by John Rolfe

Economics and the Environment: A Signalling and Incentives Approach
by Ian Wills
Allen & Unwin, Sydney,
1997, 340pp.,$45.00.
ISBN 1-86448-257-5

The quality of debate in Australia about the interrelationships between economic and environmental issues remains at a disappointing standard. It seems that many people continue to believe a simple trade-off exists between economic development and environmental factors, particularly when free market forces are involved. Worse, there appears to be a common assumption in popular debate that it is economics (defined loosely under the rubric of economic rationalism) that causes environmental problems, and that the first step in solving issues is to ignore the economists.

Happily, Ian Wills’s new book makes a welcome contribution to remedying this deficiency and helps to address several popular misconceptions. The overall theme of the work is that choices about resource use and environmental issues rely on the incentives and signals that flow to individual users and consumers. Property rights are one of the key institutions in defining these incentives and signals, and their absence, or misconception, is one explanation of why environmental problems arise. This property rights approach gives the book a very strong flavour from both Coase and Hayek.

Wills acknowledges his intellectual debt in one of the most constructive ways possible – by developing a coherent framework understandable to students. The book is suitable as a text in both specialist economic programs and in environment studies courses, but is worthy of a much more general readership. This is as much for the range of arguments that he brings to bear on environmental issues as for the ways in which he structures those arguments into a logical framework.

The book is organised into five key sections. Section one discusses how economic and environmental problems are really ones of social coordination. Environmental problems arise ‘when some people are unhappy with other people’s use of the natural environment, because it imposes harms on them to which they have not consented’ (p.5). Wills’s depiction of environmental problems as people problems casts his analysis very firmly as anthropocentric, as opposed to more ecocentric views. He notes, however, and I think he should have placed more emphasis on this point, that the notions of self interest captured in
economics do not necessarily mean that people are completely selfish. The harms that people feel may arise from wider concerns that they have, including concerns for their family, future generations, and non-human species. As a result, he is able to argue that the differences between his anthropocentric framework and many ecocentric
approaches are slight.

Market failure and planning failure

The failures of humans to coordinate over their various wishes for environmental factors can arise from a variety of sources. Wills discusses these in some detail, partly as a way of introducing students to problems of scarcity and to mechanisms for coordinating social choices. Property rights are introduced as one form of rules and institutions that have been developed and designed to help minimise conflicts, allocate responsibilities, and encourage production. Markets are introduced as mechanisms that facilitate exchange and preference satisfaction for goods with clear property rights. As economists well know, this mechanism works to maximise satisfaction even though information about private values is rarely revealed explicitly by customers. Central planning is introduced as a mechanism to allocate resources too, but it has greater information requirements than market systems.

Examples are given to show that environmental problems arise because none of the major mechanisms for allocating resource use in a complex society are fully capable of signalling the needs and wishes of the people involved. Markets have failure problems, central planning has failure problems, and traditional institutional structures are generally not adapted to specific environmental issues or the needs of modern communities.

The reasons for coordination failures are analysed in the second section of the book. These are explained as arising from high transaction costs, the non-excludability of some goods, the existence of common pool resources, and the limitation of government signalling and incentives. Four themes are worth highlighting:

• As scientific, technological and social developments occur, it becomes more feasible to assign and enforce property rights over previously ‘open access’ resources.
• The major explanation of coordination failures is the unavoidably high transaction costs involved in establishing market or government allocation systems. (Wills takes a refreshingly eclectic view of these transaction costs, pointing out, for example, that potential misuse of coercive power is a cost of establishing some government controls.)
• In a democratic system of government, the process of evaluation of particular changes in resource use may be just as important as the actual outcome. This is because while people expect that winners and losers will emerge from any change, disappointed parties will be more likely to accept the decision if they believe that it is the result of a fair planning process.
• In the real world, both market and planning systems tend to be involved in resource allocations. The challenge is to find the best use and mixture of these signalling and incentive systems.

The third section of the book focuses on the range of decision-making tools that an environmental economist might pack into his or her tool kit. The first of these relates to the choice of discounting tools for payments through time. Wills discusses some of the conceptual and practical difficulties in choosing an appropriate rate, particularly when the needs of future generations are considered. The next item in the tool kit is cost-benefit analysis; here students are introduced to a practical example of how a cost benefit analysis study might operate (using the Resource Assessment Commission study of the south-east forests), as well as a discussion of the strengths and limitations of the approach.

Following on from cost-benefit analysis, Wills discusses the range of non-market valuation techniques. The travel cost method, hedonic pricing and contingent valuation are described and analysed, and a very good summary of the limitations in applying contingent valuation is provided. The fourth compartment in the tool box to be described is the national accounting system, and Wills focuses on the range of economy-environment
interactions that are not included within national account measures. Some of the difficulties in moving to Green national accounts are also discussed, together with an analysis of state-of-the-environment reporting.

Looking at environmental problems

The fourth and fifth sections of the book introduce particular environmental problems for consideration. In the fourth section, localised problems, such as pollution and waste disposal, are considered. The limited impact of these problems (in terms of groups of people affected) means that students are exposed to relatively less complex problems of analysis. Two groups of more complex problems are then discussed in section five.

The first is problems arising from uncertainty. Challenges for social coordination arise when there is uncertainty about the impacts, causes and solutions of environmental problems. These challenges tend to raise the costs of social coordination, as well as requiring mechanisms for the incorporation of risk analysis into decision processes. The existence of risks may also lead to alternative decision processes, such as a precautionary mechanism.

The second set of complex problems presented are those with global impacts and dimensions. Here, there are three broad groups of problems discussed carefully across five chapters; ozone depletion and climate change, common pool resources, and loss of biodiversity.

The final chapter in the book summarises some of the important lessons that come out of an understanding of economic and environmental processes. Because these lessons are so important (and so poorly grasped by some groups in the community), I list them here:
 

• environmental problems will always be with us (because of the high opportunity costs of solving them)
• costs and benefits of coordination change, so the problems do not necessarily remain the same (today’s problems may be more easily resolved in the future)
• major environmental problems involve non-rivalry and non-excludability (most large problems involve many contributors and affect many sufferers)
• environmental and economic complexities make errors in environmental policies inevitable (a result of scientific and behavioural uncertainty)
• it is more important to understand processes than to design solutions (it is important to get signalling and incentive mechanisms right so that existing processes do not cause environmental problems).

These are messages that are not well understood in the political arena or by the fourth estate in Australia. The value of this text, in being able to explain to students that most environmental problems have economic causes (and solutions), should not be underestimated.

Economic rationalism

Returning to my opening charge, how does the book address the wider issues relevant to the public debate about economic rationalism? Critics of mainstream (neoclassical) economic theory often advance environmental issues as prime examples of broad deficiencies with a narrow, economic rationalist approach. Here, I think it is worth giving two broad examples of how this book helps to address these misconceptions.

Economic rationalism remains a popular whipping post in Australia. This is not surprising, because it essentially acts as an antidote to political opportunism by pointing out that measures designed to protect special interest groups generally impose much higher costs (especially in the long term) on the rest of the population. However, the depth of criticism about economic rationalism, and the weakness of the defences offered, point to some broader deficiencies in how the debate is being carried on. Of course, the use of term ‘economic rationalism’ is to some extent itself misleading, as it refers to an outsider’s view of a broad group of economic policies which tend to focus on the abilities of individuals and markets rather than governments to find allocation solutions. Internal to economics, though, there is no such discipline as economic rationalism. Instead, those concepts are drawn from a range of different economic
paradigms.

Many of the tools used by economists to measure and evaluate economic performance are drawn from the mainstream discipline of neoclassical economics. However, many of the concepts used to explain how economies grow and evolve over time are drawn from other areas, particularly from Austrian and institutional economics. There are a number of different ways of drawing together these influences to predict rational methods for maximising long term economic growth, each varying according to the situation at hand. This is one key explanation for why the level of debate about economic rationalism remains at a disappointing standard. The absence of a clearly defined discipline means that critics are free to incorporate many of their favourite hobbyhorses (especially those relating to business activities) in with their railings against economic rationalism.

A more important explanation of why the debate remains superficial is that the economics profession is not very good at explaining the principles underlying economic rationalism. This is illustrated by the situation where many economic and government advisers are asserting the need for reduced government and increased reliance on market forces, but are failing to explain clearly why. This failure is an indictment on the way that economics is taught in Australia.

For the last 50 years in America, England and Australia, there have been few deviations from the exposition formula first developed by Paul Samuelson. Introduce macro-economics by teaching students about national accounts! Introduce micro-economics by teaching models of perfect competition! Place more emphasis on macro economics! The cycle is self perpetuating because people generally use the patterns of their own learning to teach it to others. This is, of course, exactly the reason why the public is so suspicious of economic rationalism; the explanations are too complicated and too artificial. How can you convince people that economic rationalism is not about imposing models of perfect competition, when we insist on teaching it (first) as an ideal model?

The profession is beginning to realise the deficiencies in this approach. For example, focusing on models and a historical pattern of explanation sets a high jargon threshold to understanding. Limiting the analysis to artificial situations (through assumptions about perfect knowledge and perfect competition) means that it is difficult to relate economic analysis to real world cases. Focusing on macro-economic issues ignores the reality that most major
economic concepts are to be found in micro-economics.

This realisation is beginning to translate into more experimental forms of explanation and teaching where models such as perfect competition tend to be deemphasised and delayed. Wills’s book is an excellent example of this trend, as can be seen by comparing the outline described earlier with more traditional texts. It demonstrates that it is possible to teach broad economic principles without ignoring transaction costs! As well, this book is a better exponent of the economic rationalist approach than many more traditional economic texts. This is because it concentrates on the rational analysis of social coordination problems rather than simply on descriptions of economic phenomena. Readers will come away with the correct impression that the process by which choices are made is often more important than the choices themselves, and that the underlying causes of coordination problems are usually very different from superficial
symptoms.

Economics and environmental solutions

The other broad area in which this book contributes to the debate over economic rationalism is by making it clear that many environmental problems have economic causes. Many environmentalists appear to think that the environment is so important (even sacred) that it is not commensurate with other choices facing consumers and governments. The same arguments are often used to reject economic analysis of health and welfare issues. Special interest pleading is by no means confined to industry policy and the political arena!

Wills rebuts this theme by developing three consistent arguments. The first of these is to make it clear that the preferences that people express represent self-interest in a very broad sense. This means that preferences may be altruistic towards groups such as family, friends, future generations, and non-human species. Self interest does not necessarily mean selfishness.

The second argument is that preferences about environmental factors are only special in that it is usually much more difficult, compared to common consumer goods, to bring the various affected parties together. Affected parties are often diffused across space and time, and often under no compulsion to reveal their true preferences for an environmental change. Sometimes innovative solutions, such as adoption of a Safe Minimum Standard rule or the introduction of property rights, may be the best way of addressing a problem. However, the underlying reasons why problems exist (harms have been imposed that have not been consented to), are little different to other problems of scarcity and social coordination.

The third point is that corner solutions rarely exist for environmental problems. Support for environmental causes generally has to be balanced against other demands that society has. Contrary to popular perception, the transfer of responsibilities to governments does little to negate the fundamental trade-offs involved. Choices have to be made, and there are often no easy solutions available. Although there are many positive relationships between environmental quality and the welfare of people, there are usually high opportunity costs in automatically awarding ‘trump’ status to environmental amenities. In this way Wills makes it clear to the readers that the solutions that best satisfy the needs of society (including these pertaining to future generations), usually involve some trade-off between environmental and other goals.

Style of Exposition

Wills has adopted a simple, almost conversationalist style of writing that weaves together a wide ranging number of examples with a clear exposition of economic analysis. Academic references are confined to a few limited footnotes so that the flow of the arguments is not interrupted. The style of writing mirrors that of Heyne in The Economic Way of Thinking (which Wills recommends as a reference text for introductory economics). The result is a book that will be very easy to comprehend for students who have little interest in studying economics as a discipline.

The writing style has been complemented with the wide ranging emphasis on Australian environmental issues. A number of major issues, such as forestry and waste recycling, have been discussed in some detail from both political and economic perspectives. This focus will help to maintain student interest, as well as bringing the economic analysis into sharp perspective by making it relevant to issues ‘in my backyard.’ In this respect, Wills has satisfied a major deficiency in that little has been available in the way of general environmental economics texts focused on Australian issues. It needs to be pointed out that examples are not all drawn from Australian situations, and that a range of global environmental issues are also described.

I was also impressed with the extent to which micro-economic theory has been woven into the analysis of environmental problems. Students who study this book will learn without much effort a remarkable amount of detail and understanding of basic economic principles. They will become familiar with demand and supply curves, marginal analysis, opportunity costs and notions of economic value. This is background information to more detailed discussions on externalities, cost-benefit analysis, public goods and other economic phenomena.

A final facet of the book worth noting is the close weather eye that Wills keeps on the political environment in which environmental policies are generated. He continues to make clear the important linkages between the overall preferences of the population and resulting outcomes of the political process. As well, he is careful to point out the number of ‘crowding out’ effects that may occur where public environmental policies and regulations generate unforeseen impacts on individual responses. Identifying these linkages not only makes the book more realistic, but it helps to emphasise that the role of economics is to help the decision processes to identify socially optimal outcomes.

The book is reasonably long, with 320 pages of text. This is the result of the conversationalist style of writing, but in its current format, it may be difficult for some students to pick out the most salient points of argument. For example, opportunity costs are implicit in many arguments, but are only described very briefly and are not referenced in the index. I would personally have preferred to see the text broken up a little more with summary and example sections. The text is enhanced for student purposes, though, by the inclusion of discussion questions at the end of every chapter.

Overall, the book makes an excellent contribution to the environmental economics debate in Australia, and will be an important resource for those keen to see students adopt an economic way of thinking about how private and public decisions affect environmental resources. I will be setting it as a text for my students, as well as using its style of exposition as an example for writing clearly about complex issues!
 

John Rolfe is Head of Campus at Emerald for the Central Queensland University. He has an extensive background in primary production and is a resource economist specialising in non-market valuation.

Policy is the quarterly review of The Centre for Independent Studies. For more information on subscribing to Policy, click HERE

If you are interested in the Centre's activities and publications, why not subscribe to e-PreCIS, our regular email update on the latest news and events.

(e-PreCIS requires html capable email facilities, such as Microsoft Outlook Express or Netscape Messenger)