Environmental and Welfare Economics

There is here a dilemma between broadness and depth of analysis – an old problem that won’t be solved herewith. We go around it by giving up exhaustiveness. We will not review and integrate literature so as to exhaustively cover all related fields and disciplines. Instead, we take a field of reference and its present degree of

interdisciplinarity for given and work out its interfaces with other disciplines so as to answer the research questions at hand. This approach translates into a simple practice: to start with one’s disciplinary background and make assumptions explicit, allowing other scholars to further develop specific elements at the boundaries of the analytical framework thus produced.

We will take Economics as a starting point simply because it’s the background that we have. Certainly, modern Sociology would work out certain parts of what we have set up in very different ways. Same goes for all other disciplines mentioned above.

To explore them all and integrate them consistently is hardly possible within a doctoral dissertation. We will therefore look for Schumpeter’s “non-economic

bottom”⁶ in the several sub-braches of Economics that we will take as a reference, so that colleagues from different disciplines know where they can contribute to the analysis we set out to provide.

Summarising, the present chapter presents a review of the Economics literature providing clues for at least RQ0 if not for RQ1 to 4. Specific perspectives from Environmental and Resource Economics, Transaction Costs Economics, New Institutional Economics, Law and Economics, Experimental Economics and

Institutional Ecological Economics will be presented for what they may contribute to an understanding of the research questions. The subsection concludes with a critical analysis and opens the floor for the crafting of an analytical framework.

3.1. Environmental and Welfare Economics

Economic scholarship has developed a dedicated branch dealing with resources and nature: Environmental Economics. As such, this specific subfield of the profession addresses RQ1 (dealing with the link between Ecology and the Economy) from the

6 J. Schumpeter (1934) Theory of Economic Development, p. 5. Quoted in Bromley (2008), p. 3.

point of view of optimizing production factors, nature being one of those. More specifically, the branch addresses the question of achieving an efficient allocation of individual environmental features. Efficiency represents here the exhaustion of improvement possibilities at either individual or aggregated level. The comparison between the individual and the aggregated level shows the branch’s root in Welfare Economics.

The core issue that has spurred the development of this branch as an autonomous one is that “the market”, the superior allocation system from the point of view of most Economics, is not necessarily present and functional when dealing with nature. This is so for a series of reasons widely contested in the literature and to an extent bordering with Institutional Economics and Transaction Costs Economics. The header under which this is discussed is that of “Externalities” or “Market Failure”.

Introducing Externalities, we refer to the body of literature concerned with the problem of social costs (Pigou 1932; Coase 1960; Buchanan 1969), hence those costs originating from a specific activity but falling on third parties. Since “the invisible hand doesn’t work” (Kahn 2004, pg. 19) in the presence of externalities, regulation is required as private, individual bargaining by a multiplicity of actors does not produce, alone, an allocation of resources that maximises the overall utility.

Two major schools of thought exist in the way Environmental Economics deals with a similar setting: the Pigouvian and the Coasean one. The first proposes a targeted use of taxation. The second endorses a laissez-faire approach centred on the ability of the actors to efficiently bargain towards an efficient outcome. Common to both schools is the reference to Pareto efficiency as a choice criterion, together with the view of a regulator as a well-meaning actor, whose aim is to maximise the overall well-being of society.

Under these premises, the task for an hypothetical regulator is that of devising arrangements dealing with externalities in such a way that those worse off are less so than those better off (potential Pareto improvement or Kaldor-Hicks efficiency).

The debate between the two schools becomes thus relevant for RQ2 and specifically RQ2a, whose formulation focuses on the distribution of those entitlements and

obligations, which set up the economy.

The entry point of the Pigouvian tradition is the divergence between private and social costs and its effect on the outcomes of a transaction. Costs are what one gives up to get things (Buchanan 1969, Mankiw 2009); if individuals exchange goods

during a transaction (hence they give and take items according to some principle), a problem arises when some third party is affected by the transaction without

participating to the decision behind it.

The third party may be affected positively as well as negatively by such additional costs/benefits: this doesn’t change that, while taking these extra costs or benefits into account, the comparison of costs and benefits behind the transaction at hand

becomes incomplete and hence perfectible. If this is the case, efficiency claims concerning the transaction must be dismissed: there must be room for improvement.

The Pigouvian claim here is that by taxing the externality-generating transaction at a level that equals the costs it produces for the third party, efficiency can be restored.

From this point on, a clarification is due in order to fully understand the contribution of this branch of scholarship: the reference made so far to costs, benefits, utility and welfare goes along with the common-sense meaning of those words. While the further discussion of the topic has forced the profession to a certain degree of further differentiation and specification of these terms, the general tenet is that choices underlie a balancing of positive and negative entities that can be measured against a common metric. That metric is generally termed utility and often approximated via monetarisation.

The term welfare has been used and/or understood to an extent as a synonym of utility (Cooter and Rappoport 1984), raising however the question of

commensurability across individuals or “interpersonal incommensurability”. Prices, instead, presuppose an exchange situation and express a specific exchange ratio.

Money is not yet necessarily involved in the generation of prices, it can however represent a numeraire, a generalised term of comparison used to express exchange ratios⁷. If so, one can talk of monetary prices.

7 One can visualise the above by thinking of cigarettes in detention camps: as soon as no money circulates but goods and services are available (one way or another), some of those goods can be use as a general terms of reference when doing exchanges, for example cigarettes. Money would certainly have different properties in doing the same job, e.g. it doesn’t physically decay as quickly as cigarettes do. On the other side, it seldom represents a good in itself.

Costs and benefits are variations in utility which may or may not be linked to transfers of money on the basis of prices. This is important, as the whole story hinges on the difference between the costs and the benefits considered while agreeing on a price (monetary or not) for a certain good or service (which we call a “private” transaction) and the broader bundle of costs and benefits that the transaction generates if the third party is considered (which instead we call an “aggregate” or “social” transaction, a transaction seen from the point of view of society as a whole).

The Pigouvian argument was made in pre-marginalist terms, in an environment, therefore, characterised by interpersonal commensurability of utility⁸: there are

“external costs”, seen as a quantification of the loss in utility experienced by the third party. Rather than representing some sort of compensation, a Pigouvian Tax is introduced as an instrument that drives a wedge into the private cost/benefit

calculation so as to match the aggregated one and eliminate the divergence between private and social costs. The same argument has been shown to hold in a marginalist environment too, where only (relative) prices can be referred to as an expression of utility: efficient prices must include external costs, regardless of any compensation taking place (Baumol 1972; Hartman 1982).

The Coasean tradition, instead, focuses on the reciprocal nature of externalities (Coase 1960; Wirl 1992). The Coasean school has brought about a change in perspective by suggesting that the “problem” is caused as much by the transaction as by the third party. We may think of “abatement costs” as those costs stemming from specific efforts to curb certain externalities (e.g. mitigation activities, adaptation activities etc.). The suggestion thereby made by the Coaseans is that abatement costs may possibly be lower on the side of the third-party. If so, a Pigouvian Tax would not always restore efficiency: it would do so only in that subset of cases where abatement costs are indeed lower on the side of the transacting parties.

The Coaseans go however further: the asymmetry in abatement costs give rise to incentives for them to be efficiently allocated via further bargaining, this time between

8 Enlightening on this aspect is the analysis by Buchanan (1969, chapter 5). On the broader relevance of marginalism for the concepts of welfare and utility, see the discussion in Buchanan (1969, chap. 1 on pain vs.

opportunity cost) and Hennipman (1987, on material welfare as opposed to relative scarcity and interpersonal comparability vs. ordinalism).

the transacting parties and the affected third-party. Instead, a regulator can hardly know on which side the better abatement possibilities are. The Coaseans therefore argue that all it takes is to distribute clear property rights on the medium carrying the externality and a market would emerge, efficiently allocating abatements costs against the benefits of additional units of the (now fully internalised) externality. This is the essence of the (invariance claim of the) Coase Theorem.

The theorem has clear limits, which have been dealt with by Coase himself (Coase 1988) and that have led to different readings (Baumol 1972; Bromley 1989; Medema 1998; Paavola 2007; Usher 1998; Vatn and Bromley 1997). The message,

particularly for what concerns RQ2, is nonetheless that it’s preferable not to regulate the extent of activities shifting costs onto others but rather to make an informed choice on the assignment of extensive property rights, covering possible externalities and leaving the parties involved bargain towards an efficient level of external costs.

At the level of RQ4, instead, this literature recommends individual market

transactions in perfect competition as the preferred means and process so as to distribute entitlements to and obligations towards the features of a given ecosystems.

While Standard Economics focuses on the outcomes of similar transactions, a sub-branch of the profession known as Transaction Costs Economics focuses on this typology of interaction from the side of its process dimensions. To that now we turn.