MPE 781- Economics for Managers
Trimester 2, 2017 Assignment: Economics Case Study
Due on the 5th of September (11:59 pm), 2017.
I. Assignment Overview: This assignment is based on an article published in The Economists’ Voice titled ‘Global Climate Change: A Challenge to Policy’, by a Nobel laureate Kenneth J . Arrow , in 2011. The article is already attached to this assignment question. Please read the article carefully before attempting this exercise. You will also need to draw on other resources available through the library as well as external resources. Please note that you need to provide clear references for your sources when citing research and data.
II. Learning Objectives: This assignment is designed to encourage you to think about the application of concepts learned in this unit in a real world scenario. This assignment, indeed, is interesting as it explains the mechanism that leads to global warming and its impacts on our economy. Furthermore, this assignment also addresses the challenge that we face to implement effective economic polices to reduce the magnitude of impacts of global warming. We hope that this assignment will expand the horizon of your thoughts.
III. Assessment: Your score on this assignment contributes towards 40% of your final score for this unit. Your assignment will be graded on your use of appropriate economic theory and concepts; relevant diagrams and clarity of exposition and overall quality of your answers. Although you
can work in group, this is not a group assignment and you must submit
IV. Submission: This assignment must be submitted electronically on CloudDeakin (CD) Dropbox area by 11:59 pm on the due date. No hard copy submission will be graded. Print your name and student ID clearly on the first page of your answers. Please check the Academic Honesty and Misconduct section in the Unit Guide. Submitting your answers automatically implies that you have read and accepted the Plagiarism and Collusion Declaration, and that the submitted answers are entirely your own work.
V. Questions: Answer all questions. Limit the total word count of your assignment to less than 3,000 words. You are encouraged to provide necessary graphs, figures and tables with data wherever possible, which are not subject to word limit. Please be careful in implementing referencing
1. In no more than 150 words, motivate the reader to read the article bysummarising the key assumptions and main points. [8 marks]
2. According to Arrow, “We are much better to act to reduce CO2 emis-
sion substantially than to suffer and risk the consequences of failing to meet this challenge.” – in light of the article and based on your own research, please explain why he suggests so. Specifically, what sources of market failure are present? Apply the abstract possible solutions to this problem of global warming. [8 marks]
3. In this article, the consumption discount rate, denoted by d, is defined
as d = ? + g?. What do the terms ? and g? represent? Explain the
intuition behind this equation. One critique says that any kind of uncertainty regarding g may lower the value of d. Do you agree or disagree with the critique? What are the implications to the economy of having a lower value of d, when human-induced global warming is occurring? Explain. [ 8 marks]
4. Adam Morton, in his article titled “Energy crisis: Wholesale powerprices have doubled since the carbon tax was axed” published in the Sydney Morning Herald (dated the 9th March, 2017), has argued that the dramatic increase has been largely blamed on soaring gas prices and investment uncertainty over what power plants to build as ageing coal generators shut down. If so then what are the implications regarding the value of d for Australia? Explain. [8 marks]
5. In the equation d = ? + g?, assume that ? is determined by an action of a social planner. Consider the event when U.S. President Donald Trump withdrew the U.S. from the Paris Climate Accord on June 1st, 2017. What are the implications regarding the value of d for the world?
Explain. [8 marks]
1. Morton, Adam (2017). “Energy crisis: Wholesale power prices have doubled since the carbon tax was axed.” http://www.smh.com.au/ federal-politics/political-news/energy-crisis-wholesale-power-priceshave-doubled-since-the-carbon-tax-was-axed-20170308-gutf8t.html)
2. Stern, Nicholas. (2006). The Economics of Climate Change, The
report is accessible from the following source:
3. Various Data Sets regarding the recent trend of Global Warming can be accessible from the following source: https://www.ncdc.noaa.gov/ monitoring-references/faq/global-warming.php
Global Climate Change:
A Challenge to Policy
Kenneth J. Arrow
LAST FALL, THE United Kingdom issued a major government report on global climate change directed by Sir Nicholas Stern, a t op-fl ight economist. The Stern report amounts to a call to action: it argues that huge future costs of global warming can be avoided by incurring relatively modest costs today.
Critics of the Stern report don’t think serious action to limit carbon dioxide (CO2) emissions is justifi ed because there remains substantial uncertainty about the extent of the costs of global climate change and because these costs will be incurred far in the future. They think that Stern improperly fails to discount for either uncertainty or futurity.
I agree that both futurity and uncertainty require signifi cant discounting. However, even with that, I believe the fundamental
Kenneth J. Arrow won the Nobel Memorial Prize in Economics in 1972. He is the professor of economics emeritus and professor of management science and engineering emeritus at Stanford University. He thanks the Hewlett Foundation for research support.
conclusion of Stern is justifi ed: we are much better to act to reduce CO2 emissions substantially than to suffer and risk the consequences of failing to meet this challenge. As I explain here, this conclusion holds true even if, unlike Stern, one heavily discounts the future.
A PERSONAL INTRODUCTION TO GLOBAL WARMING
I fi rst heard of the effect of industrialization on global temperatures long before the present concerns became signifi cant: in the fall of 1942, to be precise. I was being trained as a weather offi cer. One course, called “dynamic meteorology,” taught by Dr. Hans Panofsky at New York University, dealt with the basic physics of weather systems (pressure variations, the laws determining the strength of winds, the causes and effects of precipitation, and similar matters). One of the fi rst things to understand was what determines the general level of temperature. The source of terrestrial temperature is of course solar radiation. But heating of the earth from the sun’s rays causes the earth to emit radiation at frequencies appropriate to its temperature, that is, in the infrared low- frequency portion of the electromagnetic spectrum. Since the earth radiates into empty space, where the temperature approximates absolute zero, it would appear that in equilibrium the earth should come to that temperature also, as is indeed the case with the moon.
What makes the difference is the earth’s atmosphere. The vast bulk of the atmosphere is made up of nitrogen and oxygen, transparent to both the visible radiation coming from the sun and the infrared radiation emitted by the earth and hence without effect on the equilibrium temperature. However, the atmosphere also contains, we learned, a considerable variety of other gases in small quantities. These “trace gases” include most notably water vapor, carbon dioxide, and methane, though there are many others. These trace gases have the property of being transparent to radiation in the visible part of the spectrum but absorbent at lower frequencies, such as infrared. Hence, the effect of these gases is to retain the outgoing radiation and so raise the temperature of the earth to the point in which life can fl ourish. The effect is strictly parallel to the use of glass in greenhouses, also transparent to visible radiation but not to infrared; hence, the widespread term, “green house effect.”
Where do these trace gases come from? The water vapor comes from the passage of air over the large expanses of water in the earth’s surface, particularly when the water is warmer than the air. The carbon dioxide and methane come from some nonbiological sources, such as volcanic eruptions, but also from the respiration of animals and from organic wastes. (Vegetation, on the contrary, absorbs CO2.)
Our instructor then added one more observation. CO2 is a b y product of combustion. There are fi res due to volcanoes and lightning, and mankind has lit fi res for 500,000 years, but the pace of combustion has vastly increased since the Industrial Revolution. So, concluded Dr. Panofsky, we can expect the world temperature to rise steadily as CO2 continues to accumulate and at an increasing rate with the growth of industry. This was not presented as a jeremiad or as controversial. Indeed, we w ere clearly being told this to vivify the quite arid set of facts we had to learn rather than to move us to action.
As any economist accustomed to general equilibrium theory might guess, the implications of a given increase in green house gases for the weather are mediated through a very complex interactive system with both positive and negative feedbacks. Elaborate climate models have been developed, each admittedly falling short of catching some signifi cant aspect. (Economists will understand.) Nevertheless, serious studies have lead to a considerable consensus, although with a wide range of uncertainty. I draw upon the most recent report, prepared by a team directed by Sir Nicholas Stern for the
United Kingdom prime minister and chancellor of the exchequer (Stern 2006). The mean levels of different magnitudes in this report are comparable to those in earlier work, but the Stern report is more explicit about ranges of uncertainty.
The current level of CO2 (plus other green house gases, in CO2 equivalents) is today about 430 parts per million (ppm), compared with 280 ppm before the Industrial Revolution. With the present and growing rate of emissions, the level could reach 550 ppm by 2035. This is almost twice the preindustrial level and a level that has not been reached for several million years.
POTENTIAL CLIMATE CHANGE AND ITS IMPACTS
Most climate change models predict that a concentration of 550 ppm would be associated with a rise in temperature of at least two degrees Centigrade. A continuation of “business- as- usual” trends will likely lead to a trebling of CO2 by the end of the century, with a 50 percent chance of exceeding a rise of fi ve degrees Centigrade, about the same as the increase from the last ice age to the present.
The full consequences of such rises are not well known. Some of the direct effects are obvious: implications for agriculture (not all bad; productivity in Canada and northern Rus sia will rise, but negative effects predominate where moisture is the limiting factor and especially in the heavily populated tropical regions) and a rise in sea level, which will wipe out the small island countries (e.g., the Maldives or Tonga) and encroach considerably on all countries. Bangladesh will lose much of its land area; Manhattan could be under water. This rise might be catastrophic rather than gradual if the Greenland and West Antarctic ice sheets melt and collapse. In addition, temperature changes can change the nature of the world’s weather system. A reversing of the Gulf Stream, which could cause climate in Eu rope to resemble that of Greenland, is a distinct possibility. There is good reason to believe that tropical storms will become more severe, since the energy that fuels them comes from the rising temperature of the oceans. Glaciers will disappear, indeed have been disappearing, rapidly, and with them, valuable water supplies.
ARE THE BENEFITS FROM REDUCING CLIMATE CHANGE WORTH THE COSTS?
The available policies essentially are ways of preventing the greenhouse gases from entering the atmosphere or at least reducing their magnitude. Today the source of 65 percent of the gases is the use of energy; the remainder arises from waste, agriculture, and land use. A number of behavioral changes would mitigate this problem: (1) shifting to fuels that have higher ratio of useful energy to CO2 emissions (e.g., from coal to oil or oil to natural gas); (2) developing technologies that use less energy per unit output; (3) shifting demand to products with lower energy intensity; (4) planting trees and reducing deforestation, since trees absorb CO2; and (5) pursuing an unproven but apparently feasible policy of sequestering the CO2 by pumping it directly into underground reservoirs. We can go further and simply restrict output.
Two factors deserve emphasis, factors that differentiate global climate change from other environmental problems. First, emissions of CO2 and other trace gases are almost irreversible; more precisely, their residence time in the atmosphere is mea sured in centuries. Most environmental insults are mitigated promptly or in fairly short order when the source is cleaned up, as with water pollution, acid rain, or sulfur dioxide emissions. H ere, reducing emissions today is very valuable to humanity in the distant future. Second, the scale of the externality is truly global; greenh ouse gases travel around the world in a few days. This means that the n ation-s tate and its subsidiaries, the typical loci for internalization of externalities, are limited in their remedial ability. (To be sure, there are other transboundary environmental externalities, as with water pollution in the Rhine Valley or acid rain, but none is nearly so f ar-fl ung as climate change.) However, because the United States contributes about 25 percent of the world’s CO2 emissions, its own policy could make a large difference.
Thus, global climate change is a public good (bad) par excellence. Benefi t- cost analysis is a principal tool for deciding whether altering this public good through mitigation policy is warranted. Economic analysis can also help identify the most effi cient policy instruments for mitigation, but I leave that to other essays in this issue.
Two aspects of the benefi t- cost calculation are critical. One is allowance for uncertainty (and related behavioral effects refl ecting risk aversion). To explain economic choices such as insurance or the holding of inventories, it has to be assumed that individuals prefer to avoid risk. That is, an uncertain outcome is worth less than the average of the outcomes. As has already been indicated, the possible outcomes of global warming in the absence of mitigation are very uncertain, though surely they are bad. The uncertain losses should be evaluated as being equivalent to a single loss that is greater than the expected loss.
The other critical aspect is how one treats future outcomes relative to current ones. The issue of futurity has aroused much attention among phil oso p hers as well as economists. At what rate should future i mpacts—in part icu l ar, losses of future c onsumption—be discounted to the present? The consumption discount rate, d, can be expressed by the following simple formula:
d = ? + g?
where ? is the social rate of time preference, g is the projected growth rate of average consumption, and ? is the elasticity of the social weight attributed to a change in consumption.
The pa ram e ter ? in the second term accounts for the possibility that, as consumption grows, the marginal unit of consumption may be considered as having less social value. It is analogous to the idea of diminishing marginal private utility of private consumption. This component of the consumption rate of discount is relatively uncontroversial, although researchers disagree on its magnitude. The appropriate value to assign to ? is disputed, but a value of 2 or 3 seems reasonable (the Stern report uses 1, but this level does not seem compatible with other evidence).
Greater disagreement surrounds the appropriate value for ?, the social rate of time preference. This pa ram e ter allows for discounting the future simply because it is the future, even if future generations were to be no better off than we are. The Stern report follows a considerable tradition among British economists and many phi los o phers against discounting for pure futurity. Most economists take pure time preference as obvious. Tjalling Koopmans pointed out in effect that the savings rates implied by zero time preference are very much higher than those we observe. (I am myself convinced by this argument.)
Many have complained about the Stern report adopting a value of zero for ?, the social rate of time preference. However, I fi nd that the case for intervention to keep CO2 levels within bounds (say, aiming to stabilize them at about 550 ppm) is suffi ciently strong as to be insensitive to the arguments about ?. To establish this point, I draw on some numbers from the Stern report concerning future benefi ts from keeping greenh ouse gas concentrations from exceeding 550 ppm, as well as the costs of accomplishing this.
The benefi ts from mitigation of green house gases are the avoided damages. The report provides a comprehensive view of these damages, including both market damages as well as nonmarket damages that account for health impacts and various ecological impacts. The damages are presented in several scenarios, but I consider the s oc alled h igh-c limate scenario to be the b est-b ased. Figure 6-5 c of the report shows the increasing damages of climate change on a b usiness as- usual policy. By the year 2200, the losses in gross national product (GNP) have an expected value of 13.8 percent of what GNP would be otherwise, with a .05 percentile of about 3 percent and a .95 percentile of about 34 percent. With this degree of uncertainty, the loss should be equivalent to a certain loss of about 20 percent. The base rate of growth of the economy (before calculating the climate change effect) was taken to be 1.3 percent per year; a loss of 20 percent in the year 2200 amounts to reducing the growth rate to 1.2 percent per year. In other words, the benefi t from mitigating greenh ouse gas emissions can be represented as the increase in the growth rate from today to 2200 from 1.2 percent per year to 1.3 percent per year.
We have to compare this benefi t with the cost of stabilization. Estimates given in table 10.1 of the Stern report range from 3.4 percent down to 3.9 percent of GNP. (Since energy saving reduces energy costs, this last estimate is not as startling as it sounds.) Let me assume then that costs to prevent additional accumulation of CO2 (and equivalents) come to 1 percent of GNP every year forever.
Finally, I assume, in accordance with a fair amount of empirical evidence, that ?, the component of the discount rate attributable to the declining marginal utility of consumption, is equal to 2. I then examine whether the present value of benefi ts (from the increase in the GDP growth rate from 1.2 percent to 1.3 percent) exceeds the present value of the costs (from the 1 percent permanent reduction in the level of the GDP time profi le). A straightforward calculation shows that mitigation is better than business as u sual—that is, the present value of the benefi ts exceeds the present value of the costs— for any social rate of time preference (?) less than 8.5 percent. No estimate for the pure rate of time preference, even by those who believe in relatively strong discounting of the future, has ever approached 8.5 percent.
These calculations indicate that, even with higher discounting, the Stern report’s estimates of future benefi ts and costs imply that current mitigation passes a b enefi t- cost test. Note that these calculations rely on the Stern report’s projected time profi les for benefi ts and its estimate of annual costs. Much disagreement surrounds these estimates, and further sensitivity analysis is called for. Still, I believe there can be little serious argument over the importance of a policy of avoiding major further increases in combustion by- products.
REFERENCES AND FURTHER READING
Stern, Nicholas. 2006. The Economics of Climate Change. h ttp://w ww. hm- treasury. gov. uk/I ndependent_ Reviews/s tern_ review_ economics_ climate_ change/s ternreview_ index. cfm.