Sustainability: Why Should We Care?

Sustainability, as defined by the World Commission on Environment and Development in 1987, is meeting the needs of the present generation without compromising the ability of future generations to meet their own needs. This definition is broad and somewhat incomplete. The definition should include the economic, social, and environmental resources that are used by the present generation and what will be left for future generations. This would incorporate intergenerational equity and dynamic efficiency into the model (Stavins, Wagner, and Wagner, 2002).

Intergenerational equity states that an economy is sustainable when it is “dynamically efficient and the resulting stream of welfare functions is non-declining over time” (Stavins, et al, 2002. p 341). This concept describes the social dimension of sustainability as a relationship between the current generation and future generations in the transfer of wealth. Intergenerational equity can be achieved through two possible means; the present generation conserves non-renewable resources and limits their use, or the present generation consumes the resources without limitations and invests in capital accumulation for future generations.

Dynamic efficiency is “the choice of a feasible consumption path such that the economy is on the Pareto frontier” (Stavins et al, 2002. p 342). This economic dimension promotes non-wastefulness in the social context of how society retains and reinvests wealth through economic development. Economic development takes into account the ever changing needs of society over time and dynamic efficiency helps to deal with this process. Externalities, which increase with population density and industrialization, should be accounted for in the value, or costs, left to the future generations through waste (externalities) and its disposal through the use of finite ecological resources, such as water, air and land (Ayres and Kneese, 1969). The ability to absorb the externalities (waste) from production is limited and therefore a finite resource.

Pareto efficiency, a conventional economic framework, is defined by the fact that one entity cannot be made better off without another’s situation being made worse. Pareto efficiency can be used to conceptualize sustainability, but lacks accounting for justice. This requires a morality component when choosing the optimal Pareto allocation of those resources. Morality should help to promote the general welfare and provide for a better situation for both the current generation and the generations to follow. Pareto improvements are actions in an economy where no one is made worse off and at least one person’s situation is made better. Potential Pareto efficiency is where those that benefit from use of the resource should compensate those that have received a worse situation due to that same use. Applying these principles to intergenerational equity can help to generate a more equitable social welfare for future generations. The optimized consumption path can fulfill the intergenerational equity component through maximizing the welfare left for future generations.

Hotteling suggests that there are three rules for sustainability when dealing with finite resources. First, future generations can be compensated by the present generation through the exchange of natural capital for man-made capital, given that they are substitutable. This allows for the present generation to consume the resource, without limitations, as long as the revenue and profits are invested in capital accumulation for future generations. Second, future generations must be left with non-declining value of finite resources over time. This would limit the resource allocation of present generations in order to ensure the availability of the resource for future generations. Third, future generations must be assured a non-declining service flow from the finite resources, perpetually. This problem pushes towards; using the resources in an efficient way, reducing waste from the production process, and recycling the waste generated to ensure a continual service flow from the resources.

Ayres and Kneese (1969) speak of externalities and the lack of attention in the realm of economics on the waste generated from production. This environmental component is important in the realm of sustainability and intergenerational equity. Decisions the current generation will make can have negative consequences on the future generations, especially when it comes to the environment. Hotteling (1931) felt that the conservationists who wanted to ration the oil extraction and production as negative, due to the fact that it would cause higher prices and be biased towards monopolies. This would be due to the imperfections of the market and the limited awareness of policies implemented.

Sustainability encompasses, not only the economy, but also includes social and environmental issues. These dimensions should be included with an understanding of the intergenerational and dynamic efficiency aspects of sustainability which include a moral and ethical component that must be applicable to ensure the welfare of every generation. Capital accumulation, technological advancements, and optimizing consumption levels can all help to ensure that the welfare of future generations is increasing, rather than declining due to non-renewable resource use.

There are several measures that are relevant to sustainable development. Hottling’s rule on sustainability states that:

MUC = Marginal User Cost

= Opportunity Costs

= cost of using one more unit of resource in the present versus future time period

= cost of using resource today

= Shadow Price

Sustain Graph

MP0=MP1 (P0-MC)/ (1+r)0= (P1-MC)/ (1+r)1

PV of MUC= MUC1=MUC2=Shadow Price in a two period allocation (simplified).

P˙/P= Pe-P0/P0=r where r= rate of change in asset price and Pe is the expected price of one unit of the resource tomorrow. MB1= 1/(1+r)t *MB2 = P˙/P= r.

Non-declining stream of benefits requires Bt+1>Bt ensures that there is no decline in wellbeing for future time periods. NKt+1+HKt+1> NKt+HKt ensures that future capital is worth more than in the present, due to the discount factor (r) and shadow price (SP). P=MC+ SP(1+r) which allows MUB1=MUB2=MUC1=MUC2= P˙. This indicates that the shadow price and resource stock have an inverse relationship. As the resource stock is depleted, the shadow price will increase. The shadow price is necessary in order to compensate the future time periods since MUC(SP) gives us a price based on the non-declining flow of resources over time. MNB1=MNB2 shows that extraction in either time period are equal due to shadow price.

Social benefit-cost analysis allows a measure of the costs and benefits in order to analyze, measure, and compare an investment project or program. This measurement helps economic developers to decide whether to undertake the project or reject it. Private companies use cost-benefit analysis in order to rank projects in order to choose what project(s) is best for the bottom line of the company. These private undertakings only look at the impact the project or program has to the company, but not to those outside the company that might be affected. Social benefit-cost analysis gives a wider perspective that includes the costs and benefits to all members of society. The social comparison is made between the benefits and costs of doing the project versus not doing the project.

A project looks favorable if the benefits outweigh the costs, but the distributional factors need to be taken into account. Kaldor-hicks criterion allows that the project be done; if those who are made better off could “potentially” compensate those who are made worse off. This allows for a potential Pareto improvement to be good enough, an actual Pareto improvement is not necessary. The benefits and costs can be converted to NPV in order to measure whether the project is the best alternative, or whether another alternative would be a better use of the resources. One difficulty with this process is deciding on a discount rate. Although the market can give some idea of what the marginal rate of time preference is for individuals in the here and now, the future generations are not represented in today’s markets.

There are two main groups, referent and non-referent, that are to be taken into consideration. The referent group consists of people that the decision-maker choses as relevant to the project parameters. The non-referent group consists of the owners and those that hold equity in the investment project. A private analysis considers only the costs and benefits (bottom line), no matter which groups might be affected. Efficiency analysis looks at the reallocation of resources using the Kaldor-Hicks criteria. This can deal with whether or not the total benefits are increased, who gains and who loses, but should also take into account the distribution of the benefits.

NPV can be used to measure the net benefits to the referent group and the non-referent group using market prices. NPV can also be measured by efficiency analysis, but these do not take into account the non-market costs and benefits of the referent groups. This could include costs, such as pollution or production waste, or benefits to the non-referent group that are not taken into account by the market assessments. The efficiency net benefit is the present value of the projects outputs plus the opportunity costs of the inputs irrelative to market prices and flows to the referent group. The non-referent group NPV will help decision makers of the firm, the NPV of net benefits to the non-referent groups, benefits based on market and non-market process, will help decision makers at the government level decide if the project should be undertaken. A referent group analysis can help to deal with the problem of distribution of benefits (net gains/losses) to all members of the referent group.

Campbell and Brown (2003) offer a four step process to follow in order to use social benefit-cost analysis for a project. First, find the referent and non-referent net benefits (cash flows) as reflected by market prices of the proposed project. Second, find the private benefits (cash flows) using market prices. Third, find the project benefits (cash flows) using efficiency prices. This would include the non-referent group, non-market prices. Fourth, distribute the efficiency cash flow among all of the members of the referent and non-referent groups.

 

References

Ayres, R. U., & Kneese, A. V. (1969). Production, Consumption, and Externalities. American Economic Review59(3), 282.

Hardin, G. (1968). The Tragedy of the Commons. Science162(3859), 1243–1248.

Solow, R. M.. (1974). Intergenerational Equity and Exhaustible Resources. The Review of Economic Studies41, 29–45.

Stavins, R. N., Wagner, A. F., & Wagner, G. (2003). Interpreting sustainability in economic terms: dynamic efficiency plus intergenerational equity. Economics Letters79(3), 339-343.