ECON101: Principles of Microeconomics

We define economics as the study of how people interact with each other and with their natural environment in producing and acquiring their livelihoods and how this changes over time and differs across societies.

Humans have always relied on their environment for the resources they need to live and produce their livelihoods: the physical environment and the biosphere (the collection of all forms of life on earth) provide essentials for life, such as air, water, and food. The environment also provides the raw materials that we use in the production of other goods – such as wood, metals, and oil.

Figure 1.20 shows one way to think about the economy: it is part of a larger social system, which is itself part of the biosphere. People interact with each other, and also with nature, in producing their livelihood.

Figure 1.20 The economy is part of society, which is part of the biosphere.

Figure 1.21 shows the flows of resources between firms and households within the economy and between the economy and the environment. Firms combine labor with structures and equipment and produce goods and services that are used by households and other firms.

Figure 1.21 A model of the economy: Flows of resources.

Production of goods and services also occurs within households, although, unlike firms, households may not sell their outputs in the market. In addition to goods and services, households are also producing people – the next generation of the labor force. The labor of parents, caregivers, and others is combined with structures (for example, your home) and equipment (for example, the washing machine in the home) to reproduce and raise the future labor force working in firms and the people who will work and reproduce in the households of the future.

Figure 1.22 shows that environmental resources are essential for sustaining both human life and the economic activity that supports and enhances it. The environment provides resources that we consume directly and the primary inputs to the production of goods and services within households and firms.

According to the Living Planet Report 2020 by the World Wildlife Fund, there was an average 68% decrease in population sizes of mammals, birds, amphibians, reptiles, and fish between 1970 and 2016. And since 1970, humanity's ecological footprint has exceeded the earth's rate of regeneration. The report estimates that we are overusing the earth's biocapacity by at least 56%. Figure 1.22 illustrates projections for future biodiversity depending on whether we can make human production and consumption more sustainable.

Figure 1.22 Global biodiversity loss under three different scenarios. (Integrated Action Portfolio refers to increased conservation efforts, increased agricultural land productivity, reductions in food waste, and changes in food consumption behavior.) Labeled points indicate the year in which biodiversity is expected to start increasing.

We have seen that capitalist institutions – private property, markets, and firms – have facilitated the continuous technological revolution and rapidly rising living standards by encouraging innovation and the successful adoption of new technologies. But many of the most important technological developments of the 20th century, from cars and airplanes to refrigeration and personal computers, have relied on carbon-based energy for their use as well as manufacture. Others, like plastics and chemical fertilizers, lead directly to ecosystem damage.

The evidence on biodiversity and climate change shows how dramatically the way we produce our livelihoods is now degrading the environment and depleting the stock of natural resources – including clean air and a liveable climate.

An example is the Grand Banks cod fishery off the east coast of Newfoundland, which sustained the livelihoods of the US and Canadian fishing communities for 300 years. Cod stocks collapsed in 1992 after several decades of large-scale commercial fishing, and the fishery closed. We still do not know if the cod will come back to their previous numbers.

One reason for the environmentally destructive pattern of technological change and resource use is that goods or technologies that deplete or destroy natural resources are artificially cheap, so we overuse them. They are artificially cheap because the prices that users of natural resources pay do not include the depletion of the natural environment. For example, what consumers pay when they buy cod goes into the wages of the crew and others employed in the supply chain and into the profits of the firms involved. But no fishing firm owner has an incentive to maintain the stock of cod on the Grand Banks. The cod stocks could be freely exploited while they lasted; if the owner of a trawler tried to conserve them by catching fewer fish per week, their own profits would be reduced, and competing trawlers would catch the fish anyway.

The depleted cod stocks parallel the case of the depletion of the Indonesian forests in Extension 1.2, which is a cost of forestry that is not deducted from the GDP. In this case, the value of the fish sold is counted in the GDP (of Canada, say), but the depletion of the stock of fish is not subtracted.

This contrasts with a firm owner whose profits depend on a stock of privately owned resources and who has the incentive to maintain it in good condition. For example, a tour operator will maintain their fleet of buses because they are needed tomorrow as well as today and are costly to replace.

Some environmental problems can be addressed by governments directly regulating the amount of emissions or other environmental damages. Examples are banning lead in petrol (gasoline), issuing a limited number of permits to emit CO_2, and allowing firms to buy and sell these permits. Without regulation, electricity generators do not pay for using up the absorptive capacity of the biosphere. By limiting the total number of permits issued, this policy limits the total amount of emissions and puts a price on the use of CO₂ because firms emitting it have to buy permits. This also provides a profit motive for owners of firms to reduce carbon emissions that are absent when they are not regulated. These policies protect the environment by making goods produced in environmentally harmful ways, either illegal or costly so that they will be used less.

One way that technological progress can contribute to mitigating climate change and biodiversity loss is by reducing the cost of goods and services that are compatible with environmental sustainability. Recent advances in technology have vastly reduced the cost of wind, solar, and other renewable sources of energy. We discuss some examples in the next unit.

The evidence on biodiversity and climate change shows how dramatically the way we produce our livelihoods is now changing the environment and depleting the stock of natural resources. By treating them as free and using them up, we affect future (human) living standards and well-being. From global climate change to local resource exhaustion, these effects are the results of the expansion of the economy (illustrated by the growth in total output) and the way the economy is organized (what kinds of things are valued and conserved, for example).

Addressing environmental problems to enable those in low-income countries to transition out of poverty and to sustain living standards in rich ones requires governmental and other collective solutions, whether local, national, or international. Local communities can organize recycling schemes or agree on regulations for the use of a lake. Governments can limit or prevent the sale of damaging products, as some have done in the case of incandescent light bulbs or petrol- or diesel-powered cars, or subsidize beneficial investment, for example, in public transport infrastructure, solar and wind power, or home insulation. Climate change and the conservation of oceans and some rivers require not only individual government action but also international agreement.

Although governments are far more able than individuals and firms acting singly to take action to protect the environment, they often fail to do so. The centrally planned economies of Eastern Europe, where governments controlled production, had a particularly poor record on pollution control. Per capita mortality from air pollution in Eastern Europe (outside the European Union, EU) and China remains high relative to the EU and North America. But although democratic governments have been more active in reducing pollution that negatively affects the lives and health of their citizens, they have been reluctant to adopt environmental policies that restrict individual choice – for example, to tax or limit the use of private cars – or that would reduce profits of companies providing carbon-based energy.

Source: CORE Econ, https://core-econ.org/the-economy/microeconomics/01-prosperity-inequality-13-economics-biosphere.html
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