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Chapter 1. Why caring for the environment

1.1 Summary

The main purpose of this chapter is to provide an overview of how environmental goods and services or environmental resources contribute to increase the welfare of societies.

First it presents a classification of environmental issues (natural resources and environmental problems) and points out that the choice of the most suited measures and institutional setting to address the environmental problems depends on the type of environmental issues.

Then it examines the economy-environment interactions and highlights that environment does not provide only raw materials but also a number of other valuable functions. It discusses the reasons why the goods and services provided by natural and environmental resources are generally underestimated and often do not enter the economic analysis. In particular the following causes are addressed:

Finally the chapter addresses the issue of sustainable development and the role the environment plays in ensuring that future generations are at least as well-off as the present one.

1.2 Defining environmental issues

To understand better the role and contribution of environment in sustainable development, it is useful to first provide some definitions and classifications of environmental resources and problems. Indeed these general statements encompass a variety of situations, facts, processes, all of which have specific characteristics as well as management and policy implications.

A possible classification of environmental issues is presented in Figure 1.1. Two broad categories are first identified between natural and environmental resources and environmental problems.

Figure 1.1 Environmental issues classification

Natural and environmental resources

Natural and environmental resources generally describe all the elements available in nature that are used or can be used in the economic system. These can be:

Natural and environmental resources can be further split into renewable and non-renewable, and non-renewable in recyclable and non-recyclable resources:

... renewable

· renewable resources are reproducible and in principle could be maintained perpetually. Examples of renewable resources are forests, animals, and water. The availability and reproduction rate of these resources depends generally on their management by humans. The management issue related to renewable resources is the optimal rate of extraction;

... and non renewable

... recyclable

... non- recyclable

· non-renewable resources on the contrary cannot be regenerated or the regeneration takes place so slowly that it will not increase significantly the stock of resources in any reasonable time span. Examples of non-renewable resources are oil, gas, minerals, and so forth. Non-renewable resources can, in turn, be divided into recyclable and non-recyclable resources. Recyclable resources such as minerals, paper, glass, do not lose their properties when they are used in economic processes. Therefore they can be reused in the economic system. In theory 100 percent of these resources could be recycled but for economic reasons[1] only a fraction of these are. As for renewable resources, the management question is what is the efficient amount of recycling. Non-recyclable resources are finite in the sense that once used, their stock is no more available for future use. This is the case of energy resources such as coal, gas, oil. The management problem in this case involves substitution with renewable or transitional resources.

Environmental problems

Environmental problems are mainly related to the impacts of human activities on environmental resources. These generally take the form of pollution, depletion or degradation of water, air and soil. Soil erosion, water salinity and pollution, desertification, forest depletion, coastal degradation are accounted for as the major environmental problems in the developing countries.

Various forms of pollution exist: point and non-point and persistent and fund.

Point pollution

· Point pollution is generally associated with the possibility of identifying the source of emission and with the limited domain over which its damages are experienced. This would be the case, for example, of wastewater of industries polluting a lake, a river or a coast.

Non-point pollution

· Non-point pollution, on the contrary, refers to a non-identifiably precise source of emission and to a more extended area of its negative impacts. A typical case of non-point pollution is surface water pollution due to various and widespread emission sources, such as industrial and urban wastewater, or use of nitrogen in the agricultural sector. Another example of non-point pollution is air pollution due to the increase of carbon-dioxide in the atmosphere. This pollution is originated by many economic activities (industries, cars, deforestation, etc.) and by many countries (industrialized as well as developing countries).

Stock pollution

· Stock pollution refers to pollutants that cannot be absorbed and are accumulated in the environment. Examples of stock pollutants are lead, many chemicals such as dioxin, and so forth.

Fund pollution

· Fund pollution is given by pollutants that can be absorbed by the environment provided their concentration does not exceed the absorptive capacity of the environment. Among fund pollutants are organic matter, which is transformed by bacteria in less harmful inorganic matter. Carbon dioxide is also absorbed and transformed by plants and oceans.

The understanding of the peculiarities of the various types of environmental resources and problems is of primary importance in the identification of both the most appropriate management and policy measures as well as the most suitable institutional level to cope with them.

1.3 Environment provides the resource base for life support

Environment as a bank

“The bank (environment) is filled with limited amounts of renewable and non-renewable natural assets or capital. Through bank operations, the capital generates interest. An environmentally sustainable society protects the renewable capital, lives-off the interest, and uses the non-renewable capital wisely. In this way massive debt is avoided and the ecosystems are kept running.” (Gray et al., 1995).

... it provides

There is now widespread recognition that the environment interacts with the economic growth of economies, and in general contributes to the welfare improvement of societies through three main functions:

... direct utility

(i) it supplies raw materials that will serve as inputs in the economic activities processes;

... sink for wastes

(ii) it functions as a sink for wastes of any type produced by the economic and human activities; and

... raw materials

(iii) it provides direct utility to people.

Its greater relative importance for developing economies

The relationship between environmental resource base and welfare is particularly true for the developing economies. Indeed, in contrast with developed countries, developing countries and particularly the poorest ones depend substantially on renewable resources and on the self-regeneration capacity of the environment. This is mainly due to the fact that technological substitution has not yet developed as in the industrialized countries.

Thus, for example, water pollution is less an issue in industrialized countries than in developing ones because water treatment plants are more widespread, whereas populations of developing countries still rely on water sources (rivers, wells, etc.). Another example is the substitution of fossil fuels for fuelwood in developed countries, whereas wood is still the major fuel source in developing countries. Table 1.1 illustrates the dependence of developing countries on the major renewable resources.

Table 1.1 Some indicators of dependence of developing countries on renewable resources in the 1980s


Traditional fuel as % of total energy

Excess harvesting of wood over sustained yields



























Source: Various authors.

The economic-environment system can be thought of as a circular economy where stocks and flows of natural resources interact with the economic processes in various ways. This model contrasts with the conventional linear conception which assumes, as depicted in the situation 1 and 2 of Figure 1.2 on the forthcoming page, that the natural resources serve the purpose of production processes (P) for both consumption (C) or capital creation (K)[2], which in turn create utility or welfare[3].

1.4 Environmental resources are scarce

The earth is finite

“Its ability to absorb wastes and destructive effluent is finite. Its ability to provide for growing numbers of people is finite. And we are fast approaching many of the earth’s limits. Current economic practices... cannot be continued without the risk that global systems will be damaged beyond repair. Pressures from unrestrained population growth puts demands on the natural world that can overwhelm any efforts to achieve a sustainable future.”[4]

Excessive use of renewable resources

Renewable resources (soils, vegetation, water) are being used in excess of their regeneration capacity, thus resulting in the depletion of stocks, the reduction of many functions of the environment, and consequently in decline of welfare[5]. This is due mainly to the fact that in the course of time, population growth and per capita consumption expansion have led to an increase in both the use of natural resources and the production of wastes, thus determining the rising importance of the economic system relative to global environmental resources[6].

This is illustrated in Figure 1.3, where the scale of the economic sub-system (production P and consumption C systems) increases, whereas the terrestrial ecosystem capacity of providing raw materials to the economic system (RM) and to absorb wastes generated by economic activities (W) decreases.

Figure 1.2 Environment-economy interaction

1. Linear concept of the economy

Production processes generate goods that can be either consumed (C) or invested (K). In the long term, K is also consumed. Therefore K can also be assumed to be consumer goods and will disappear from the subsequent models. Both C and K create utility (U).

2. Raw material supplier

To produce goods, raw materials are required. These can be exhaustible (oil, coal, other minerals) or renewable (forests, water, solar energy, and so forth). All of them are provided by the ecosystem.

3. Waste absorption

All the components of the previous model produce wastes. Some of them can be recycled (glass, aluminium, paper and so on) but most of them are not and are assimilated (absorbed) by the environment (air pollution, industrial effluents, etc.). Environment is assumed to have a finite absorption capacity. If wastes are higher than the absorption capacity, the resilience of the environment will be affected negatively and the economic function of the environment as waste assimilation will be reduced.

4. Circular concept of economy

Environment also provides direct services to consumers such as aesthetics, recreation, etc. The model beside depicts the functioning of a circular economy incorporating the economic functions of the environment.


A = Assimilation

P = Production

C = Consumption goods

K = Capital goods

U = Utility

R = Natural Resources

W = Waste Products

r = Recycling

ER = Exhaustible Resources

RR = Renewable Resources

y = Yields

h = Rate of harvest

Source: Pearce and Turner (1990).

Figure 1.3 Growing economic system compared to the environmental ecosystem

Two major views on finite resources

The question of finite availability of natural resources has been addressed by various thinkers advocating two main broad views.

...ecosystem threatened by present economic growth model

The first[7] claims that the increasing economic subsystem (internal sphere in Figure 1.3) relative to the environmental goods and services provided by the ecosystem is putting environmental resources under stress, and that their supply is becoming limited in relation to the demand. This occurs for raw materials but also and increasingly for the sink and the amenity services of the ecosystem. Though some of these limits can be overcome (for example, substitution of solar energy for oil based energy), many of them are not (for example, landfills) and will pose a real threat to welfare improvement (Box 1.1). As a conclusion, it maintains, the present model of economic growth is conflicting with environmentally sustainable development.

Box 1.1 The economic concept of welfare

Welfare is often used interchangeably with well-being and utility. The economic concept of welfare can be related to the definition of income articulated by Sir John Hicks (1947), who maintains that a man’s income can be defined as “the maximum value, which he can consume during a week, and still expect to be as well off at the end of the week as he was at the beginning”. Following the above definition, welfare decrease or increase is generally measured as the amount of goods and services consumed by households in one year divided by the population to obtain the consumption per capita. If consumption per capita increases, then the average member of the population is better off; if consumption decreases, then the average member of the population is worse off.

Several objections have been raised, however, to this measure of welfare. The two most important are that: i) the standard national account system, from which consumption indicators are derived, fails to account for the depreciation of natural capital and; ii) does not account for equity or income distribution, thus leading policymakers to undertake unsustainable development strategies.

Depreciation of natural capital

For human-made capital (dams, roads, buildings, plants, etc.), national accounts set aside an amount called depreciation to compensate for the decline in value as the capital wears out; no increase in economic activity is recorded as an increase in income until depreciation has been subtracted from gross returns. No such adjustment is made in the national accounts for natural capital. It follows that we can deplete our natural resources and the associated economic activities will be recorded only as income, not as a decline in natural capital endowment.

Income distribution

According to economic theory, welfare is maximized when Pareto efficiency has been achieved, that is when welfare of some individuals has increased without making anyone else in the society worse off. The most severe limitation of the Pareto principle is that it is related only to an individual’s welfare, not to the relative well-being of individuals. Therefore, it does not account for the situation of increasing income gap between poor and rich. Efficiency is attained provided that the net gain of welfare in society is positive.

To cope with these flaws, a number of studies have been carried out attempting to adjust welfare measures and new indicators have been constructed. The most important is the measure constructed in 1990 by the UNDP, the Human Development Index (HDI), which is based on three major components: longevity, knowledge, and income. Other indicators (World Report on Human Development, 2000) based on the same components have also been constructed to take account of social and environmental concerns, namely the Human Poverty Index (HPI) and the Human Development Sex-specific Index (HDSI).

... economic growth is compatible with maintaining natural resources

The second puts forward a more optimistic view[8] arguing that economic growth remains feasible without necessarily exhausting natural resources because:

(i) technological progress allows the replacement of renewable resources for exhaustible ones as well as the reduction of the quantity of natural resources required per unit of economic output;

(ii) there is the possibility of substitution of man-made capital for natural capital, though within some limits (Box 1.2); and

(iii) new sources of exploration are possible.

It is argued, however, that the above is possible on condition that the price system reflects the real total value (i.e. the value incorporating all the value components of environmental resources and adjusted for the market failures; see Section 1.5.3 for more details) of the goods and services used and produced by the economic system, including those supplied by the environment.

Box 1.2 The limits of substitution of man-made capital for natural capital

Mainstream economists, though recognizing that some resources, particularly exhaustible resources are scarce, argue that technical change and substitution of man-made capital for natural capital could secure economic growth without depleting the natural environment. They suggest that what matters is that overall capital stock (natural plus human and man-made capital, including operating capital such as fertilizers and chemicals) of the economic system is not depleted. Therefore natural capital can be replaced by man-made capital so long as the social rate of return of man-made capital is higher or at least equal to natural capital. So, for example, deforestation can be allowed if the development project secures a higher social rate of return than the services provided by the forests.

This argument may not always hold for the following reasons:

  • the degree of substitutability between the various types of capital may vary considerably from perfect substitutability (for example, between two types of natural capital such as coal and oil), to imperfect substitutability (for example, between natural capital and man-made capital such as soil nutrients and fertilizers) and non-substitutability (for example, it is difficult at least in the short to medium term to imagine how man-made capital can substitute for the ozone layer);

  • the proceeds of exploitation of natural resources are seldom reinvested totally in man-made capital. A proportion of the proceeds is often consumed, thus leading to additional depletion of the environmental resources through waste generation. If these impacts are not accounted for the value of net capital stock may decrease;

  • man-made capital requires that other natural resources be used for their construction (Perrings, 1987). So for example, production of chemicals is energy demanding. Similarly to the previous point, if the value of these resources is not incorporated in the assessment of costs and benefits, net capital stock value will decrease. This fact contrasts with the substitutability idea and is more consistent with the complementary idea suggested by the Brundtland Commission (Brundtland Commission, Our Common Future, 1987);

  • knowledge of ecological processes is not yet perfect (for example, the way in which forests protect soils, regulate water flows or affect the climate, is not yet well understood), therefore we cannot be sure how man-made capital can substitute for all forests’ functions; and

  • some natural resources cannot be substituted for by man-made capital because either it is considered immoral or the benefits of the man-made capital should be infinite. This is the case when substitution involves the irreversible destruction of natural capital stock. In this case, substitution can be viewed as immoral because it leads to the destruction or extinction of habitats and animal species and it entails that man-made capital benefits be infinite because the natural stock replaced is lost forever.

Since prices reflect the scarcity value of goods and services, the advocates of this view also recognize implicitly that environmental resources are limited.

Disregarding the different emphasis placed on how limited environmental resources are and, particularly, the policy implications of their conclusions, the various schools of thought acknowledge that the scarcity of the quantity and the degradation of quality of environmental resources have increased dramatically in the last decades, particularly in the developing countries, and that environmental considerations in decision-making are far more important today than past economic management assumed.

1.5 Misestimation of environmental values can impair economic growth

One of the reasons why environment is seldom considered in policy appraisal stems from the fact that environmental goods and services are not marketed and therefore do not have prices that can be comparable with development costs and benefits. Economic theory explains the absence of markets for these goods and services with the market and policy failure arguments.

1.5.1 Market failures

The dominant economic theory maintains that free and perfectly competitive markets[9] will lead to optimal allocation of resources, including environmental goods and services, or to economic efficiency.

Reasons for market failures

Market failures are defined as those circumstances that prevent the perfect competition, and therefore economic efficiency, from being achieved. The major sources of market failures related to natural resources are summarized below.


... positive and ... negative

Externalities occur when an economic activity affects technology, consumption, or preferences of someone who is neither the producer nor the consumer (i.e. a third party). These effects can be either positive or negative[11]. In the first case the third party will be better off and in the latter it will be worse off. In neither case externalities will be included in the financial price paid for the good produced. In other words, the market does not signal the costs/benefits of externalities to the perpetrator, who will therefore not change his/her behaviour accordingly.

An example of negative environmental externality (sometimes also called external diseconomy) is the case when the aerial dispersion of sprays applied by farmers contaminate nearby livestock operations, increasing their production costs in the form of additional veterinarian’s bills and medication.

The perpetrator of environmental costs will not be informed by the market about the costs generated to livestock producers, so he/she will not receive incentives to reduce pollution. The existence of externalities prevents achieving the optimal allocation of resources in that they provide wrong signals as to where should the resources be optimally allocated. In the example above, it might be that if farmers were obliged to internalize the pollution costs generated, the resources would be allocated to alternative and more efficient uses. For the environment, externalities may occur only in the future, thus affecting future generations. Yet, the links between humans and environment are often not known a priori nor can the preferences of future generations be known vis-à-vis environmental resources. In general, only when environmental damages occur do these linkages become known. Therefore this kind of externalities would be better treated in the context of uncertainty.

Public goods

Though environmental goods and services are frequently defined as public goods, this section will demonstrate that their belonging to one or another category of goods may vary according to the circumstances. As is shown in Table 1.2 below, goods and services are generally divided into four categories on the basis of two main characteristics: excludability and rivalry.

Table 1.2 Goods and services classification






Private Goods

Common Pool Goods


Toll Goods

Public Goods

Excludability relates to a situation where consumers who do not meet the conditions set by the supplier of the good/service are excluded from using (consuming) it.

Rivalry relates to a situation where one person’s consumption of the good/service comes at the expense of another person’s consumption. So, if one person uses the good/service another person cannot use the same good/service.

Private Goods: goods for which there is high rivalry and high excludability. Moreover, private goods are also generally divisible in smaller exchangeable units (e.g. square meter of land).

Common Pool Goods are resources used by multiple individuals regardless of the type of property rights involved. Excludability for such goods and services is low but rivalry is high. Examples are common land, fisheries, wildlife, and rivers.

Toll Goods (also called Club Goods) are non-rivalrous, at least up to the point where capacity constraints may influence the marginal cost of further provision, but which are excludable. A typical example is roads, but national parks could also be considered toll goods.

Public Goods[12]: goods and services that are non-excludable, non-rival, and indivisible. In other words public goods are goods and services that each individual can consume simultaneously in equal amounts. Typical examples are public information, defence.

The identification of the category the good belongs to is very important because it will influence the institutional arrangements determining the behaviour of individuals/societies towards the use of natural resources. For example, the most appropriate institution for private goods is the market, where individuals will exchange them on a voluntary basis. The behaviour towards public goods will generally be influenced by command and control mechanisms determined at the highest hierarchical level. Common pool goods use is based on the common interest principle.

Environmental goods

Most of the environmental goods and services belong to the category of public goods or common pool goods either because they are non-excludable and non-rival or because they are non-excludable but rival.

as public or common pool goods

To the first category belong, for example, sunlight, weather, biodiversity, flood control services of forests and coral reefs. Other environmental services are also generally classified as public goods, notably: scenery, clean air, clean water. However, the latter services can be subject to increasing rivalry or excludability as they approach a congestion point. Beyond this point they may assume the characteristics of either common pool, toll, or private goods and services.

Take, for example, the case of an open access site with charming scenery. As long as the number of visitors enjoying the site is low, scenery service of the site can be considered a public good. If demand for the site increases, congestion problems may arise and users’ benefits decrease up to a point where marginal costs become higher than marginal benefits, which will push many users to search for alternative sites. Moreover, if the number of visitors exceeds the carrying capacity of the site, degradation effects will most likely occur. This scenario would suggest a situation much closer to common pool goods than public goods.

... or toll goods

Take now the example of clean air (a similar reasoning holds for clean water too). Nobody can be excluded from using good quality air. As long as the supply of good air is abundant and users are few, this environmental resource can be considered a public good. But think about a big city where clean air is a privilege of only few residential areas located near gardens. Most likely the prices of houses/apartments in these areas will be higher than houses/apartments with the same characteristics but located in an industrial area. The difference of prices reflects the value of clean air individuals/households are willing to pay to benefit from good air. The fact that individuals/households are willing to pay some money to benefit from clean air means that this good is excludable (i.e. only individuals/households willing to pay the price of clean air will be allowed to benefit from it, while all the others will be excluded). In this case, the characteristics assumed by the good in question are much similar to a toll good.

The second category includes all the renewable natural resources, notably forests, water, wildlife, fisheries. It is worth pointing out here that many times this category of resources is used interchangeably with open access resources or common property resources. The latter categories entail a property right regime regulating the access and use of the natural resources. Open access resources entail that no common rules at all exist regarding the access to and use of common pool resources. Common property resources, on the contrary, are subject to property rights based on enforceable rules all the users agree upon and comply with. The degree of exploitation and degradation of common pool goods is very much dependent on whether a property rights regime exists or not, and on the effectiveness of the rules and rights established.

In the extreme case of an open access resource, say grazing land, the use by one herder will not exclude the same use by another herder. If herders behave rationally (i.e. if they aim at maximizing their profits) they will use as much as they can of the environmental resource (herders, for example, will bring to the grazing area the highest number as possible of animals and leave them on the area as long as possible) for the simple reason that the exploitation cost of the resource is zero. It is clear that by doing so the grazing land will deteriorate very quickly. But, since the herders have no incentive to reduce their use of pasture they will not change their behaviour and land will be overexploited. This case, which is often referred to as the Tragedy of the Commons (after the article by Garret Hardin[13]), highlights the problem of the property rights discussed in the following section. An economic analysis of the reason why open access resources may not lead to efficient exploitation is provided in Appendix 1.1.

Property rights

Property rights are any kind of legal acts defining the rights of individuals to use natural resources. These rights can be ownership rights, lease, or use rights conferred by law (e.g. the right to use water passing over one’s property). The underlying assumption of the property rights argument is that well defined, exclusive, secure, transferable, enforceable, and clear property rights allow to create markets for public goods and externalities, and consequently to place an economic value (price) on them. If the above conditions are not met, like in the open access situation, the incentives to conserve, protect, and manage natural resources in a sustainable manner will be undermined.

According to Wade (1986), the need of property rights is tightly linked to the perception of ecological risk. The higher the risks of degradation of the natural resources, the more incentive there is to manage them collectively and to create rules ensuring the rights as well as the duties towards the resource.

Let us take the case of farmers disposing their waste waters in a lake. The absence of property rights will generate a situation where farmers believe that they have the right to pollute. Let us assume now that water is also used by recreationists who are claiming the right to use clean water for swimming. A conflict will emerge between the two parties on who actually has the right on the resource. If conflicts are not settled, the natural resource (i.e. lake) will deteriorate very quickly because all polluters will behave as in the open access situation. If, on the contrary, the parties involved are aware of and concerned about the value of the resource and the risk of deterioration, they will concur in the definition of rules toward the access to and use of the lake. Whatever the instrument used to overcome the dispute (negotiation, government intervention with laws or economic incentives, courts), the outcome will be the setting up of property rights.

In South India, for example, landowners often have rights to their crops but not to the stubble left after harvesting. The village establishes rules for the grazing of the stubble land, including, for example, charging for grazing and paying for the manure that these herds generate. Outside herders come to an agreement with the village authorities and some grazing rights are even auctioned to the highest bidders. And if some crops are still standing, and are at risk from the grazing, additional rules of behaviour are sought and guards are posted[14].

The problem of property rights is particularly important in developing countries where modernization of the tenure systems in agriculture has often been accompanied by the removal of local traditional and custom-based rights to the use and management of environmental resources, without substituting them with effective alternatives. The disruption of traditional tenure and management systems have in many cases led to situations very close to open access resources, and therefore to overexploitation of resources.

An example of a similar risk is reported by a WWF and OXFAM study[15], which highlights that following the establishment of the free trade area between Canada, Mexico, and United States (NAFTA), social disintegration and decay of traditional social institutions charged with managing communal grazing land have had various negative environmental, economic and social impacts. From the environmental viewpoint, overgrazing and erosion have become the major problem. From the economic point of view, poor maize producers who benefited from access to communal grazing have seen their benefits progressively eroded. Moreover, reduced maize prices due to the higher competition with maize produced in the United States, mean that poor producers have to rely more and more on wood gathering as a source of fuel for heating and cooking. From the social point of view, migration and unemployment have increased substantially.

Ignorance and uncertainty

Ignorance and uncertainty may also hinder the functioning of markets. The limited knowledge of some environmental processes does not help providing the users of natural resources with the required information on the possible impacts in terms of quantity, quality and time of occurrence in order to adjust their behaviour.


Short-sightedness adds on the market failures in that individuals or countries (particularly those belonging to the lower income groups) have usually short time horizons, thus preferring investments yielding benefits in the short to medium term rather than in the long term. In other words, the marginal value of a US dollar one now is worth more than the same in the future. This time preference is reflected in positive discount rates of benefits generated in the future (Box 1.3). The effect of positive discount rates is that the present value benefits occurring in the future will be less attractive than the benefits obtained in the short term.

Box 1.3 Discounting the future benefits and costs

Discounting1 is the computational technique that measures the preference of the individuals for the present. It calculates the velocity of loss of value of money in the future. The larger the discount rate, the higher the velocity of loss of value. So, for example, a discount rate of 10 percent to a benefit of US$10 received in 10 years time will be worth US$3.85 now. If the discount rate is 3 percent, the same amount of money received in 10 years time will be worth US$ 7.44 now. The formula to calculate the present value (the value now) of the benefits received in the future is:

A*1/(1+i)n where: A = amount of money received; i = discount rate used and; n = the year the amount will be received from now. In the examples above, the formulas will be:

US$10*1/(1+0.1)10 = US$3.85 and US$10*1/(1+0.03)10 = US$7.44

Let us assume that we have to decide between two possible options for rehabilitating an abandoned area: the first is an industrial development project; the second is reforestation. The industrial plant will most likely yield benefits in the first years, whereas the investment in reforestation may generate benefits only after 30 years. Let us assume for simplicity that both projects yield the benefit in one shot but in different years: the industrial plant in Year 3 and the reforestation project in Year 30. We assume also that the net benefits of the industrial plant are worth US$3 000 and those of the reforestation project US$15 000.

With a positive discount rate of 8 percent, the present value of the two investments, using the formula of Box 1.3, will be US$2 381 and US$1 491 respectively. It follows that despite the higher benefits generated by the reforestation project, the industrial project has a higher present value. The above example explains why environmental investments are seldom put first in the development agenda.


Irreversibility is a typical element of environmental market failure. Some development investments may determine the irreversible loss of natural assets both for the present and future generations. This will reduce the options available to future generations to use the asset in question. Since preferences of future generations cannot be known, it is difficult to state whether it is worth destroying forever one resource or conserve it.

How to overcome market failures:

Market failures can be overcome either through direct negotiations between the parties involved or through intervention of the government at both the local and central level. In both circumstances, the estimation of the economic value of natural resources and environmental impacts of investment projects can facilitate the task (this topic is addressed in Section 1.5.3).

...negotiation among affected parties

(i) negotiation among the affected parties usually happens when there is a small number of parties involved and the cost of transactions is low. Transaction costs are the costs incurred to reach an agreement. If these costs are higher than the expected benefits of the agreement, the deal will fail. Possible transaction costs are the time necessary to get the parties together, the absence of clear information on benefits obtainable and costs incurred, the difficulty of enforcing the agreement, and the difficulty of establishing how to implement the agreement. Examples of possible conflict resolution through negotiation are provided in Chapter 2.7.

... government intervention

(ii) government[16] intervention at the central or local level generally takes the form of economic incentives and command and control measures aimed at modifying the behaviour of agents towards the use of the environmental goods and services. A multitude of economic incentives are ownership rights, taxes, tariffs, charges, fees, royalties, subsidies, tradable permits, green funds, deposit refund systems, and environmental bonds; among command and control measures are norms, standards, and regulations. A more detailed description of these tools and their effectiveness in the developing countries is provided in Annex 1.

1.5.2 Policy failures

The rationale behind government intervention is the existence of the above mentioned market failures, and the concern about both the distribution of market outcomes and the social morality of markets. In other words governments intervene to achieve efficiency objectives (internalize externalities in the production processes, define property rights, etc.) as well as non-efficiency objectives such as income distribution between social groups and regions (equity issue), poverty alleviation, moral achievements such as avoid that market mechanisms can “justify” markets of immoral goods and services (for example, health-affecting construction materials, introduction of uncontrolled genetically modified varieties etc.), political consideration such as strategic food stocks, and so forth.

Sometimes, however, government interventions have contributed to the mismanagement of natural resource by providing the wrong signals to individuals and firms. Many examples can be cited of distortions in the allocation of natural resources induced by poorly designed government interventions.

Examples of policy failures

Some of the major sources of policy failures affecting the environment in developing countries are generally attributed to:

(i) low tariffs of environmental resources’ use, such as irrigation water;

(ii) subsidized energy-intensive inputs, such as fertilizers and pesticides;

(iii) poorly designed property rights;

(iv) poorly designed investments;

(v) credit subsidies for environmental depleting activities (e.g. ranching);

(vi) low royalties on natural resource mining; and

(vii) nationalization of natural resources can also be a policy failure in certain cases, notably when high transaction and management costs are involved. This is the case, for example, of forest resources of many developing countries where governments are unable to control access to forest lands under public ownership and lack financial resources for efficient management of forests. In Nepal, where the government recently decided to change the forest property regime and protect forests as a state-owned resource, this policy, which excluded communities from the management of the forests, modified land use incentives and led individuals and communities to view state-owned forests as open-access resources[17].

Pricing natural resources

1.5.3 Pricing of natural resources: the total economic value concept

Values of environment are not fully known

“There is much uncertainty about possible economic uses of many non-wood forest products. A number of tropical fruits, nuts, and medicinal plants sold only in local markets, or not at all, may have export potential provided research is done on their properties and proper market development takes place. The ignorance of all the possible values of forest resources and sometime the impossibility to place an economic value on them impair the ability to promote efficient resource management. Undervaluation of forests in developing countries has caused governments to assign a low priority to the forestry sector because of its apparently low contribution to gross national product.” (Sharma, 1992).

As was stressed in the previous paragraphs, though a general agreement exists on the fact that environmental resources have a scarcity value, their goods and services are not priced. In addition, their value is generally underestimated due to lack of scientific knowledge and data on all the possible services they can supply, thus determining a policy bias in favour of competing uses of these resources.

The issue of total economic value of natural resources was first addressed by Weisbrod in 1964, and Krutilla in 1967, two environmental economists who proposed a classification of economic values, which encompass some of the major externalities of natural resources exploitation. Although there is not yet complete agreement on this classification[18] it is widely accepted that two broad categories of values exist: “use values” and “non-use values”.

Use values

Use values are the benefits that derive from the actual use of the natural resources. Forest, for example, can be managed for providing benefits such as erosion prevention, recreation, landscape view, etc. Use values are sometimes further divided according to various authors in:

(i) primary values or marketed goods and services or also consumptive value; and

(ii) secondary values or non-marketed goods and services[19], including ecological benefits, that is those services provided by forests that contribute to the preservation of ecological integrity (such as soil, water and air quality).

Non use values or existence value

Non-use values correspond to those benefits which do not imply a contact between the consumers and the good. That is, people do not require to use the good they are willing to pay for. One example is the willingness of people who will probably never visit Africa to pay for the protection of elephants in Africa (Wes et al., 1989). Non-use values are by many authors also defined “existence value”. The arguments behind existence value are intrinsic value and bequest motive:

Intrinsic value

(i) intrinsic value relates to the existence of a landscape or a particular habitat (i.e. the satisfaction of preserving the forest for itself and not as a function of any human use); and

Bequest value

(ii) bequest value involves altruism such as, for example, the desire to preserve forests for the enjoyment of other people both now (intragenerational) and in the future (intergenerational).

In addition to these values, environmental economists have introduced another value: the option value.

Option value

Option value is the value placed on environmental assets by those people who want to secure the use of the good or service in the future. The classification of this value is controversial in so far as some authors consider it as a use value, whereas others regard option value as a non-use value. Option values can be either positive or negative.

Figure 1.4 provides an illustrative but incomplete list of the values usually attributed to forests by the economists[20].

Total value

The total value of an environmental asset is therefore obtained by summing up all the value components: use values, including option value, and existence value. Of course when summing up the goods and services, caution should be used in order to avoid double-counting. Indeed, before proceeding with the aggregation of these values, the analyst should be sure that they are not mutually exclusive (for example, benefits of clear-felling cannot be added to recreation or soil protection) or that they are not already captured by other value components (for example, option values can be captured partly by use values and existence values).

Figure 1.4 Total economic value of forests

Assume, for example, that a railway line is planned to pass through a valuable forest area and will cause its destruction. Whether the development project is worth doing will depend on an accurate analysis of the flow of costs and benefits it generates. The formula for cost-benefit analysis is:

where: B are the benefits of the development project, including generally the primary goods of Figure 1.4; C are the development costs (investments and operating); E are net environmental costs or benefits, including secondary and ecological goods and services, as well as option values and existence values; i is the discount rate and n is time.

The problem exists however of how to place an order of magnitude/importance on these values. Ideally these values should be expressed in monetary terms so that they can be compared with all the other costs and benefits of policy decisions. In practice, as already mentioned, many environmental goods and services cannot be priced. In the past decades, several tools and techniques have been developed to measure the total economic value of natural resources. These are both monetary techniques and non-monetary techniques. A brief description of these is provided in Annex 2.

1.6 The sustainable development motive

With the publication of the Brundtland Report (Our Common Future, 1987), which brought the term “sustainable development” into common use, and the conclusions of the United Nations Conference on Environment and Development (UNCED) - the Earth Summit - of 1992, it has been made clear to the whole world that without better environmental and social considerations (both intragenerational and intergenerational) in decision-making, development would be undermined. The definition of sustainable development suggested by the Brundtland Report placed particular emphasis on needs and intergenerational equity:

Sustainable development

Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs.

Though many interpretations have been put forward for this term and other definitions have been added, thus making the real meaning of the concept still somewhat elusive[21], all definitions available suggest that sustainable development cannot be achieved unless two major aspects are addressed in development strategies:

(i) the profound interrelationships existing between the three main goals of development are accounted for (i.e. economic efficiency in the allocation of scarce resources, equity in the distribution of resources, and conservation of the natural environment); and

(ii) the necessity to ensure that the future generations have at least the same development opportunities as the present one.

The definition adopted by the FAO highlights these points by stating that:

Sustainable development is “...the management and conservation of the natural resources base, and the orientation of technological and institutional change, in such a manner as to ensure the attainment and continued satisfaction of human needs for present and future generations. Such sustainable development (in the agricultural, fisheries and forestry sectors) conserves land, water, plant and animal genetic resources, is environmentally non-degrading, technically appropriate, economically viable and socially acceptable”.

It is implicitly argued in this statement that each single dimension (economic, social, and environmental) has a cause-effect relationship with the other two and that according to the circumstances, these can be conflicting or complementary (see Box 1.4). For example, it is possible that environmental and social gains of a new water supply scheme that provides clean water to the poor is achieved at the expense of increasing costs. In this case efficiency goal may conflict with social and environmental goals, whereas social and environmental goals are complementary. It might also be that a solution is found whereby the new water scheme improves economic as well as environmental and social goals. This case would be the win-win situation for sustainable development.

Box 1.4 Environmental degradation-economic growth: two antagonist or complementary goals?

Most of the debate on the interactions between environment and economic growth has focused on the question whether these two dimensions should be considered alternative or complementary goals. The evidence shows that this cannot be stated unless other elements are accounted for in the analysis of the interactions. Among these are: the scale and the structure of the economic and the social systems, the technology, the efficiency with which natural resources are used. For example, efficient management of natural resources using appropriate technologies will reduce environmental impacts per unit of output. Depending on the type of natural resource, economic growth may help solve environmental problems. The World Development Report 1992: Development and Environment, reports, for example, that water pollution problems and related health effects decline as incomes increase. The same happens with particulate and sulfur dioxide levels in the air, although air pollution may increase at early stages. On the contrary, emissions of carbon and nitrogen dioxides worsen as income increases. The figure beside provides an idea of these interrelationships observed by the World Bank[22].

The understanding and measurement of these interactions are indispensable for proper decision-making. For example, it is now recognized[23] that there is a causation relationship between environmental degradation and underdevelopment and that many environmental problems in developing countries originate from the “lack of development, that is from the struggle to overcome extreme conditions of poverty”[24].

In short, sustainable development entails a decision-making approach based on a continuous and dynamic configuration of trade-offs between the three dimensions (economic, social and environmental) rather than on the optimization of each one of them.

This means that if the goals pursued by the development strategy are conflicting, a choice must be made as to which objective should receive the priority. An illustration of the various levels of integration of economic, social, and environmental issues in decision-making is provided in Figure 1.5. The optimal approach to decision-making for sustainable development lies in the intersection area (A in the Figure) between the three dimensions (economic, ecological, and social). In reality, however, it is rare that an approach integrating the three dimensions is used. More often, development plans are designed taking into account one (area C in the Figure) or, at the best, two (area B in the Figure) of the three dimensions simultaneously.

Figure 1.5 Three dimensions for sustainable development

The problem remains of how to translate theoretical definitions into practical terms. The most widely accepted practical implication of the sustainable development concept is that renewable natural resources should be used at “rates within the capacity of renewal” (IUCN/UNEP/WWF, 1991) or, in economic terms, “spending interests and not the principal” (Robinson, 1993). Other possible criteria are listed in Box 1.5.

Box 1.5 Criteria for sustainable use of environmental resources

(i) Extraction rates of renewable resources should not exceed regeneration rates

(ii) Non-renewable resources should be replaced, to the extent possible, by renewable resources and/or subject to technological progress[25]

(iii) Estimate the economic value of environmental services and goods, both now and in the future (Appendix 1.2 provides a demonstration of economic valuation of natural resources taking into account future generations)

(iv) The economic value of natural capital remains constant in real prices over time

(v) Protect, as far as possible, non-substitutable natural capital

(vi) Avoid irreversible processes.

Appendix 1.1 Economic analysis of efficient provision of common pool goods

Let us assume the case of a hunting activity. Harvest is obtained by using some production factors, say labour.

Let us also assume that the cost of labour (marginal cost corresponding to the opportunity cost of labour in the economy) is constant and is worth 4 m.u.

Assume finally that the production function is of the following form:

Y = - l2 + 8l

From the economic point of view, the efficient exploitation of animals is where the Marginal Value Product (MVP) of harvest equals the Marginal Cost (MC) of labour.

The MVP is obtained by calculating the first derivative of the production function, i.e.:

MVP = - 2l + 8

At this stage it is possible to calculate the efficient level of exploitation of animals. In the table below are reported the values of harvest (Y) and MVP given the MC of labour (MCl).

If l=




AVP=Y/l except for the 1st


(-02 +8*0)=0










































































The above data are used to draw the graph below:

The level of output that makes the MVP equal to the MC of labour is 12. This is also the point where hunters maximize their benefits or, which is the same, marginal benefits are just equal to marginal cost.

Let us assume now that resources are open access. In this case, there will be no restrictions to hunting. New hunters will be attracted by this activity as long as the Average Value Product (AVP), that is the total value of production divided by the total harvest, is higher or equal to the Average Cost (AC) of labour (also equal to the opportunity cost of labour in the economy). The values of AVP are reported in the table above and the corresponding curve is depicted in the graph by the curve AVP. It can be seen from the table and the graph that the new harvest level (16 units) is higher than the previous efficient situation, thus resulting in excess exploitation. It is also worth noting that marginal productivity is zero.

In an open access situation, the main reason why hunters will overexploit the resources stems from the fact that the benefits derived from restricting harvest to the efficient level by one hunter would not be captured by the same hunter but by other hunters.

Appendix 1.2 Pricing of natural resources taking account of future generations (Marginal User Cost Concept)[26]

Since resources are scarce, present uses of resources diminishes future opportunities. If large quantities of resources are used now, future generations will bear higher costs for exploiting the same resources. In other words, if the present uses of resources do not account for their scarcity value, scarcity in the future will increase, thus leading to extra costs to society to exploit the same resource. The cost of extracting a resource is measured by the marginal cost (MC) of extraction, i.e. the cost for extracting the last unit of resource. A rational user will exploit the resource up to the point where marginal cost is equal to marginal benefit (MB). The understanding of this equality is straightforward. Indeed, if the cost of extracting one additional unit of resource is lower than the marginal benefit generated by that same unit, there is still room for the user to increase his net benefits. If by contrast, the marginal cost is higher than the marginal benefit, the user gets negative net benefits. The optimal quantity of resources to exploit is given by the point where MC=MB.

In a static efficient allocation model, the price of the resource would be equal to the MC. In a dynamic efficient allocation model, taking into account the time factor and future generations demand, the MC is not equivalent to the price of the resource. The price of the resource is the MC + the marginal user cost (MUC), or the additional marginal cost that future generations will bear if there is excess use now. By introducing the MUC in resource pricing, the optimal extraction level will be lower, thus leading to less exploitation and higher sustainability of resources. This is illustrated in the graph below where MC is a constant marginal cost, MUC is the marginal user cost, D is the demand for the resource, Q is the quantity extracted and P is the price per unit of resource.

It is clear form the graph that if the MUC is added to the MC of extraction, the total marginal cost (MC+MUC) increases from P1 to P2 and the quantity of resources extracted decreases from Q1 to Q2.

[1] The entropy law also explains why only a fraction of recyclable resources can be reused.
[2] Capital goods are not considered here for matter of simplification of the presentation.
[3] Pearce and Turner (1990), Serageldin (1996).
[4] Declaration signed by 1 575 scientists, including 99 Nobel Prize winners, reported by the Times Magazine in 1992.
[5] According to some estimates resource degradation due to biomass losses in some African countries could be costing as much as 9% of GNP (Burkina Faso, Lallement 1990). Soil erosion, deforestation, and water pollution in Nigeria amount to 17.4% of GDP (the World Bank, 1991). A study by Repetto et al. (1989) reports that depreciation of forests assets in Indonesia accounts for around 3.6% of GNP. In Costa Rica, deforestation costs sum up to 7,7% of GNP (World Resource Institute, 1991).
[6] According to some authors (Speth, 1989), it took almost 1900 years to attain a US dollars 60 billion scale economy, but today this amount is produced in only two years. If this path remains unchanged, he maintains, the present US dollars 20 trillion economy may be five times bigger in only one generation.
[7] Meadows (1974) and, subsequently, others such as Rees (1990), Daly (1991), Ehrlich and Ehrlich (1990), Hardin (1991), Goodland (1991).
[8] Solow (1974 and 1986), Stiglitz (1974), Dasgupta and Heal (1979), Pearce and Turner (1990).
[9] Perfect competitive markets means that markets are characterised by a large number of buyers/consumers and sellers/producers who are perfectly informed and engage freely in transactions for private goods. As it is pointed out in this section, these conditions are often missing in the markets of both developed and developing countries.
[10] For a more detailed discussion on this issue the reader is referred to Buchanan and Stubblebine (1962), Dasgupta and Pearce (1972), Ward et al. (1991), Carlson et al. (1993), Panayotou (1993).
[11] Though this work considers mainly negative environmental externalities, the same analytical approach can be used for positive environmental externalities.
[12] Public goods (sometimes also called collective goods (Johansson, 1991) have also a third property, namely indivisibility. That is, public goods cannot be broken down into individually consumable units.
[13] Hardin (1968).
[14] Wade (1986) as reported by OECD (1994).
[15] Nadal Alejandro (2000).
[16] The term government here means anybody to which the society has given the power to regulate behaviour or apply penalties for not complying with the regulations. It may therefore stand for any sub-national level board in charge of deciding, for example, charges for irrigation water, water distribution calendars, etc.
[17] Pradhan and Parks, in Hanna and Munasinghe (1995).
[18] Other classifications have been devised, for example, by Filion (1993), Sarker and McKenney (1992), McNeely et al.(1990).
[19] Pearce and Turner (1990); Young (1991); OECD (1994); Sharma (1992); Bateman (1993a), Pearce and Warford (1993).
[20] Ecological economists suggest a different classification, where life-support and ecological values are considered primary services and consumptive and non-consumptive goods and services are secondary. In substance, ecological economists invert the classification of mainstream economists by placing higher importance on ecospheric values such as sunlight, lithospheric energy, soil, water, landforms, climate, atmosphere, and organisms, to which it is difficult to assign monetary values.
[21] For a more detailed discussion on this concept the readers are referred to Barbier (1987) and Pezzey (1992) who provide a valuable review of the many possible interpretations and definitions from the viewpoint of economic theory.
[22] Similar results have been obtained with other studies well documented in Goldin et al. (1995).
[23] Myrdal (1968), Chambers (1986), the World Bank (1985).
[24] Bartelmus (1986).
[25] Pearce and Turner (1990).
[26] For a more rigorous and formalized illustration of how MUC can be calculated, the reader is referred to Tietenberg (1996, pp 25-30).

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