefits” refers to benefits generated for others. For example, if a farmer were to be funded to plant a highly profitable tree crop in place of grain crops, they may generate both private benefits (greater commercial returns) and public environmental benefits.

There is a large body of theory on public goods in the economics literature, but the indexes of economics textbooks on my shelf do not include any entries for public benefits or private benefits. And yet the terms do have currency. The argument one hears is that governments should focus on funding works that generate public benefits, not private benefits. Some Australian Government funding progams (e.g. the Natural Heritage Trust, or NHT) have included the criterion that works that generate private benefits should not be funded. I will refer to this position as the “public benefits argument”.

It is important to be clear about what we mean by “private benefits”. Economists would look at the overall net benefits to the landholder of undertaking the environmental works. The criterion used in NHT seems to have focused on whether there are positive net returns per hectare without considering the opportunity cost of land used for the works. But that is a crucial omission. If, for example, the farmer switches land from highly profitable cropping to less profitable tree production, that comes at a cost.

Using my more comprehensive definition of “private benefits”, the public benefits argument is usually a reasonable guide. If the overall private benefits of adopting a new practice are sufficiently positive, the practice will be taken up without government funding, so the funding should be saved for other uses. Using the NHT definition of “private benefits”, the public benefit argument can be terribly counter-productive. The greatest public environmental benefits per dollar of public funding will often come from supporting environmentally beneficial land uses that are nearly, but not quite, commercially competitive with existing land uses. They would be land uses that generate commercial returns, but not large enough to be more attractive than what the farmer is currently doing. For these land uses, the level of public funding to make them sufficiently attractive will be low, whereas public funding required to support land uses with no commercial return will be very high. By tending to move funds to the latter category, the NHT criterion actually reduces the likely environmental outcomes of the program.

Note that the public benefits argument presented above is not derived from the theory of public goods. It is a relatively simple application of logic on how to maximise environmental bang for the public buck. The sound version of the public benefits argument identifies situations where consideration of market failure due to public goods is irrelevant, because the adoption of environmental works can be driven by private benefits alone. There might actually be public good issues involved, but they would be over-ridden by the public benefits argument. If private benefits are not sufficient for that, then the subtler question of whether there are public-good issues comes into play.

Despite the way they are sometimes discussed, “public” and “private” are not categories of winners or losers that have any status in economic theory. From the point of view of economics, benefits to one part of the “public” (e.g. taxpayers, people who value the environment, consumers) are not more or less special or relevant than benefits to another part of the “public” (e.g. big business, shareholders, small business owners, polluters). The public is simply an aggregation of many private individuals. The public benefits argument is not founded on who in society ought to benefit from public funding. Indeed economics has nothing much to say about that.

Discounting (short-term)

Discounting benefits and costs in the distant future raises all sorts of uncomfortable feelings and complex questions (see next section). Discounting for short-term investment decisions is straightforward and theoretically uncontroversial, but it still manages to generate a degree of confusion among non-economists. I think this is partly because of the way we use the present as our default time for comparison of the investment options.

How should time be accounted for when comparing different projects that involve different costs and benefits at different times, in the relatively short term? The only thing that is really obvious is that you can’t ignore the issue. You can’t just pretend that a dollar now is equivalent to a dollar in ten years time, because the dollar now can at least earn interest in a bank account, if not higher rates of return in an alternative investment.

This insight actually points the way to part of the solution. The first thing you need to know (or decide or guess) is what you would do with the money, and what the benefits of that use would be, if you did not put it into this new investment your are considering – let us call it investment X. The strategy that you would have pursued provides a benchmark for comparison. Economists call the benchmark the “opportunity cost”, since it is an opportunity you have to give up in order to pursue investment X.

The new option, investment X, has to be “better” than what you were already planning to do. Presumably, you weren’t planning to leave the money in a cardboard box under your bed, which is the sort of thing you would have to do to break the link between time and money. The choice of a realistic benchmark already implicitly includes some aspects of time, because the benchmark use of your money would have involved some growth of the asset over time.

The second thing you need to decide is what “better” means at the start of that last paragraph. What rule will you use for judging it? In economics and finance, the universally-used rule is: the better option is the one that generates the greatest accumulated benefits by the end of the time period. We imagine that the investment, whatever it is, is like a bank account that starts with a zero balance, and that all costs and benefits are taken out of or put into that account. If the current balance is positive, you earn interest, and if negative you pay interest. The final balance is a combination of benefits, costs and interest.

Now, while this rule has a lot of intuitive appeal, it has to be admitted that this is not the only conceivable rule you could use. Nevertheless, it is the standard approach, and we’ll stick to it for purposes of this explanation. It is a rule that gets us into some difficulties when we get to really long-term investments, but we’ll worry about that (and some other complexities) in the next section.

That is pretty much essence of the solution. Things do get more complex when you try to put it into practice, but the understanding essential idea is not that hard. Assets compound in value over time to some final value. Which investment option grows to the largest final value? The benchmark investment that you were going to do, or the new option, investment X?

Unfortunately economists then confuse matters mightily by turning around the direction of time, and talking about asset values as if they shrink as time passes backwards!!

This kind of negative growth is the idea behind “discounting”, with the notional interest rate (the average rate of compound growth) reinterpreted as a “discount rate”. We “discount” future benefits and costs back to the present (giving us their “present value”) and then we can compare them validly because we have factored time and interest out – the opposite of what we did above, which was factoring time and interest in.

Discounting to calculate a “present value” is exactly equivalent to the “largest final value” approach that involves compounding benefits and costs through to the end of the planning period and comparing them at that point in time. If you do them both properly, they will always give the same ranking of the options.

In fact it doesn’t matter which point in time you choose to make the comparison. It could be somewhere in the middle of the time period if you wish, requiring discounting of later values, and compounding up of earlier values. It will work out, as long as you choose a single point in time and use it to compare all of the benefits and costs. Economists always choose the present, but this is arbitrary.

Note that this discussion is not about inflation. The usual approach is to factor inflation out of all the costs and benefits before you start the above calculations, expressing them in “real” terms. Of course you then have to factor inflation out of the discount rate used as well. So we are talking about growth of benefits and costs beyond the inflation rate, due to the opportunity cost of money: its value in generating real benefits over time.

Some people get really worried about the use of discounting. It just doesn’t feel right, somehow. Part of the problem is that it has such dire implications about the present value of benefits in the future. Some people find it objectionable that a dollar of benefits in 30 years time should only be considered to be worth about 5 cents in the present. It seems almost immoral! For at least some of those people, I think it can help to get them to think about it as being effectively the same as choosing the “largest final value”. The dollar in 30 years time will then still count as a dollar, but the dollar earned in year one will have accumulated enough interest to be worth say $20. Same effective result, but maybe it feels more reasonable.

One colleague working in biological science once objected to me that we are assuming that the money earned will actually be reinvested at the going rate and will continue to accumulate interest until the end of the period. What if this doesn’t actually happen? What if the investor did not reinvest the proceeds, but took some of them part way through the period and used them to pay for CDs or hold a big party?

He had in mind that this should reduce the discount rate used, so that future benefits would not be so diminished in the present. However, the logical implication is quite the opposite.

If I buy CDs, rather than leave money in the bank (which is pretty much how I actually behave, mostly), it is because I am judging the overall benefits to me of having the CDs to play is greater than the benefits of letting the money accumulate interest in the bank. In effect, the benchmark for me is a better option than using the bank, so the effective rate of inflation of benefits over time is higher. Or equivalently, the rate of deflation of future benefits to the present (the discount rate) should also be higher.

Discounting (long-term)

Discounting for short-term benefits and costs (within say 20 years), or for purely commercial investments, is theoretically uncontroversial. Discounting for investments that pay off over the very long term (say, 100 years or more) is a more difficult matter, and in my view, has not been well resolved theoretically.

To get a feel for the issue, consider the following example. Suppose that there is some foreseeable catastrophic threat that would have its impacts in 200 years time. Suppose that this foreseeable threat could only be prevented by some action taken right now. Perhaps the problem is due to a comet that is passing by currently and is forecast with a high degree of certainty to strike the earth on its next orbit in 200 years.

Assume also that:

·        World GDP will grow by 3 percent per year to $8 quadrillion (15 zeros) by 2205;

·        The discount rate is 7.5 percent (that’s the sort of rate routinely used by bodies such as government departments);

·        The value of all damage (including loss of life and environmental damage) is $4 quadrillion, in 2204 dollars – half the global GDP.

Now, the question is, what is the most that the current generation should be willing to pay to prevent this forecast catastrophe? To make it easy to comprehend the size of the result, express it as the value per head of current population. In other words, if we were to fund the preventative action with a levy on each of the current six billion people on earth, what is the most that it would be reasonable to ask them to pay (on average)?

Using standard discounting methods, the answer is 35 cents each. If you doubt this, do the following calculation: 4 x 10¹⁵/(1.075²⁰⁰ x 6 x 10⁹).

Can that be right? It seems to imply such callous disregard for the welfare of our distant descendents. The implied rationale is that an expenditure of any sum greater than 35 cents each ($2.16 billion in total) could be set aside in investments that would yield 7.5 percent return per year, and that this would compound to a value greater than the $4 quadrillion that is under threat. But would it? Why would this $2.16 billion grow more rapidly than the rest of the world economy (which, remember, is growing at 3 percent)? Perhaps it might do so early in the time period when it is a tiny proportion of the world economy, but what about late in the period when it will be (theoretically) a large share of the world economy? It is simply not plausible to suppose that it could keep growing at 7.5 percent while the rest of the economy grows at 3 percent.

Clearly, discounting in this way produces a nonsense answer. Perhaps we should apply a discount rate of zero. This has been seriously suggested by some. However, this implies that the average personal cost to current individuals could be as high as $667,000, which is about 180 times the current average GDP per person. Zero discounting doesn’t produce a workable and reasonable answer either. Why should we give up absolutely everything (and more) now to prevent a partial loss in the future?

How about discounting at the expected rate of growth of the world economy: 3 percent, for the sake of this discussion. This has been suggested by some eminent economists as the appropriate approach for large long-term public investments. It would yield a value of $1800 per head, half the global average GDP per head. This at least has some intuitive relationship to the event it is intended to prevent: it implies that to avoid losing half the world GDP in 2205, we should be prepare to give up as much as half the world GDP in 2005.

But is that reasonable? The idea raises all sorts of difficult questions?

·        How certain can we be that the comet would actually hit? In reality, it might be deflected slightly by gravity as it passes another planet and miss us by a long way. Or it might not cause as much damage as predicted. Either way, our sacrifice might turn out to be more than could be justified.

·        What might happen with technology over the next 200 years? The extraordinary advance in technology from 1805 to 2005 will probably seem small compared to the advance from 2005 to 2205. Diverting the comet in 2205 using some currently unimaginable technology might be a simple matter. We (the current generation) would have given up so much for so little gain to anyone.

·        What is the risk of the earth being destroyed in between time by some other cataclysm?

·        Is it fair to expect people today to give up half of our current wealth to prevent a loss that would still leave the world economy vastly larger than it is today (around 200 times larger, even after losing half of it)?

·        On the other hand, is it fair not to give up an amount of wealth now in order to avoid a future generation losing 400 times as much?

·        Is it simply a matter of wealth? Even with 400 (or 200) times as much wealth, the future generation would probably not be that much happier or more satisfied than we are today? Should we account for that, and if so, how?

·        In what real sense could we consider $1 x 10¹³ in 2005 to be equivalent to $4 x 10¹⁵ in 200 years time? Given the likelihood of dramatic changes in technology, health, wealth, institutions, culture, religion, age distribution, and so on, surely it is a case of comparing apples and oranges.

·        The losses would include loss of life and damage to environments on a world scale. How should they be valued? In thinking about our investment in comet diversion, should we value them from the point of view of the current generation, or their contemporary generation, or aggregate over a whole lot of generations? If the latter, who should be included and why? And even if we are happy with non-market valuation methods for current generations, how can we anticipate how future generations might value human life and the environment?

Overall, the question is vastly more complex and subtle than just choosing which discount rate to use. It pulls economics into areas of ethics and morality which we have not usually handled well, and it forces us to deal the deepest uncertainty about future outcomes and values. My guess is that we will make further progress in clarifying the issues, but that it will probably always remain a problem with no clear answer.

Double Counting in Benefit-Cost Analysis

Every so often I get asked about whether it is valid to include improved land values in economic evaluations of land conservation works on farms, or I read an analysis in which it has been done. The way it is usually done, or proposed to be done by non-economists, amounts to counting the same benefits twice. Your starting point should always be not to do it.

It is possible in some special situations to include some consequences of changes in land value as a benefit in an analysis of a land conservation investment, but you need to be very careful how you do it in order to avoid double counting. For the purposes of this sort of analysis, land value differences would reflect differences in future productivity as a result of the investment in conservation. If you do include changes in land value at a particular date, then you must exclude from the analysis all productivity changes subsequent to that date, because they have already been included in the land value change. (Rationale: to realise the capital gain, you have to sell the land, and then you don't have access to the land to realise subsequent productivity differences.)

Conceivably, you could include productivity differences for 20 years, and then a difference in land value at year 21 to factor in ongoing effects beyond year 20, provided that you then discounted that difference back to the present. In practice, however, I would ask, how should you determine the change in land value to be included at year 21? The best way would be to do a discounted cash flow analysis of subsequent productivity differences. If so, why not just extend the time frame of the productivity analysis? It amounts to the same thing.

There are some complexities that could be added to this relatively simple story. For example, if land value increases, farmers may be able to access greater debt finance to invest in productivity. Benefits from such investments, if you could anticipate them and quantify them, would be legitimate inclusions in the analysis of the investment in land conservation. However, they are really second order benefits – almost certainly much smaller than the error margins surrounding the first order benefits – and they could only ever be highly speculative. They are also completely different in nature to the direct inclusion of changes in land value.

Be aware that if you assume that prices, yields and costs are constant over time (which is a common, though dubious, thing to do), there is no justification for even expecting land prices to increase, let alone including these increases in the analysis. Unless ...

Conceivably there could be an expectation of speculative increases in land value, not reflecting productive value, and a belief that such increases would occur WITH the land conservation investment but not WITHOUT it. If one has some sound rationale for expecting this, then fine, include it as a benefit, but I wouldn't like to be investing any of my own money on that basis, and good luck trying to justify it to any reviewers of your analysis. Substantial differences between the value of land for production and the amount people actually pay for it are not sustainable in the long term, due to competitive pressures, unless the land has values other than for production (e.g., it is close to a city).

Putting that aside then, I would note that the analyst should be considering whether the assumption of constant prices, yields and costs is the most reasonable. We know that real prices for agricultural commodities have been falling for at least the past century (the real price of wheat has been falling since the 1700s), and I don't think it's time to expect that trend to change. We also know that yields have increased, and will probably continue to. The "constant real everything" assumption is only reasonable if price falls and yield increases are expected to cancel out.

Land prices increases COULD occur if technology is advancing fast enough for productivity growth to more than offset the price falls. This has been happening in Western Australia, though it applies to land generally, not just land that has had a land conservation investment.

If the productivity growth is different in absolute terms with and without the land conservation investment, then you perhaps could allow it in the analysis. For example, if degraded and non-degraded land both have the same percentage productivity growth – say 1% per year – this implies a small difference in absolute terms, because 1% of a larger yield is more than 1% of a small yield. You might want to accounted for this, although it smacks of desperation!

If you did include this effect of different absolute productivity improvements, I would strongly suggest doing so in the discounted cash flow analysis of the land conservation investment, rather than as a land value change. Pulling a number like 1% out of the air obscures the implicit assumptions about rates of productivity improvement etc. that are being made. Better to represent these assumptions directly and explicitly. Even if you did want to base the analysis on land values rather than productivity, it certainly wouldn't be correct to include the full 1% increase as a benefit in the analysis of the land conservation investment, unless you believed there would be no increase at all in the value of land which had not benefited from the land conservation investment.

Overall, it's an area where it is easy to go astray unless you know what you are doing. The cases where you can validly include land values are really special cases and would not likely make a big difference anyway, so the safest approach is just to exclude land values completely and make the period of the analysis sufficiently long to capture productivity effects over the long term.

Producer surplus as an estimate of profit

In simple text-book theory, use of producer surplus is justified because it is an approximate measure of producer profit.

Not the other way around.

I have been surprised a few times to read that producer surplus can be useful because it is an approximation of producer surplus. Such a statement puts the cart before the horse.

In slightly more complex theory, producer surplus encompasses any other considerations affecting production decisions, such as risk aversion, preference for leisure, or voluntary environmental works – anything that affects the position of the supply curve.

In practice estimates of the position, shape and elasticity of the supply curve are always rough. The influence of risk aversion and those other factors would almost certainly be small relative to the error margins in the estimation of producer surplus. So good quality information about producer profit should generally be preferred to low quality information about producer surplus, even if it does encompass in additional factors.

Estimating the cost of resource degradation

Some people seem to think that a good use of economists is to estimate “the cost of” things. Particularly in the realm of environmental impacts or natural resource degradation, we often see very large numbers bandied around as estimates of "the cost of" this or that. Most recently, large estimates of “the cost of” weeds in Australia (around $4 billion per year) have been released, and compared publicly with the smaller “cost of” salinity, with implications that relative levels of public funding are inappropriate.

This is unfortunate. There are a number of problems with “the cost of …” concept that make it not very relevant to policy making . The three main problems are:

1. “The cost of” X looks at only one side of the ledger. It provides hints (although only very rough hints) about the benefits of taking action to remove the problem, but no information about the costs of taking action.

2. No matter what action is taken, the problem, typically, will not be eliminated entirely. How far you can reduce the problem through practical management or policy actions is a key consideration in deciding what to do, and the degree of mitigation will vary widely between different issues and different actions. “The cost of” X can be quite misleading as it relates to an unattainable, mythical world where the degradation problem costlessly disappears.

3. From the point of view of guiding government policy, focusing on "the cost of" ignores the question of whether there is any market failure to justify governments taking action. Is it a fully private issue, where benefits and costs are borne by the same people, or an issue with “public good” dimensions; that is, where an action by one person affects others through externalities or where there are free-rider problems? Economists argue that it is usually not appropriate for governments to get involved in fully private issues. A large estimate for “the cost of” X would not affect this argument. It would be up to private individuals to judge whether the benefits to them of reducing X outweighed the costs.

For all these reasons, “the cost of” X relative to “the cost of” Y, provides no evidence whatsoever about whether X is more or less deserving of government attention or funding. A big "cost of" provides no evidence that there is any issue worth responding to.

In my view, economists should resist calculating “the cost of” anything, unless it is done as part of a broader analysis considering the costs and benefits of taking specific actions, and considers whether there is market failure to justify a government response.

In the case of both weeds and salinity, there are some aspects that are fully private, and some that are partly or fully public. In both cases, there are plenty of examples where “the cost of” a particular weed or salinity impact is very high, but the cost of repair or eradication is even greater. There are, of course, also cases where benefits of taking action outweigh the costs. A sensible decision on relative levels of public funding would require an unpacking of these issues for each case. It is not obvious to me which would “win”.

Is economics hard hearted?

Some people look upon economists as a hard and joyless bunch. "The dismal science" they say. I'm not certain what they mean, but perhaps it relates to the way that economists can often be party poopers, arguing against actions or projects or reforms that others have considered to be a good idea. One of my contributions to this genre has been to criticise the proposal by the Australian Conservation Foundation and the National Farmers Federation for the Australian Government to spend A$65 billion over 10 years on a dramatically expanded environmental program. An easy target, perhaps, but one that got a ridiculous amount of coverage in the media for a while.

One argument against the conception of economists as being hard-hearted is the characters and interests of economists themselves. I admit that I do know one or two who fit the "hard and joyless" description, but I know many more who are passionate about their areas of professional interest and who care deeply about promoting the best interests of the community. Indeed, attempting to promote and protect the best interests of the broad community (especially against the efforts of special interest groups to corner the political market) is something that economists put more effort into than most other disciplines. David Bennett puts it nicely: “The profession of economics is at its best when it is defending the public interest in the widest possible sense,” (Pannell 2004).

One way that economists attempt to protect the public interest is by applying a constraint that the benefits of action (broadly defined) should exceed the costs. Calls for government action put forward by environmental advocates are sometimes couched in terms that imply the action should be pursued at any cost. Economists particularly decry such calls. At any cost is too high.

I made this point in something I wrote two years ago: "A determination to prevent all environmental degradation at any cost only makes sense if one is willing to overlook the potential alternative uses for these enormous sums of money, including improved services for people with mental and physical disabilities, health services, poverty alleviation, education, and so on. Of course the environment can and should hold its own in the allocation of resources, but one cannot sustain an argument that it should take precedence over all other uses of public funds."

This is not to advocate that a full benefit:cost analysis should be conducted for every possible environmental investment. That would be both problematic and expensive. Rather it should be seen as a need for investment in the environment to be balanced against other possible investments. It is not about economising for economy’s sake. It is a recognition that the “opportunity cost” of public money is important to the community. Funds spent on the environment are not available to be spent on other important public services or amenities.

Furthermore, expenditure of any public funds has the opportunity cost that, as a consequent of their removal from private individuals or businesses through the tax system, the funds will not be spent in the ways that would have been most beneficial to those people, as judged by them.

The positive-net-benefit criterion of economists, which is sometimes interpreted as hard-hearted or even anti-social, is actually a reflection of soft-hearted and pro-social objectives on a broader canvas.

I heard a lovely comment by Bill Malcolm on this theme last year. It was to the effect that people think economists are dismal because we sometimes say you shouldn't do certain things. But we're not. We just say you shouldn’t do stupid things.

The use of economics to predict behaviour

"In general, the Modern Humans of the Upper Palaeolithic [i.e. late stone age, 40,000 to 10,000 years ago] appear to have had a significantly greater ability to predict the movements of animals and to use that knowledge in their hunting strategies. How were they managing to do this? The answer lies in ... anthropomorphic thinking. This is universal among all modern hunters and its significance is that it can substantially improve prediction of an animal’s behaviour. Even though a deer or a horse may not think about its foraging and mobility patterns in the same way as Modern Humans, imagining that it does can act as an excellent predictor for where the animal will feed and the direction in which it may move." (Mithen, 1996, pp. 191-192).

When I read this I was struck by how applicable it is to the way that economists think about other people when we wish to predict their behaviour. Just like hunters of the Upper Palaeolithic, we economists generally start by assuming that the subjects of our attentions will behave just as we would ourselves in the same circumstances. Perhaps this should be called "economorphic" thinking.

Behaving “just as we would” in this context means conducting a systematic and thorough weighing up of the pros and cons (i.e. the benefits and costs, broadly defined) of alternative courses of action, and choosing the action with the highest net benefits. That’s what economists seek to do when they use their models to help people make decisions, and it influences the mindset for most economists in their everyday lives. Economists I know often trot out some economic theory or jargon when talking to each other about everyday matters. They tend to do it in a semi-joking way, but it's not purely a joke – it’s a way of thinking.

Of course, non-economists don’t often do this systematic and thorough weighing up of benefits and costs. But like Mithen’s hunters, economists get a lot of milage out of assuming that they do. It seems simplistic, and perhaps even simple minded, but it is a powerful device. Very often the results from models that use the "thorough weighing up" assumption conform to an aggregated version of reality. Clearly an assumption doesn't have to be literally and completely true to be useful. It just has to be true enough for model outcomes to be consistent with trends of behaviour across populations. This is not nearly so demanding a requirement as complete and literal truth.

Most economists apply economorphic thinking in what are recognisably economic contexts: consumption decisions by consumers and production decisions by business managers. Some, however, stretch the envelope. The grand champion of economorphic thinking is Gary S. Becker, who has applied it to issues as diverse as marriage, crime, immigration, baseball, religion and drugs. There is a collection of 138 essays by him in his book called See The Economics of Life for a readable collection of his essays (Becker and Becker 1997). The success of his approach can be gauged by the fact that he won the Nobel prize for economics in 1992.

Interestingly, economists aren’t the only discipline playing this game. Evolutionary biologists have taken to using an identical strategy and even some of the same models to explain the course of evolution. They assume that individual organisms will, on average, in the long term, operate in a benefit-maximising way (where the benefit in question is the successful passing on of their genes). They build this assumption into complex models and let the implications play out, resulting in some fantastic insights into observed evolutionary results. For examples, see The Selfish Gene by Richard Dawkins (1978).

More recently, evolutionary psychologists are doing something rather similar similar to explain aspects of human psychology (e.g. Pinker, 1997). This is some real irony in this, as economists have sometimes been criticised for paying too little attention to psychology.

Having said all this, as an economist I think it is important that don’t we take our simplifying assumptions too seriously. It is always tempting, but not wise, to believe your own publicity. We can use simple behavioural assumptions to help generate interesting and useful insights into likely human behaviour, but should always remember that the totality of human behaviour is vastly more complex and subtle. When used for forecasting, our models suggest likely trends in behaviour across the population, but not much more than that.

I also have long thought that economics should worry more about the realism of its assumptions and attempt to develop more detailed, sophisticated and accurate models of human behaviour. In the last few years this has started to happen in a big way, with the emergence of experimental economics as a large and exciting field of research. This is moving us closer to psychology and psychologists. It is complemented by agent-based modelling, which represents individual economic agents interacting, not just an amorphous mass of people aggregated to form a supply curve or a demand curve. I predict that these two new areas will have major impacts on economics over the next 50 years, but that the simpler approach of economorphic thinking will continue to be very useful and instructive.

Non-market valuation

Now and then I get involved in discussions with non-economists about the potential contribution of economics to improved environmental management. I find that the first thing many of them think of (either positively or negatively) is the capacity to put dollar values on intangible environmental benefits, such as the satisfaction one gets from knowledge that a species has been protected from extinction. Economists refer to these benefits as “non-market” benefits, as they cannot be bought or sold in the same way that more tangible goods can be.

I think some people hope that valuing non-market values will help the environment hold its own in the struggle for public resources. Personally, I suspect this is often not true, either because policy makers are skeptical about the idea of assigning dollar values to these intangible benefits, or because they would support the protection of environmental assets just as strongly on the basis of biological or physical information alone.

Some non-economists hold a contrasting view of non-market valuation: almost a horror at the very idea. It’s as if any attempt at valuing non-market benefits is an act of profanity

The diversity of attitudes to non-market valuation among non-economists is mirrored within the economics discipline, although the points of disagreement are different. There has been a spirited academic debate about the validity and usefulness of non-market valuation methods, particularly the survey-based method called contingent valuation (CV), which is the most widely used technique (Adamowicz 2004).

Arguments put forward by advocates of CV have included:

(a) When done well, the technique gives plausible and realistic results; and

(b) Even though the techniques are not perfect, it is important to attempt to measure non-market values using the best available methods because it assists in having environmental values fully and properly considered in public planning and policy making.

On the other hand, some economists reject argument (a). For example, Plott (1993), in summarizing the findings of contributors to Hausman (1993) says that:

“The basic conclusion of all the papers is that CV should be discarded as a public-policy tool for determining economic damages to the environment [because] (1) The numbers are too variable to be reliable. (2) The numbers do not measure what they are supposed to measure. (3) In fact, the object to be measured by the methods might not be measurable at all. (4) The appropriateness of CV for assessing damages, as opposed to more procedural methods, is challenged.” (Plott 1993, p.477)

Much of the critique is technical (mostly based on arguments that results from actual CV studies are illogical in a variety of ways). A different survey-based technique, Choice Modelling (CM) avoids some of the problems associated with CV, and its advocates make reasonable claims that it is a superior technique. However there are some more general concerns about CV that would also affect CM.

The first relates to the reliability and validity of survey-based techniques in general. To investigate this, survey specialists have set out to check the answers people give to simple, factual questions asked in surveys, such as “Do you have a driving license?” or “What is your age?” Typically, error rates in responses to such simple questions are between 5 and 17 per cent (Foddy 1993). This can't help but raise doubts about the capacity of surveys to probe more subtle or complex questions, such as non-market environmental values.

Secondly, the great majority of people surveyed have low levels of knowledge of the complex issues about which they are being surveyed. They obtain some knowledge from the survey’s introductory material, but realistically this knowledge would not be deep. One study found that survey respondents themselves were concerned about this issue (Clark et al. 2000). On this theme, Diamond and Hausman (1993, p.30) argued that

“It makes no more sense to rely directly on ill-informed members of the public to evaluate the dollar value of such environmental damage than it would be to rely on an ill-informed public to choose between alternative designs for airplanes or nuclear power plants.”

With sufficient investment of time, effort and interest, most people would, no doubt, be able to express meaningful opinions on the specific environmental issues being examined, but they are not given this opportunity in a survey.

Argument (b) (that we need to measure non-market values so that they are given due weight in policy and planning) may perhaps have some merit. One potential concern is whether the improvement in decision making is sufficient to justify the considerable expense of conducting valid and reliable surveys, estimated by Dumsday to be “anywhere from $40,000 to $200,000”. In a compromise approach that moderates the expense, work is underway to develop a process of “benefit transfer” in which a database of past non-market valuation studies is used to provide indicative valuations that are relevant to new issues.

Despite argument (b), some continue to believe that it is adequate to quantify environmental outcomes in terms that are biologically meaningful, such as the number of species affected, or the area of habitat affected, or the increased probability of preventing extinction of a species. This does not avoid the fact that somebody still has to weigh up the information and make a choice between the management or policy options, and that this choice implicitly values the environmental assets at some monetary value. But it does not follow from this observation that a non-market valuation survey is mandated.

Finally, regardless of the process and the techniques used, the quality of the outcomes is limited by our ability to answer basic (non-monetary) questions such as:

·        What would be the effects of different management options on environmental outcomes?

·        In what ways are the environmental outcomes significant (e.g. in ecological terms) and why?

My own view is that research to improve the quality of answers to these question is often a more pressing need than research to value the results in monetary terms.

The link between externalities and market failure

References

Adamowicz, Wiktor L. (2004). What's it worth? An examination of historical trends and future directions in environmental valuation. Australian Journal of Agricultural and Resource Economics 48(3): 419- 2004.

Becker, G.S. and Becker, G.N. (1997). The Economics of Life: From Baseball to Affirmative Action to Immigration, How Real-World Issues Affect Our Everyday Life, McGraw-Hill, New York.

Clark, J., Burgess, J. and Harrison, C.M., 2000. “I struggled with this money business”: respondents’ perspectives on contingent valuation. Ecological Economics 33: 45-62.

Dawkins, R. (1978). The Selfish Gene, Oxford University Press, New York.

Diamond, P.A. and Hausman, J.A., 1993. On contingent valuation measurement of nonuse values. Pp. 3-38 in Contingent Valuation: A Critical Assessment ed by J.A. Hausman.. North Holland, Amsterdam.

Foddy, W., 1993. Constructing Questions for Interviews and Questionnaires. Cambridge University Press, Cambridge.

Hausman, J.A. (ed.), 1993. Contingent Valuation: A Critical Assessment. North Holland, Amsterdam.

Mithen, S. (1996). The Prehistory of the Mind: A Search for the Origins of Art, Religion and Science, London: Phoenix.

Pannell, D.J. (2004). Effectively communicating economics to policy makers. Australian Journal of Agricultural and Resource Economics 48(3): 535-555. full paper from journal (138K pdf) also available via the Journal homepage: www.blackwellpublishing.com/ajare

Pinker, S. (1997). How the Mind Works, London: Penguin.

Plott, C.R., 1993. Contingent Valuation: A View of the Conference and Associated Research, In: Hausman, J.A. (ed.), Contingent Valuation: A Critical Assessment. North Holland, Amsterdam, pp. 467-478.

Randall, A. (1981). Resource Economics, An Economic Approach to Natural Resource and Environmental Policy, Wiley, New York.

Citation: Pannell, D.J. (2005). Some issues of confusion or controversy in microeconomics. Presented at the 49th Annual Conference of the Australian Agricultural and Resource Economics Society, Coffs Harbour, NSW, 9-11 Feb 2005 http://www.general.uwa.edu.au/u/dpannell/dp0501.htm