Posts by David Schatsky from April 23, 2008

David Schatsky | April 23, 2008, 07:20 PM
Earth Day Economics

In honor of Earth Day, I wanted to go back to the idea I wrote about last month: "How concepts are defined--the clarity and the scope of the definition--has an enormous influence on the usefulness of the concept."

Then I wrote about the limits of economics in explaining human behavior. Since then, I stumbled on an utterly fascinating economics paper (from 1991) that proposed to explain why economics has traditionally failed the environment.

["Towards an Environmental Macroeconomics," by Herman E. Daly, published in Land Economics, Vol. 67, No. 2 (May, 1991), pp. 255-259]

Of course policies like carbon taxes or cap-and-trade are intended to yoke the forces of economics to environment choice-making. A major challenge in making those policies effective, though, is determining an appropriate value to place on something like a ton of atmospheric carbon.

Part of the reason that is hard is that we don't have a concept of the optimum scale of global economic activity. This paper offered the insight that microeconomics, which describes the behavior of individual actors in an economic system, possesses concepts, such as "optimum scale," that had not been extended to macroeconomics, leaving macroeconomics mute on some key questions.

Here's how the paper explains "optimal scale," an explanation that will be familiar to anyone who's ever studied microeconomics.

An activity is identified, be it producing shoes or consumign ice cream. A cost function and a benefit function for the activity in question are defined. Good reasons are given for believing that marginal costs increase and marginal benefits decline as the scale of the activity grows. The message of microeconomics is to expand the scale of the activity in question up to the point where marginal costs equal marginal benefits, a condition which defines the optimal scale.

So far, so good.

when we move to macroeconomics, however, we never again hear about optimal scale. There is apparently no optimal scale for the macro economy. There are no cost and benefit functions defined for growth in scale of the economy as a whole. It just doesn't matter how many people there are, or how much they each consume, as long as the proportions and relative prices are right!... I will admit that if the ecosystem can grow indefinitely then so can the aggregate economy. But, until the surface of the earth begins to grow at a rate equal to the rate of interest, one should not take this answer to seriously.

Since this paper was published, there has been further theoretical work aimed at extending the scope of economic concepts to make economics more useful for shaping decision making at the macro, environmental scale. But we obviously have a long way to go. Here's to progress.

Happy Earth Day. (A day late.)