What is Environmental Economics? Explained


  1. Introduction
  2. Fundamentals Of Neo Classical Economics
  3. Birth Of Environmental Economics
  4. Analytical Approach Followed In Environmental Economics
  5. Internalizing The Externalities
  6. Conclusion


Over the past 60 years, three specialized, separate, yet related fields have emerged from the mainstream of economic theory. The three are (i) ecological economics; (ii) natural resource economics; and (iii) environmental economics. Environmental Economics first appeared in the 1960s, but Natural Resource Economics first appeared in the 1950s with the founding of Resources for Future (RFF) in 1952. By the late 1980s, ecological economics had become more concrete. All of these sub-branches were founded on the fundamental tenet that the dominant neo-classical model of a market-based allocation system was unable to take into account the environmental constraints that were becoming more and more obvious all over the world.

Although the initial impetus for the emergence of these three specialized branches of economics emerged from concerns about unrestrained consumption of nature and her resources, each of their approaches has been distinctively different. We'll describe these distinctions now. Since natural resources are produced by nature and their availability is governed by their natural rate of growth, natural resource economics is particularly concerned with the unrestricted use of these resources, which are shared among their users but have a limited supply. Forestry, fisheries, mineral resources, and others are a few examples of these. They are able to be distributed at the margin, though, due to their divisibility. Additionally, natural resources contribute to the dynamics of the economic system by being used as inputs in the production process. On the other hand, environmental economics deals with resources that cannot be shared among users in terms of consumption. Environmental resources include things like air and water bodies, such as rivers and the ocean. Environmental resources are affected by the economic system's activities, such as pollution, unlike natural resources, which are used as inputs. By bringing economists and ecologists together to study the connections between socio-economic and ecological systems, the field of ecological economics—which is still relatively new—was intended to advance knowledge. "Ecological economists are willing to explicitly consider ethical and philosophical issues, such as intergenerational and intragenerational equity, and even, in some cases, to acknowledge non-human values. " (Beder 2011, p. 146).

Here we need to make a point. Natural Resource Economics and Environmental Economics have adapted to the core principles of neo-classical economics, despite the fact that all of these branches were created to address some of the shortcomings of the neo-classical model. Ecological Economics is frequently accused of being heavily influenced by the fundamental philosophies of mainstream economic ideas focused on the concept of markets, despite claims that it is an attempt to integrate economics and ecology and thus a departure from neo-classical economics.

Fundamentals Of Neo Classical Economics

A perfectly competitive market exists for each good produced and traded in it, which defines the fundamental structure of neoclassical economics. Such perfectively competitive markets make up a market system. When every market is perfectly competitive, economic progress and efficiency are maximized. However, a few suppositions must be made in order for a perfectly competitive market to exist. They are:
  • Existence of a complete set of perfect markets: All goods and services exchanged through a market system should be exchanged individually through a competitive market. The efficiency argument in favour of a market system will be nullified in case market does not either exist even for a product (service) or operates inefficiently (in a sense of being imperfect). 
  • Rationality: Every participant in a market, either as a producer or as a consumer, wants to maximize her objective – satisfaction while consuming and profit while producing. This is possible, because everyone prefers more of satisfaction or profit to less and none is satisfied with what is available. 
  • Perfect knowledge: Both the producer and consumer have perfect knowledge while they make an economic decision. Each of them not only knows prices of all goods and services procured from market, but also everything about their qualitative features. Further, they are aware of the behavior of other buyers and sellers operating in the market. They also know about the steps to be taken by the government. So there is no risk or uncertainty about future and the predictions about future outcome made by them are absolutely on spot. 
  • Property rights: Property right on the product or service exchanged through a market is well defined and such a right shifts from the seller to the buyer immediately and in a costless manner as and when the exchange happens in a market. 
  • Diminishing returns: Marginal satisfaction from an increased unit of a good or a service goes down gradually as its consumption level increases. 
  • Equality of sale and purchases: This condition is necessary to ensure equilibrium. In case of a seller running with an inventory, they are considered to have been sold or not to have been produced. To ensure such equality, it is also assumed that transactions are instantaneous and costless. 
  • Unique equilibrium: Equilibrium is reached when both the buyer and the seller are satisfied with maximized objectives – satisfaction for the buyer and profit for the seller. Convexity in the choice and production sets ensures that the equilibrium is unique with no possibilities of multiple equilibrium. 
  • Many participants, with freedom to enter and leave the market: to ensure an optimal equilibrium, it is imperative that neither the buyer nor the seller dominate the market process and influence the price. This assumption takes care of such a requirement. Else the market outcome may turn out to be an inefficient equilibrium. 
  • Independence of demand and supply: Buyers’ behavior is distinct from that of sellers, so that the act of buying does not affect selling, and vice versa. They interact only through the mechanism of the market. 
  • Only “goods” are exchanged: All goods and services produced and sold give positive utility to consumers and hence positive profit to the producers. There is no possibility of production of “bads” that has the potential to yield negative utility to buyers if consumed. 
  • And finally, no externality: Externality refers to a situation where the act of exchange between a buyer and a seller does not affect the wellbeing or interest of a third individual. This condition is ensured by the assumption that all consumers are identical in terms of their choice pattern and so also are all the sellers in terms of their production behaviour. Further, one’s economic activity does not affect that of another. Externality may thus be considered a consequence of an economic activity which affects other parties without this being reflected in market prices.

Birth Of Environmental Economics

A lot of these presumptions that are required to support the market-centric arguments for efficiency are sometimes found to be unfeasible in the context of environmental resources, which is why environmental economics is a more recent field of study. Take a second look at a few of the presumptions.
  • Existence of a complete set of perfect markets: Markets do not exist for many of the effluents generated out of a production process and thrown into air, land or water as pollutants. So their economic prices are indeterminate. 
  • Perfect knowledge: Neither the producer nor the consumer have perfect knowledge about the implications and impact of the pollutants. So they may not decide on their optimum choice.
  • Property rights: Property right on these effluents are difficult to be defined unambiguously.
  • Diminishing returns: This assumption may not be effective for a product – in fact, pollution -- that gives negative satisfaction on consumption. 
  • Equality of sale and purchases: Environmental economics is concerned with products that have producers but no willing purchasers. 
  • Unique equilibrium: Production set of environmental pollutants may be non-convex leading to possibilities of multiple equilibrium. 
  • Many participants, with freedom to enter and leave the market: the producers dominate the exchange process as no market exists for environmental pollutants. 
  • There is only possibility of production of “bads” that has the potential to yield negative utility to buyers if consumed. 
  • Environmental goods, being indivisible in consumption, are often subject to externalities.

Analytical Approach Followed In Environmental Economics

Environmental Economics is a distinct field of study that was born out of the realization that many of the fundamental assumptions of neoclassical economics do not appear to apply to environmental goods. As we shall see, the analytical approach to this new field of knowledge has mainly focused on introducing concepts to make environmental goods amenable to the fundamental assumptions of the neo-classical market driven paradigm so that rigorous analytical models to address problems relating to environmental goods can be meaningfully developed. The focus has been on developing virtual markets for environmental goods, on the one hand, to address the problem of their efficient pricing, and, on the other hand, identifying the sources of market failure in resource allocation between different uses and developing policies to allow the government to intervene to "correct" the market failure. These three steps make up the effort.

Make environmental goods distributable to those willing to pay reasonable (equilibrating) prices to use them. This is the first step. To put it another way, develop a market for a particular environmental good, build supply and demand curves, and then let them interact to determine the equilibrium price and equilibrium amount to be supplied.

Step 2: Establish the appropriate level of environmental protection using techniques for valuing various environmental goods. Typically, these valuation techniques build fictitious or revealed demand curves for environmental goods and compare them to the cost of supply, which is made up of the opportunity cost of the resource in question and the costs associated with protecting it. There are various valuation techniques. Hedonic pricing, the contingent valuation method, and the travel cost method are a few of these commonly used techniques. For concise summaries of these techniques, see the Boxes below.

Step 3: Choose the best level of environmental protection and find the most effective way to implement it. The final step involves identifying the measures necessary to achieve the desired level of environmental protection after the most effective level of protection has been determined using theory and methods. The creation of a strong environmental policy paves the way for the accomplishment of such protection-related goals. It was argued that internalizing environmental externalities in a market where they are generated was the best way to achieve the desired level of environmental protection. Based on the equilibrium price determined through analysis of a virtual market created through various evaluation methods developed in the literature, such internalization can be accomplished either by taxing those who engage in environmental damage or by funding efforts to improve environmental quality. As an alternative, "real" markets for environmental products and services could be established.

Internalizing The Externalities

Creating a theoretical framework that aids in the internalization of the externalities produced by market failure is, as we can see, the fundamental focus of environmental economics. As a reminder, externalities are considered to exist when an economic agent's actions have external effects on other agents by changing prices. BOX: 3 -- HEDONIC PRICING The hedonic pricing method is used to estimate economic values for ecosystem or environmental services that directly influence market prices. The variations in housing costs that take into account the value of regional environmental attributes are where it is most frequently used. Environmental amenities like aesthetically pleasing views or close proximity to recreational areas can be used to estimate the economic benefits or costs associated with: environmental quality, including air pollution, water pollution, or noise environmental amenities. The basic tenet of the hedonic pricing method is that the cost of a marketed good is correlated with its features or the services it offers. For instance, a car's price reflects its features, such as its ability to transport people, their belongings, and their comfort and luxury as well as its fuel efficiency. Thus, by examining how the price people are willing to pay for a car or other good changes when the characteristics change, we can value the individual attributes of a given good. Environmental amenities that influence the cost of residential properties are most frequently valued using the hedonic pricing method. A CASE: For the Estuary and surrounding land areas, the Peconic Estuary Program is considering a number of management options. A hedonic valuation study was carried out using 1996 housing transactions in order to evaluate some of the values that might result from these management actions. The Analysis The study discovered that the following factors, which are important for local environmental management, had a significant impact on Southold's property values: Open Space: Properties next to open space had an average per-acre value that was 120.8 percent higher than comparable properties elsewhere. Farmland: The average per-acre value of properties next to farms was 13.3 percent lower. With greater distance from farmland, property values slightly increased. Major Roads: The average value of a property per acre was 16 points 2 percent lower when it was located within 20 meters of a major road. Zoning: The average per-acre value of properties in areas with two- or three-acre zoning was 16 point 7 percent higher. Wetlands: The average per-acre value increased by.3% for every percentage point increase in the percentage of a parcel classified as a wetland. The findings Based on the study's findings, managers could, for instance, determine the benefit of preserving a piece of open space by calculating the effects on the values of the nearby properties. In a fictitious straightforward case, it was determined that the value of preserving a 10 acre parcel of open space that was surrounded by 15 "average" homes was $410,907. These external effects are not taken into account. These externalities are subsequently internalized if the resulting consequences are eliminated, the individuals affected are compensated for their suffering, or even a combination of both. A graphic explanation of externalities and potential solutions to internalize them in addressing environmental issues can be found in the Box below.

The existing literature on externalities identifies three potential causes for the development of externalities in relation to environmental goods and services and the corresponding corrective actions.
  • Incorrect prices and possible ways to adjust them by using taxes or subsidies, pollution cess on automobiles or fuel surcharge are examples of taxes, while subsidies to locals through developmental support for protecting forests are some such examples. 
  • Missing markets and possible solution in creating a market for pollution, use of tradable permits for carbon emission, fishing efforts are some such examples. 
  • Imperfect property rights which may be rectified through defining unambiguous property rights, like Forest Rights Act, in India or increasing demands for community management of environmental resources.


According to what we discovered, environmental economics is a market-based approach to finding solutions to their excessive use as a sink of wastes. The primary strategy of this specialized branch is to address the absence of markets by developing market or market-like structures to facilitate the exchange of environmental goods and services. The state must effectively intervene by incorporating the necessary public policy tools in order to address "market failures" as they may creep in. Creating appropriate, clear, and effective property rights structures around such environmental goods and services is another fundamental requirement that must be met in order for them to be capable of being traded in a manner that responds to price incentives.


  • Beder, S. (2011). Environmental economics and ecological economics: the contribution of interdisciplinarity to understanding, influence and effectiveness.Environmental conservation, 38(02), 140-150. 
  • Bhattacharya, R.N. eds. (2001): Environmental Economics: An Indian Perspective: Oxford University Press: New Delhi, India
  • Dasgupta, P., & Mäler, K. G. (1999). Net national product and social well-being.The Beijer Institute Of Ecological Economics-The Royal Swedish Academy of Sciences. Paper, (125).


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