The Market is the arbiter of economic activities in a capitalist society. The price of labor and goods, is determined by an ‘invisible hand’, depending on supply-demand push-pull forces. Whether or not these forces are allowed to operate in our economies, free of rigging, is a whole different debate. But, more or less, we do have some semblance of markets operating in all modern economies. To many ‘free market’ ideologues, there is almost a religious belief that markets can solve any problem. So, what is the market solution to protecting the environment ? If we really have free markets today, why is there a problem at all ? Is the market really the all-knowing hand of God, Or does the market have limitations ? Has the market failed us, or we failed the markets by not taking market limitations into account ? Lets Explore.
First of all, what does the cost of any product, typically include ? It includes cost of labor, raw materials and capital. Add profits and taxes, and we get the sales price. The idea is that the costs of the factors of production should be included in the price of the product. And this obviously includes the cost of the capital directly employed in producing the good or service. For example, the cost of machinery used to produce a car. That’s capital directly employed in producing the good. The price of the car includes (its share of) the cost of capital used to produce it.
The interesting thing is, the process of producing or using a product, may be affecting another valuable service. This is called an ‘externality’ in economics jargon. Example: Use of oil affects the climate service. The production of metals, first involves mining the ore from sensitive ecosystems which provide ecosystem services. The production of paper or timber, may first involve cutting forests which provide anti-flooding, carbon-sink and innumerable other services. All these natural services provided by nature may be considered as ‘natural capital’. So, the process of producing or using a product, may be depreciating ‘natural capital’. Obviously, the price of the product should include the capital depreciation cost it incurs, so that it presents a true picture of the costs of producing or using that product.
The crux of the matter is, we are not doing that. In other words, the prices of our products do not include costs of environmental externalities. Because price is the most important variable in a market economy, we have extremely distorted use of resources — An overuse of polluting resources such as oil because of cheap price, which also creates a disincentive for investing in and adopting cleaner technologies. Excess demand for products such as metals or timber or paper or plastics, without regard to environmental costs.
In Plan B 2.0, Lester Brown sums it up:
The central challenge, the key to building the new economy, is getting the market to tell the ecological truth. The dysfunctional global economy of today has been shaped by distorted market prices that do not incorporate environmental costs. Many of our environmental travails are the result of severe market distortions.
The market distortions occured because “The market” by itself, is blind to externalities. The market is like a super computer into which we feed costs of everything, and it turns out an optimal allocation. The costs of labor, raw materials, and man-made capital, are all automatically fed into this machine by humans who have a stake in getting their products & services valued. But nature unfortunately does not speak. The climate nor the forests, do not demand a return on their services. When costs of critical services are not fed into the market-machine, the market does throw out faulty resource allocations. Garbage-in Garbage-out. The important point is, the process of feeding environmental costs into the market-machine, is a political decision our societies have to make. It does not happen automatically.
As a practical example of how environmental externalities can be accounted for, here is a wonderful report specifically with respect to costs of climate change , and pricing of carbon. Stern review report.
Are these extra taxes ?
Often, environmental costs are referred to as “environmental taxes”, such as “carbon tax”. For some people, the word “tax” is an anathema. For them, a tax by definition creates “inefficiencies” (besides a hit on the wallet). It should be clarified that environmental costs are not “taxes” in regular sense of the word. These are actually legitimate costs that one has to pay, for depreciating natural capital through the use a product.
There are also proposals that this effort be part of wider “ecological tax reform” which aims to be revenue-neutral. That is, same level of taxation, but just a shifting of tax structure. More on that in a later post ..
Finally ..
Comparing our current market pricing practices, with faulty accounting practices of bankrupt corporations Enron and Worldcom, Lester brown warns:
Faulty corporate accounting systems that leave costs off the books have driven some of the world’s largest corporations into bankruptcy, costing millions of people their lifetime savings, retirement incomes, and jobs. Distorted world market prices that do not incorporate major costs in the production of various products and the provision of services could be even costlier. They could lead to global bankruptcy and economic decline.
Footnote: The larger question is, how did we humans come to this stage of having to consider everything natural as a “capital asset” or a “service” ? And, having to put a number on everything, to be able to preserve it ?
